United States: U.S. Congress Approves Significant Changes To The Tax Rules For Nonqualified Deferred Compensation Plans

On October 11 2004, the U.S. Congress passed the American Jobs Creation Act of 2004, also known as the JOBS bill. It is anticipated that President Bush will sign the JOBS bill shortly after the November presidential election. In addition to substantially changing corporate tax provisions, the JOBS bill makes the most significant changes to the tax rules applicable to nonqualified deferred compensation plans in a generation. These changes are not limited to just traditional salary and bonus deferral programs. The new rules affect supplemental executive retirement plans (SERPs), statutory restoration plans, equity-based compensation arrangements such as stock appreciation rights (SARs) and restricted stock units (RSUs), long-term incentive plans and directors’ fee deferral programs.

These rules will dramatically restrict the flexibility participants currently have to change the time and form of their nonqualified deferred compensation plan benefits. Limits will also be placed on the timing of deferral elections and the structures available to set aside assets to provide benefits under these plans. Due to the expansive nature of these changes, it is reasonable to anticipate that virtually all employers will need to amend their nonqualified deferred compensation plans to comply with the JOBS bill. The new rules will be effective for deferrals of compensation on and after January 1, 2005. Exactly how much time employers will have to make any required amendments is unclear. Given the limited period of time before the effective date and the significant nature of this pending legislation, we recommend that employers give immediate and careful consideration to the impact that the JOBS bill will have on their nonqualified deferred compensation plans and the changes that will be necessary and appropriate to comply with the new rules.

The JOBS bill adds a new Section 409A to the Internal Revenue Code of 1986, as amended (the Code). For a participant to defer compensation on a tax-advantaged basis going forward, a nonqualified deferred compensation plan (as defined below) must meet new additional requirements under Section 409A. Section 409A(a) sets forth constructive receipt rules to restrict when participants may schedule payment of benefits, when payment of benefits may be accelerated and when participants may elect to defer payment of their compensation. Failure to follow these requirements will result in the immediate taxation of an affected participant’s vested deferred compensation (i.e., compensation that the participant has a nonforfeitable right to receive in the future). Section 409A(b) provides that placing property offshore in a trust in certain situations and restricting trust assets upon changes in an employer’s financial condition will cause a nonqualified deferred compensation plan to be funded for tax purposes. In the event there is a violation of any of these new constructive receipt and funding rules, Section 409A provides for automatic assessment of penalties and interest against affected participants. Proposed restrictions on permissible plan investments, which were included in the earlier U.S. Senate proposal, were removed in conference and are not included in the JOBS bill approved by Congress.

Section 409A(a)(2) requires that compensation deferred under a plan may not be distributed earlier than:

(i) separation from service as determined by the U.S. Department of the Treasury,

(ii) the date a participant becomes disabled as defined in the statute,

(iii) a specified time (or pursuant to a fixed schedule) specified under the plan at the date of deferral of the compensation,

(iv) the participant’s death,

(v) a change of control to the extent provided by the Treasury Department, or

(vi) the occurrence of an unforeseeable emergency.

In addition to these requirements, a nonqualified deferred compensation plan must also prohibit distributions to a "specified employee" on account of separation from service before the date that is six months after the separation from service (or, if earlier, the date of death of the specified employee). For this purpose, a "specified employee" is generally defined to mean a "key employee" (under Section 416(i) of the Code) of a publicly traded corporation. Under Section 416(i) of the Code, a key employee generally includes up to 50 officers of the employer having annual compensation greater than $130,000, 5 percent owners and 1 percent owners having annual compensation from the employer greater than $150,000.

Section 409A does not define "separation from service." It is clear from statements made by senior Treasury officials that "separation from service" will not cover all terminations of employment. For example, a participant’s termination of employment will likely not be a "separation from service" for purposes of Section 409A if the participant immediately thereafter commences employment with an affiliate of the participant’s prior employer. Open questions exist as to whether joint ventures and other types of non-controlled entities will be treated as affiliates for this purpose. The JOBS bill provides that rules "similar" to the controlled group rules applicable to qualified retirement plans shall apply for purposes of Section 409A. It is anticipated that guidance will be provided by the Treasury Department on what constitute a "separation from service."

A participant will be considered "disabled" for purposes of Section 409A if he or she (i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or (ii) is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than three months under an accident or health plan covering employees of the participant’s employer.

