I. Effective Date Extended
The much anticipated guidance on Internal Revenue Code Section 409A (pursuant to the American Jobs Creation Act of 2004 - AJCA) was released on September 29, 2005. The deadline for bringing plans into compliance with the new rules has been extended to December 31, 2006. Also, the deadline for making new distribution elections for existing account balances without having to comply with the change in election limitations has been extended to December 31, 2006. This is intended to give plan sponsors more time to restructure their plans in light of the new limitations and restructuring opportunities created by the new legislation. In order to comply with Section 409A, deferred compensation arrangements must be in writing on or before December 31, 2006.
The proposed regulations reiterate that “good faith” compliance with AJCA is currently required with respect to all amounts accrued, deferred or vested under a nonqualified deferred compensation plan after December 31, 2004, as well as to previously credited amounts under plans which are “materially modified” after October 3, 2004.
The December 31, 2005 deadline has not been extended for cancellation of deferral elections or termination of participation in a plan. Thus, plans may provide participants with a right to terminate participation in the plan only this year and must be amended on or before December 31, 2005. The proposed regulations clarify that offering an election to participants to terminate participation in a grandfathered plan is a material modification which requires amounts not distributed to comply with 409A. Thus, employers should consider carefully whether they want to terminate grandfathered plans or offer participants an election to terminate participation prior to the end of the year.
Also, no extensions have been provided with respect to initial deferral elections. Thus, compensation for services performed in 2006 must be deferred prior to December 31, 2005 unless such compensation meets the definition of “performance based compensation” which may be deferred up to 6 months prior to the end of the performance period.
Grandfathered amounts include earnings and appreciation in vested stock due solely to the passage of time. Equity rights are grandfathered to the extent the right was either immediately exercisable for payment in cash or vested property or was not forfeitable on December 31, 2004. Grandfathered amounts do not appear to include increases in earning attributable to services rendered after December 31, 2004 and thus may not include rate enhancements based on additional years of service.
II. Arrangements Covered
The regulations provide additional guidance on the types of arrangements covered by Section 409A. The new rules apply broadly to any arrangement giving a service provider a “legally binding right” to the payment of compensation in the future, excluding various specified types of qualified plans. The rules apply to directors and independent contractors as well as employees. However, they do not cover unrelated independent contractors (other than directors) who provide the same type of services to more than one employer.
Short Term Deferrals
Importantly, Section 409A excludes from coverage “short term deferrals” payable within 2½ months after the end of the later of the employee’s or the employer’s tax year in which compensation is no longer subject to a substantial risk of forfeiture. This provision should allow many types of compensation arrangements to avoid the application of Section 409A.
Section 409A does apply to severance benefits but the regulations carve out involuntary and window severance plans if they are limited to 2 times final compensation paid in 2 years. Exemption does not count constructive/good reason terminations as involuntary. Thus, many employment agreements with typical severance provisions may be treated as providing for deferred compensation and will need to be brought into compliance with the new rules before the end of next year. Note that existing employment agreements will not generally be grandfathered due to the fact that severance benefits do not vest until termination of employment. Also, the proposed regulations' position, that voluntary severance is the same as deferred compensation, may have a negative impact on severance plans sponsored by tax-exempt organizations subject to Section 457.
The new rules exclude undiscounted stock options and SARs (Stock Appreciation Rights) even if not publicly traded and include guidance on valuation of stock. Publicly traded stock may be valued based on the last sale before or first sale after the grant, the closing price the trading day before or day after the grant, or any other reasonable method, and may apply an average over a pre-established valuation period extending not more than 30 days before and 30 days after the grant date. The regulations also establish a number of factors to be taken into account and presumptions with respect to valuation of non-public stock. The regulations do not yet address the application to partnerships except to say that similar rules will apply.
Split dollar life insurance arrangements are treated as deferred compensation in specified circumstances such as i) endorsement arrangements where the employee has a right to get the policy, ii) irrevocable endorsement arrangements, or iii) collateral assignment loan arrangements including a promise of loan forgiveness.
III. Timing of Deferral Elections
The proposed regulations clarify that while deferral elections must be made on a calendar year basis for salary deferrals, plans may allow deferrals prior to the beginning of the employer’s fiscal year for payments such as bonuses which are paid on a fiscal year basis. There is an exception for “performance based compensation” which may be deferred up to 6 months prior to the end of the performance period. Commissions compensation must be deferred in the year prior to the year in which the customer renders payment. Evergreen elections which allow a participant’s prior year's election to be carried over to future years unless the participant elects a change are specifically allowed under the proposed regulations.
