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New Tax Law Makes Significant Changes to Deferred Compensation Rules

Client Advisory

October 29, 2004
by Jerome Cohen

On October 22, 2004, President Bush signed into law H.R. 4520, known as the American Jobs Creation Act of 2004 (the “Act”).  The Act adds  to the Internal Revenue Code new section 409A, the provisions of which make fundamental changes in the requirements that must be met in order for deferrals of compensation under nonqualified deferred compensation plans to avoid being subject to current tax for federal income tax purposes. Section 409A also places new restrictions on the circumstances under which deferred compensation may be funded through a “rabbi trust”.  A plan’s failure to comply with these new deferral and funding rules not only will result in current taxation of the amounts deferred under the plan; new interest and penalty provisions will apply as well.

The new rules generally are effective for compensation deferred after December 31, 2004. They do not change the basic “constructive receipt” and “economic benefit” principles which have governed the taxation of deferred compensation in the past. Their major thrust is merely to end certain plan designs and practices that, in light of the Enron and other recent corporate scandals, were viewed as having pushed those principles beyond their intended limits. Deferred compensation plans remain viable tax-effective programs. However, the new rules will substantially limit the flexibility executives previously had in terms of controlling the timing of their distributions from these plans. Virtually all  nonqualified deferred compensation arrangements currently in effect will have to be amended  to bring them into compliance with section 409A’s new requirements.

Set out below is a discussion of these new rules, and their impact on companies’ existing deferred compensation arrangements.

1.         Covered Plans

The new rules apply to deferrals of compensation under a “nonqualified deferred compensation plan”.  This is defined to include any “plan” other than (a) a “qualified employer plan”[1] and (b) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.  The term “plan” is broadly defined to include any arrangement or agreement providing for the deferral of compensation for services performed, including an arrangement or agreement involving only one person.  It would thus include deferral arrangements provided under employment contracts or other agreements with individual employees.  It would also include arrangements for the deferral of compensation payable to persons who are not employees, such as a company’s outside directors and those providing services to the company as independent contractors or consultants. The new rules generally will apply to all forms of deferred compensation, whether payable in cash, or in stock, or in units of “phantom” stock; and they will apply to both elective deferral arrangements, as well as to non-elective arrangements, such as supplemental executive retirement plans (“SERPs”).  However, the Conference Report for the Act[2] indicates that the following will not be treated as involving deferrals of compensation subject to the new rules:  annual bonuses or other compensation  paid within 2-1/2 months after the close of the year in which the services required for payment have been performed; options granted under employee stock purchase plans meeting the requirements of Code section 423; incentive stock options that meet the requirements of Code section 422; and nonqualified stock options with exercise prices at least equal to the market value of the stock at grant date.[3] The Conference Report leaves it to the Treasury Department to determine, in regulations issued by it, whether stock appreciation rights (“SARs”) will be treated as subject to the new deferral rules.  Neither section 409A nor the Conference Report addresses whether grants of restricted stock will be treated as involving a deferral of compensation.  However, our view is that restricted stock grants should not be so treated as long as the restrictions lapse, and the employee is taxable on the value of the shares, upon the employee’s completion of the period of service specified in the terms of the original grant.

2.         The New Deferral Rules

Set forth below are the requirements that must be met in order for deferrals not to be subject to current tax under the new rules.  These requirements not only must be reflected in the plan or other documents evidencing the deferral arrangement; they must be complied with, as well, in terms of actual operations. (a)  Initial Deferral Election.  An election to defer compensation for services performed during a participant’s tax year generally must be made no later than by the close of his preceding tax year.  There are two exceptions:
  •  A newly eligible plan participant is given 30 days after he first becomes eligible to make the election.
  • In the case of “performance-based compensation” based on services performed over a period of at least 12 months, the participant’s deferral election may be made no later than 6 months before the end of the service period.
Regulations to be issued under section 409A will define the term “performance-based compensation”.[4]  They will also provide guidance as to when an initial deferral election for other types of compensation must be made where (as almost always will be the case) the participant’s tax year is a calendar year but the plan operates on the basis of the employer’s fiscal year which is not a calendar year. (b)  Permissible Distributions Amounts deferred under a plan may only be paid out to a participant in one or more of the following circumstances:
  • Upon the participant’s “separation from service”, as determined under the regulations to be issued under Section 409A.[5]  However, in the case of a participant who is a “key employee” (as defined in section 416(i) of the Code)[6] of a corporation whose stock is publicly traded, payment on account of the participant’s separation from service (other than as a result of death or disability) cannot be made until after the expiration of a period of at least 6 months from the date of the participant’s separation from service.
  • Upon the participant’s death, or upon the participant becoming “disabled” as defined in section 409A.
  • Upon the occurrence of an “unforeseen emergency” as defined in section 409A.
  • Upon the occurrence of a change in control of the participant’s employer, to the extent provided in regulations to be issued under section 409A.
  • At a time, or at times determined pursuant to a fixed payment schedule, specified under the terms of the plan at the date of the participant’s initial election to defer the  amounts that are to be distributed, or as specified by the participant in an election made at the time of his initial deferral election.[7]
A plan may not permit distribution of deferred amounts upon the occurrence of any event other than one of the events described above.  In addition, a plan must not allow any distribution to be accelerated, that is, it cannot allow payment with respect to a participant’s deferred amounts to be made any earlier than the time established for the payment of those amounts when the participant made his initial election to defer those amounts.  Several events that were often used as triggers for distributions in the past will not be permissible under the new distribution rules. Specifically, a plan may no longer allow, among other things:
  •  distributions to be made at any time upon a participant’s request, as long as the distribution is subject to a “haircut”, i.e., a penalty involving forfeiture of a portion (e.g. 10%) of the amount withdrawn.
  • distributions to be made to a participant upon the enrollment of his child in college, although the new rules would permit a participant to elect to have distribution made to him at a specified date which he anticipates will be the date when his child starts college.
  • distributions to be made to a participant upon the occurrence of a “financial health” trigger, i.e., the occurrence of some specified change in his employer’s financial condition (e.g. a decline in the employer’s net worth or stock price) that would indicate the imminence of the employer’s bankruptcy or insolvency.
(c)  Changes in the Time and Form of Distributions.  A plan may permit a participant to make a subsequent election to change the time and form of payment for his deferred amounts, as established at the time of his initial deferral of those amounts.  However, such an election may be made only to further defer the time of payment.  A subsequent election cannot be made to accelerate the time of payment, or to change the form of payment to one permitting payments to be made earlier than at the time or times originally established.  For example, a participant whose deferred amounts were originally payable in installments cannot subsequently elect to have them paid instead as a lump sum.