With respect to distributions that can be made at a "specified time," the Conference Report states that only a specified date, and not an event, can qualify as a specified time under Section 409A. This clarification in the legislative history is restrictive and will reduce distribution flexibility under current constructive receipt principles. For example, distribution of a fixed-dollar amount to a participant upon the participant’s child entering college would not qualify as a distribution at a "specified time." Instead, a participant would need to designate the exact time for the distribution when making the deferral election in order to access plan benefits under this rule.

Distributions on account of a change of control will only be permissible under Section 409A to the extent allowed by the Treasury Department. It appears there is concern certain types of corporate transactions provide executives with too much control over triggering payment of their nonqualified deferred compensation. The Conference Report provides that the change of control definition for Section 409A shall be "similar" to the change of control definition used for golden parachutes under Section 280G of the Code, but more "restrictive." The JOBS bill requires the Treasury Department to issue guidance on what constitutes a change of control for purposes of Section 409A 90 days after its enactment.

The term "unforeseeable emergency" is defined in Section 409A to mean a severe financial hardship to the employee resulting from illness or accident of a participant (and certain family members), loss of the participant’s property due to casualty or "other extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant." The amount of the distribution may not exceed the amount necessary to satisfy such an emergency plus amounts necessary to pay taxes reasonably anticipated as a result of the distribution, after taking into account the extent to which such hardship is or may be relived through reimbursement or compensation through insurance or by liquidation of the participant’s assets.

Section 409A does not expressly allow for payment of nonqualified deferred compensation upon a plan termination (as is the case with Section 401(k) plans under Section 401(k)(10) of the Code). Nonqualified deferred compensation plans often provide for payment of benefits in a lump sum upon a plan termination. It is unclear whether this type of provision violates Section 409A. It remains to be seen whether and under what circumstances guidance will allow for payment of benefits in a lump sum or other accelerated form of payment upon a plan termination.

Few, if any, nonqualified deferred compensation plans will comply with all of these distribution requirements. For example, many plans will likely need to be amended to reflect the restrictive "separation from service" and "disability" definitions under Section 409A. Plans that define change of control broadly in a manner consistent with Section 280G will likely need to be amended in light of more restrictive rules to be issued by the Treasury Department. Employers will also need to remove plan provisions that allow for distributions upon an event elected in advance by a participant.

Section 409A(a)(3) requires that a plan not permit the acceleration of the time or schedule of any payment, except as provided in regulations by the Treasury Department. This requirement prohibits the common practice of using so-called "haircuts" and one-year advance distribution elections. Haircut provisions allow a participant to receive a payment of vested deferred compensation at any time by paying a penalty, which was often 10 percent (but sometimes as low as 6 percent) of the participant’s then current account balance. One-year advance distribution elections allow a participant to receive an accelerated payment of vested deferred compensation without paying any penalty by electing payment at least one year in advance of the originally scheduled payment date.

The Conference Report clarifies the scope of Section 409A’s anti-acceleration requirement. A choice between cash and taxable property (assuming the time for payment and amount of taxable income is the same) and a choice between a lump sum payment or a fully taxable annuity contract will not be considered to be a prohibited acceleration. In addition, the Conference Report reflects Congress’ intention that the Treasury Department provides rules allowing for the choice between actuarially equivalent life annuity payments. This guidance will be important for employers. Absent such guidance, changing a nonqualified deferred compensation plans’ distribution election from a 50 percent survivor benefit to a single life annuity benefit could be viewed as an impermissible acceleration. Switching from any form of an annuity to a lump sum benefit would be an impermissible acceleration.

The Conference Report also suggests that limited exceptions should be made by the Treasury Department to accommodate situations in which "an accelerated distribution is required for reasons beyond the participant’s control and the distribution is not elective." Cited examples include payments due to court-approved settlements, compliance with federal conflict of interest rules, withholding of employment taxes upon vesting of deferred compensation and de minimis cash-out distributions for administrative convenience (for example, automatic cash outs of amounts less than $10,000 could be permitted, except in the case of specified employees). Other potential issues are protective distributions to preserve "top hat" status (i.e., if a participant in a nonqualified deferred compensation plan turns out not to have been a member of a select group of management or highly compensated employees, can a distribution be made to that participant immediately?) and payment of benefits that the employer has determined were previously taxable to the participant.