A participant entering a plan for the first time who does not already participate in any other employer plan of the same type may make a deferral election within 30 days of commencing participation in the plan to defer amounts attributable to services performed after the date of the election. The regulations suggest that the participant be allowed to defer a percentage of bonus compensation based on the ratio of days remaining in the bonus period after the election over the total days in the bonus period.
IV. Distribution Alternatives
The proposed regulations flexibly apply the AJCA distribution limitations which allow distributions on only one of 6 events: death, disability, termination of service, financial hardship, change in control or a specified date. The regulations provide that the plan may allow distributions to be triggered by multiple distribution events which may supersede each other. Thus, the plan may provide for payment on the earlier of specified date or termination of service and allow different distribution form elections for each.
A specified date may be any date which may be objectively determined at the time amounts are no longer subject to a substantial risk of forfeiture. The plan may specify a year of distribution without specifying the particular date within that year.
Termination of Employment
Termination of employment may not include leaves of absence in excess of 6 months unless reemployment is required after a longer period by law or contract. The regulations specify that continuation based on consulting services to avoid a termination of employment trigger must be at least 20% time actually worked for at least 20% of prior pay. To trigger a termination of employment, continued services may not be more than 50% time for 50% of prior pay. The regulations do not incorporate same desk rule applicable under qualified plans.
The regulations specify that it is permissible to require discontinuation of deferrals on hardship distribution and to discontinue deferrals if required to obtain hardship distribution under 401(k) plan.
Change in Control
The definition of Change in Control essentially follows the prior guidance.
Coordination with Qualified Plans
The proposed regulations confirm that distribution elections under nonqualified make up plans may not be tied to the form of benefit distribution under a qualified plan. However, the proposed regulations clarify that changes in qualified plan benefits will not generally cause 409A violations for nonqualified plans even though they affect calculation of nonqualified plan benefits. Changes in 401(k) deferral elections or matching provisions will not cause violations of 409A as long as they do not result in an increase in the amounts deferred or contributed to all nonqualified plans in excess of the 402(g) limit.
V. Changes in Distribution Elections
The proposed regulations flexibly interpret the AJCA limitations on changes in distribution elections. AJCA provides that distribution may not be accelerated and may only be delayed if i) the election does not take effect for 12 months, ii) elections regarding distributions on a specified date, separation from service or change in control delay the payment by at least 5 years, and iii) elections regarding distributions on a specified date be made no less than 12 months prior to the previously scheduled distribution date. Over the last year, there has been much confusion and speculation regarding how these provisions would be applied to different payment structures and whether changes must apply to all distributions under a plan or may apply separately to individual payments or dollar amounts. The proposed regulations clarify that each separately identified distribution may be treated as a “separate payment” for purposes of applying the timing of election changes and the delay requirement unless the plan indicates otherwise.
Thus, plans may separately define payments to allow separate application of change rules to each payment or installment or may define installment payment as one payment and require application of change rules to the entire payment schedule. For example, the plan may either i) define a 5 year installment payment as separate payments and defer each payment separately 12 months before each and must delay each by at least 5 years; or ii) define the 5 installments as one payment stream and 12 months before the first payment may delay the entire amount to a lump sum payment in 5 years. The exception is a life annuity which is always treated as a single payment election. The regulations allow participants to change between actuarially equivalent single and joint life annuities at any time before the first payment is made without a delay in commencement.
Also, the proposed regulations provide that the change rules apply to separate distribution events separately. For example, if the plan provides for distribution on the earlier of a specified date or termination of employment, the participant may change his distribution election with respect to the specified date by delaying commencement by at least 5 years and not affect the termination distribution trigger – that is, it will be fine to pay benefits on termination prior to the end of the 5 year delay period.
VI. Plan Terminations
The proposed regulations confirm that employers may not accelerate distributions upon plan terminations except in limited contexts: i) during 12 months following a change in control, ii) liquidation or bankruptcy, or iii) termination of all participants in entire class of plans (e.g. all defined benefit plans) and distribute all benefits no less than 12 months and no more than 24 months following termination and do not adopt another plan for 5 years. The proposed regulations do provide additional flexibility with respect to delays in distributions based on disputes, securities limitations, 162(m) limitations and violation of loan covenants. They also allow for accelerations to cover taxes due on vesting under Section 457(f) or in the event amounts are deemed to be included in income under Section 409A.
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.