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Proposed nonqualified deferred compensation regulations under Section 409A were released September 29th extending the deadline for bringing plans into compliance with the new legislation to December 31, 2006. Nevertheless, the new rules are subject to good faith compliance at this time and apply to many arrangements not typically thought of as deferred compensation.
The American Jobs Creation Act of 2004 creates a new section in the Internal Revenue Code that specifically deals with deferred compensation plans. This Section, 409(A), applies to any "plan," "agreement," or "arrangement" that provides for deferral of compensation, other than tax-qualified plans and tax-deferred annuities, IRAs, SEPs, SIMPLEs, 457(b) plans, and plans providing for vacation, sick leave, disability, compensatory time, and death payments. Section 409A is not limited to elective non-qualified deferred compensation arrangements but applies to supplemental nonselective pensions (SERPs), severance and split dollar life insurance as well as many other types of arrangements.
Credit unions have historically been treated as tax-exempt entities subject to special deferred compensation rules under Section 457. While there is some indication that federally chartered credit unions may be treated as federal instrumentalities not subject to the provisions of Section 457, most existing plans continue to meet the requirements of Section 457 pending clear resolution of this issue. The Internal Revenue Service recently authorized federal credit unions to continue eligible Section 457(b) plans until further notice.
Section 457(b) plans essentially allow tax-exempt organizations to create an additional layer of Section 401(k)-like deferral on top of a qualified plan. However, because contributions under a Section 457(b) plan are limited, tax-exempt employers generally provide additional or supplemental retirement benefits under what is often called a Section 457(f) plan. Under Section 457(f), benefits are taxable at contribution or vesting, whichever is later. Thus, Section 457(f) plans typically provide for employer contributions rather than voluntary deferrals and pay benefits in a single lump sum on a specified distribution date.
The most significant provision of the new Section 409A rules addresses the timing of deferral and distribution elections. Because Section 457(f) plans generally do not involve voluntary deferrals of compensation, credit unions will not need to worry about the new timing of deferral election rules. Also, because 457(f) plans generally cliff vest (i.e. vest all at once on the retirement date) benefits on retirement and do not offer any choices regarding the time and form of distribution nor opportunity to accelerate distributions, except on death or disability, the new rules limiting forms of distribution, acceleration and changes in distributions should not greatly affect Section 457(f) plans.
However, new Section 457(f) plans might be designed to take advantage of the new Section 409A rules with respect to changes in timing of scheduled date distributions. The new rules provide that a plan may permit participants to change distribution elections to further delay a payment or change the form of a payment, as long as (1) the election does not take effect until at least 12 months after the date on which the election is made, (2) if the election relates to a distribution to be made on separation from service, a specified time or a change of control, then the payment with respect to which the election is made must be deferred for a period of at least 5 years from the date the payment would have otherwise been made and (3) if the election relates to a specified time, then it must be made at least 12 months before the date of the first scheduled payment. The proposed regulations provide that accelerated distributions necessary to pay income taxes due to vesting in a Section 457(f) plan will be allowed.
Thus, a Section 457(f) plan might be designed to allow participants who want to delay their retirement to make an election at least one year prior to the scheduled vesting and distribution date to receive only enough of the distribution to pay the taxes due as a result of the benefit vesting and to delay receipt (but not vesting) of the balance of the benefits for a period of at least five years. Thereafter, the plan might provide that the vested balance will continue to earn interest and may even provide for additional employer contributions or accruals during the additional deferral period. Such additional contributions should not vest until the new deferred distribution date in order to avoid additional acceleration of taxes during the additional deferral period.
The proposed regulations include a much more expansive definition of substantial risk of forfeiture which can be expected to influence the interpretation of this term under Section 457(f) in the future. For example, the proposed regulations ignore any extension or delay in a risk of forfeiture whether at the discretion of the employee, employer or both. Thus, plans that allow employee or employer to roll or delay vesting under any circumstances should be carefully reviewed. The proposed regulations also provide that a noncompete requirement will not be treated as a substantial risk of forfeiture.
Another type of arrangement often provided by tax-exempt organizations which is subject to new Section 409A is a severance arrangement. The proposed regulations exempt from the application of the new rules involuntary or window severance arrangement if the severance does not exceed twice the final compensation and is paid out within 2 years following termination. However, the term involuntary termination does not include constructive termination, termination for good reason or termination after a change of control. Thus, many severance arrangements or provisions in employment contracts will be subject to the new rules and may also be treated as deferred compensation under Section 457. The regulations state that severance payable on voluntary termination is deferred compensation. If this principle is applied under Section 457, severance agreements that pay severance benefits on voluntary termination of employment may result in severance benefits being currently taxable. Because severance benefits do not vest until termination and are generally based on changing levels of compensation, an existing arrangement will not be grandfathered under Section 409A and no grandfathering rules apply to changing interpretations under Section 457(f). Thus, it will be very important to carefully review all severance arrangements prior to December 31, 2006.
Although the changes that will have to be made to Section 457(f) plans may not be substantial absent creative restructuring of distribution alternatives, the new rules will require certain definitional changes such as the definition of disability under the plan and may also require amendment of termination provisions which allow employers to liquidate the plan. Also, the new rules may apply to severance plans or split dollar plans sponsored by tax-exempt employers. Therefore, it is important that employers have all of their executive compensation arrangements reviewed for compliance with the new rules.
This client alert is a publication of Loeb & Loeb and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations. If you have further questions or would like us to review your plan for compliance with the new rules or to evaluate the alternatives for restructuring please contact Marla Aspinwall at (310) 282-2377.
Circular 230 Disclosure: To assure compliance with Treasury Department rules governing tax practice, we inform you that any advice (including in any attachment) (1) was not written and is not intended to be used, and cannot be used, for the purpose of avoiding any federal tax penalty that may be imposed on the taxpayer, and (2) may not be used in connection with promoting, marketing or recommending to another person any transaction or matter addressed herein.