Moreover, an election to further defer payment will be  permitted only if these conditions are met:  (i) the election cannot be given effect until 12 months after the date on which it is made; (ii) an election related to a payment that is to be made at a specified date, or to one of a series of scheduled payments, must be made at least 12 months before the specified date, or before the date when the first of such payments is scheduled to be made; and (iii) except in the case of a distribution that is to be made on account of death, disability or an unforeseeable emergency, the additional deferral elected must be for a period of at least 5 years from the date on which the payment otherwise would have made.

(d)  Consequences of Failure to Comply with the New Deferral Rules.  If a plan fails to comply with the new deferral rules, the participants affected by the failure will have the following consequences:  (i) the amounts deferred by them in the year of the failure, as well as the amounts deferred by them under the plan in all prior years (and all earnings credited to their deferrals under the plan) will be includible in their gross income and subject to tax in the year of the failure or if later, in the year in which the deferred amounts become vested; (ii) interest at 1% above the usual “underpayment” rate will be imposed on the underpayment of tax attributable to the deferrals of these amounts; and (iii) a new “penalty” tax at the rate of 20% will be imposed on the deferred amounts (and plan earnings thereon) that are required to be included in gross income as a result of the failure, in addition to the regular income tax imposed on those amounts.

3.         The New Rabbi Trust Funding Rules.

The new rules still permit deferred compensation to be funded through a “rabbi trust” as long as the assets in the trust remain subject to the claims of the employer’s general creditors.  However, section 409A adds new funding requirements designed to prevent certain aggressive attempts that have been made in recent years to effectively shield the assets in these trusts from the claims of creditors. Under  section 409A, deferrals will become subject to current tax (or if not yet vested, subject to tax as soon as the deferrals do vest), to the extent that  trust assets  that fund the deferrals (i) are, or become, located outside of the U.S. and the result of their being located in a foreign jurisdiction is to effectively place them beyond the reach of the employer’s creditors, or (ii) are, or may become, restricted to the payment of the deferrals, and thereby cease being subject to the claims of the employer’s creditors, upon the occurrence of a “change in the employer’s financial health”, as defined in regulations to be issued under section 409A. Failure to meet section 409A’s new funding rules will result in imposition of the same interest and penalty provisions as described above in Section 2(d) , in addition to current taxation of the applicable deferred amounts.

4.         The New Tax Reporting Rules

Compensation deferred for each year beginning after December 31, 2004 must be reported to the IRS[8], even if those amounts are not required to be included in gross income currently under section 409A.[9] Deferred amounts which are taxable currently under section 409A must also be reported to the IRS, and if an employee’s deferrals are so taxable they will be subject to federal income tax withholding as well.