Section 409A requires that nonqualified deferred compensation plans restrict when elections may be made to defer compensation. In general, these rules are more restrictive than prevailing plan practices, particularly with respect to bonus and incentive compensation arrangements.

(i) Initial Deferral Elections

The general rule under Section 409A is that a plan must require initial deferral elections to be made no later than the end of the immediately preceding taxable year (or otherwise as provided by regulations) in order to avoid immediate income taxation. For example, if a participant wants to defer salary to be paid in 2005, the election to defer that compensation must be made before the end of the 2004 taxable year. In the case of a person who first becomes eligible to participate in a plan, the election to defer compensation with respect to services to be performed subsequent to the election may be made up to 30 days after that person’s initial eligibility.

An important exception to the general rule is provided for "performance-based compensation." In the case of any performance-based compensation relating to a period of at least 12 months, the election to defer compensation may be made up to six months before the end of such period. For example, if a plan provides for a long-term incentive payment based on performance from January 1, 2005, until December 31, 2007, any election to defer receipt of the long-term incentive payment may be made at any time before July 1, 2007, consistent with Section 409A. However, note that even if a plan meets Section 409A’s election requirements, general constructive receipt principles may require an earlier deferral election to avoid constructive receipt of income.

The scope of the "performance-based compensation" exception is unclear at this time. Section 409A itself does not define "performance based compensation." The Conference Report provides that "performance-based compensation" should have a meaning similar to such term under Section 162(m) of the Code (i.e., the $1 million deduction limitation), but the plan would not be required to meet all of Section 162(m)’s requirements. To qualify as "performance-based compensation," the compensation would need to be variable and contingent on the satisfaction of a pre-established organization or individual performance criteria and not readily ascertainable at the time of the election. However, it is anticipated that subjective criteria could be used as criteria in a benefit formula, and the compensation committee would not be required to determine the amount of any plan payment.

Complying with the "performance-based compensation" exception may require changes to existing incentive compensation programs. For example, criteria for bonus payments to employees (other than named executive officers) may not be established until well into the performance period and may take into account events or circumstances that were not anticipated at the beginning of such period. Discretionary bonuses may also be administered as unwritten practices. In order to rely on the special performance based exception, performance goals will likely need to be set forth in writing by employers no later than 90 days after commencement of the performance period.

(ii) Subsequent Deferral Elections

Section 409A provides rules for "subsequent deferral elections" (i.e., elections after compensation has been deferred on a participant’s behalf that change either the time or form of payment). Nonqualified deferred compensation plans have long provided subsequent deferral elections to allow participants an opportunity to make more informed decisions regarding the timing of their plan benefits. There has been great uncertainty regarding how constructive receipt principles applied to subsequent deferral elections due the prohibition against IRS regulation in this area and conflicting principles in the case law. Enactment of Section 409A will now bring much greater certainty to this area.

Section 409A provides three requirements for plans that permit participants to change either the date or form of a payment after an initial deferral election. First, the plan must require that the subsequent deferral election not take effect until at least 12 months after the date on which such election is made. Second, if the subsequent deferral 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 such election is made must be deferred for a period of at least five years from the date the payment would have otherwise been made. Third, if the subsequent deferral election relates to a distribution that otherwise was to be paid at a specified time, then the election must be made at least 12 months before the date of the first scheduled payment.

Vested deferred compensation must be unfunded in order for a participant to avoid current income taxation under existing law. Compliance with this rule requires that a participant’s contractual rights to receive payment not be superior to those of an unsecured creditor. This lack of security exposes the participant to a risk that the employer may be unable to meet its obligations due to insolvency. Various techniques have been designed in an attempt to provide participants with better protection against this risk without triggering current income taxation. Senior IRS officials have expressed concern over the years that certain uses of rabbi trusts and accelerated payment provisions effectively shielded assets from the claims of the employer’s creditors.

Section 409A provides special funding requirements to address two specific security techniques that were considered to be particularly abusive. Section 409A provides for a deemed "transfer of property" under Section 83 of the Code to a participant if an employer either uses certain offshore funding arrangements or secures payment of plan benefits upon a change in the employer’s financial health. Any subsequent increase in value in, or earnings with respect to, such property will generally be treated as additional transfers of property. A transfer of property triggered under Section 409A will be subject to immediate taxation, unless the participant’s rights to the property are subject to a substantial risk of forfeiture (i.e., conditioned upon the future performance of substantial services).

If assets are set aside directly or indirectly in a trust (or a similar arrangement identified by the IRS) for the purpose of paying deferred compensation, the assets will be treated as having been transferred to affected participants for purposes of Section 83 of the Code when the assets are no longer located within the United States. This rule applies whether or not the assets are subject to the claims of the employer’s creditors. This rule is specifically intended to discourage the use of so-called "Rastafarian trusts," in which some employers established rabbi trusts outside of the United States in order to make recovery more difficult for U.S. creditors.

Section 409A provides an exception to the rule against having assets located in an international jurisdiction "if substantially all of the services to which the nonqualified deferred compensation relates are performed in such jurisdiction." This exception covers the situation in which a U.S. citizen or resident alien is assigned to an international jurisdiction and substantially all of the services to which the deferred compensation relates are performed in that jurisdiction.

There are open questions as to how these provisions will apply in other situations. Consider a U.S. citizen or resident alien who provides services in the United States and is covered under a nonqualified deferred compensation plan sponsored by a non-U.S. company or an international subsidiary of a U.S. company. The exception to the rule for assets in a foreign jurisdiction may not apply in this situation, as substantially all of such participant’s services are being provided in the United States. Non-US companies may want to consider establishing U.S.-based rabbi trusts to fund benefits for their participants who are providing services in the United States and subject to U.S. income taxation.

Another issue that will need to be resolved is the treatment of multinational executives covered by rabbi trust. It is not uncommon for a participant to work in more than one country outside of the United States during a single taxable year and to have benefits funded in a single international jurisdiction. Read literally, the foreign asset exception would not apply to this situation. Instead, assets could only be set aside in any one jurisdiction to the extent that such participant provided services in that jurisdiction. It is unlikely that Congress intended this result. Companies will need to await guidance from the Treasury Department on these international issues.

Some plans provide for benefits to be paid upon a change in the company's financial condition. Covered events included changes in the company's financial position, financial ratios or net worth. Section 409A is intended to end the tax-deferred use of security techniques for vested deferred compensation based on changes in an employer’s financial health. If compensation is deferred under a plan, there will be a transfer of property for purposes of Section 83 as of the earlier of (i) the date on which such plan provides that assets will be restricted to the provision of benefits under the plan in connection with a change in the employer’s financial health or (ii) on the date on which the assets are so restricted. Although Section 409A does not define a "change in the employer’s financial health," the Treasury Department is directed to issue regulations defining this term. It is reasonable to anticipate that the Treasury Department will interpret this provision broadly.

Section 409A requires assessment of immediate income tax, automatic penalties and interest against participants with respect to whom there is a violation of Section 409A’s constructive receipt and funding rules. Vested deferred compensation for the taxable year and all preceding taxable years (to the extent not previously included in income) must be included in the affected participant’s gross income for the then current taxable year. An affected participant must also pay (i) interest using the IRS underpayment rate, increased by one percentage point, on the underpayments that would have occurred had the deferred compensation been includable in gross income for the taxable year in which first deferred (or, if later, the first taxable year in which the compensation was not subject to a substantial risk of forfeiture) and (ii) an additional tax equal to 20 percent of the compensation that is required to be included in gross income. Similar rules are provided for violation of the funding rules.

An important issue that remains to be resolved under the penalty provisions is who will be an affected participant. Earlier versions of the JOBS bill provided that a failure to comply with the Section 409A rules in any respect would cause all participants in the plan to be subject to Section 409A’s penalties on all of their vested deferred compensation. In response to comments by practitioners that this structure was overly punitive, the affected participant language was eventually added to the JOBS bill so not every violation would result in penalties. There is no definition who is an affected participant, so it is difficult to know when a failure relates to a particular participant. For example, does an employer’s failure to maintain a plan document in compliance with Section 409A relate to or affect a participant if the participant did not exercise any right inconsistent with Section 409A’s rules and the employer makes corrective amendment as soon as reasonably possible? Unfortunately, there is no express exception in the statute for good faith mistakes in plan drafting or plan administration that is promptly and fully correct upon discovery.