5.         Effect of the New Rules on Existing Plans

As indicated above, the new rules apply to compensation deferred after December 31, 2004. Under section 409A’s “grandfather provisions," deferrals before January 1, 2005 are exempt from the new rules if certain conditions are met.  Section 409A also allows plans a transition period for making the amendments needed to comply with the new rules with respect to compensation deferred after December 31, 2004.  Set out below is a summary of section 409A’s grandfather and transitional provisions, and some thoughts as to what steps companies should take regarding their deferred compensation programs before the end of 2004. (a)  Pre-2005 Deferrals.  Compensation deferred before January 1, 2005 and plan earnings credited thereon both before and after that date (“grandfathered amounts”) generally will not be subject to the new rules.  As a result, the provisions of existing plans relating to permissible distributions and subsequent elections to change the time and form of payment of deferrals may continue to apply to grandfathered amounts. However, in order to preserve their grandfathered status, it probably will be necessary in most cases for plans to be amended to provide separate accounts for grandfathered amounts and post-2004 deferrals, to permit post-2004 plan earnings to be credited separately to each, and to permit the plan’s existing and new distribution and change of  election rules to be separately applied to each.  Also, these additional points must be kept in mind:
  • The Conference Report indicates that compensation will be treated as having been deferred before January 1, 2005, for purposes of the grandfather provisions, only if the compensation has become fully earned and vested before that date.  If any additional services have to be performed after December 31, 2004, or if any other conditions have to be met after that date, in order for an employee to be entitled to payment, the deferral of that compensation will be subject to the new rules even if the employee made his election to defer that compensation before December 31, 2004.
  • A plan may continue to apply its pre-Act distribution and change of election provisions to grandfathered amounts only if those plan provisions comply with the law in effect prior to section 409A’s enactment.  The Conference Report states that no inferences may be drawn that a plan’s existing provisions are in compliance with pre-Act law.
  • Grandfathered amounts will lose their status as such, and will become subject to the new rules, if the plan is materially modified after October 3, 2004 with respect to amounts deferred before January 1, 2005.  The Conference Report states that a plan amendment that adds any benefit, right or feature that applies to grandfathered amounts, will be treated as a material modification.
(b)  Post-2004 Deferrals.  Although plans have to be amended to comply with the new rules with respect to compensation deferred in tax years beginning on or after January 1, 2005, these amendments do not have to be in place before the start of 2005. Within 60 days of section 409A’s enactment, regulations are to be issued providing further guidance as to some of the new deferral rules, and providing a limited transition period during which (i) plans can be amended to conform to the new requirements, and (ii) participants can cancel their outstanding elections to defer post-2004 compensation, if they wish to do so. We believe that companies should wait until these regulations are issued before attempting to amend their plans. However, companies whose deferred compensation plans operate on a calendar year basis should be prepared to take the following  actions before the end of 2004, unless regulations or other guidance issued before then make it clearly unnecessary to do so.
  • Their employees who want to defer their 2005 base pay, or their annual bonuses for 2005 that are not performance-based,  should be allowed to make elections to defer these amounts on or before December 31, 2004, to be sure that they will in fact be able to defer these amounts under the new rules. They should also be allowed to make elections, on or before December 31, 2004, as to the time and form of distributions for their 2005 deferrals, so that they can choose forms and times of payment (e.g. a lump sum payment) now that they may be precluded from choosing later via a subsequent change of election because of section 409A’s prohibition on acceleration of distributions.[10]
  • With respect to performance-based compensation that will be determined on the basis of achievement of goals over a performance period of at least 12 months that begins on January 1, 2005, these companies should allow their employees  (if their plans do not already do so) to make their election to defer these amounts any time up to 6 months before the end of the performance period; and they should advise their employees to wait to make these deferral elections until after regulations have been issued providing further guidance on the new section 409A rules.
  • These companies will have to notify  participants in their deferred compensation plans before the end of the year about the new rules under section 409A, the need for the plans to be amended to reflect the new rules, and the impact the new rules are likely to have on their continuing participation in these plans.
Questions regarding this advisory should be addressed to Howard J. Barnet (212-238-8608, barnet@clm.com) or Patricia Matzye (212-238-8730, matzye@clm.com)


Endnotes
[1] This term is defined in Section 409A(d)(1) to include pension, profit sharing, 401k plans and other plans that are tax qualified under Code section 401(a), 403(a) 408(k) and 408(p), as well as certain tax qualified retirement and deferred compensation arrangements of tax-exempt and governmental entities.

[2] H.Rept 108-755 (October 7, 2004)

[3] The Conference Report does not address whether nonqualified stock options that are “in the money” at the date of grant would be treated as including a deferral feature; but the implications are that it would be so treated.

[4] The Conference Report indicates that the definition of this term will include requirements similar to those that must be met under Code section 162(m) to avoid the $1 million limit on deductions for executive compensation.

[5] For this purpose, the “controlled group” rules of Code sections 414(b) and (c) will apply so that payment may not be made to a participant upon his transfer of employment from one entity in the controlled group to another.

[6] As so defined, “key employees” generally include officers with annual compensation greater than $130,000 (but limited to only 50 such employees), 5% owners, and 1% owners with annual compensation greater than $150,000.

[7] The Conference Report indicates that the form of payment, as well as the time of payment, of amounts deferred under the plan must be established at the time of the participant’s initial election to defer those amounts.

[8] On Form W-2 for employees, and on form 1099 for non-employees.

[9] The regulations to be issued under section 409A may establish minimum amounts that will not be subject to reporting, and may not require reporting for amounts deferred under nonqualified defined benefit pension plans until the amounts become reasonably ascertainable.

[10] The Conference Report indicates that the regulations to be issued under section 409A may provide exceptions to the rules regarding timing of elections, and perhaps as to other requirements of the new rules as well, during the transition period. However, the extent to which the new rules will in fact be relaxed during the transition period is presently quite uncertain.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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