Note that there are no sanctions against the employer for violating Section 409A, even though the employer may have been responsible for the violation. Of course, the employer may face exposure in the event of a failure to properly report and withhold for income and employment taxes. An ironic result from this omission in the penalty structure is that the employer may benefit from a violation of the Section 409A rules, as it would receive a tax deduction for the income that is taxable to the affected participant (subject to any limitations under Section 162(m) of the Code).

Section 409A will impact many different types of compensation and benefits practices. The term "nonqualified deferred compensation plan" is broadly defined as any plan, arrangement or agreement providing for the "deferral of compensation," other than a "qualified employer plan"* or a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. While the precise scope of this definition is not yet clear, there is no doubt that Section 409A covers more than just elective deferrals of salary and bonus. Set forth below is a partial list of some of the affected benefits practices and selected key issues regarding their treatment under Section 409A.

It appears the Treasury Department will issue regulations to treat SARs and phantom stock as "nonqualified deferred compensation" subject to Section 409A, even if benefits are paid in stock. If this happens, there will be no ongoing advantage for participants to receive SARs, as any increase in stock price will be taxable immediately upon vesting. It is unclear at this time whether the IRS would treat net settled stock options as SARs. As discussed below, employers that have issued SARs that are unvested as of Section 409A’s effective date face special transition issues.

There is no express exception for stock options from the definition of what is a "deferral of compensation." A senior Treasury official has indicated that drafting of Section 409A was intended to provide flexibility for the IRS to treat deeply discounted stock options (i.e., options with an exercise price less than the value of the option property on the grant date) as a form of a "nonqualified deferred compensation plan." What the IRS will consider a "deeply discounted option" remains to be seen. However, we understand that the IRS will issue guidance providing that stock options with an exercise price equal to the stock’s fair market value on the grant date does not constitute a "nonqualified deferred compensation plan." The Conference Report also suggests that the guidance will exempt from Section 409A incentive stock options under Section 422 and employee stock purchase plans under Section 423.

Restricted Stock Units (RSUs) — awards that provide for the deferred payment of stock after vesting — are covered under Section 409A. As a result, participants will have much less control over the timing of the stock payment. In general, Section 409A will require any election to further defer payment to be made 12 months in advance and require the payment date to be deferred for at least five years from the previously scheduled payment date.

SERPS are subject to 409A regardless of whether they are "excess plans" that merely make employees "whole" for benefits lost under the qualified retirement plan due to Code limits or "target plans" that provide a top hat group with an enhanced benefit level. However, in SERPs, as opposed to elective deferred compensation plans, participants typically do not make an election to participate in the plan or any sort of an initial deferral election. Instead, the participant’s first election regarding these types of plans historically do not occur until a relatively short period of time before distributions. To avoid any constructive receipt issues with these distributions, employers have taken a number of approaches ranging from requiring participants to make their distribution election at least 12 months before distributions could commence or requiring participants to receive their SERP benefits in the same format as their benefits under the corresponding qualified plan. These approaches, while raising some technical issues under current law, have been frequently used by employers with their SERPs. Due to the distribution and election requirements under Section 409A, most SERPS will have to be redesigned to restrict changes in the time and form of payment. How to implement those new rules will be particularly difficult because the transition rule will effectively mean that a participant in a SERP may have to manage three pieces of his or her retirement benefit: (i) the tax qualified plan benefit; (ii) the SERP benefit accrued and vested through December 31, 2004, and (iii) the SERP benefit accrued on and after January 1, 2005. Further, employers will likely be required to calculate the SERP benefit "accrued" as of December 31, 2004, which is also unclear (i.e., is it just the dollar amount of the participant’s accrued benefit as of that date or can it include early retirement subsidies on that benefit that the participant may "grow into" after December 31, 2004?). The Treasury Department is expected to issue guidance on the application of the new rules to SERPS including how to determine the December 31, 2004, accrued benefits and the ability of participants to choose between various annuity forms of payment without violating Section 409A of the Code.

It is common for directors to defer payment of their fees for Board service. There is no exception to Section 409A for directors, and these types of plans are subject to Section 409A. It is important that companies keep proper records demonstrating compliance with Section 409A’s election requirements.

Given the broad scope of Section 409A, certain types of severance arrangements may constitute nonqualified deferred compensation plans. There is no express exclusion for severance benefits in Section 409A, as is the case under Section 457 of the Code for arrangements provided to employees of tax-exempt organizations and governmental entities. Senior Treasury officials have expressed concern that if there was such an exception, there would be an effort to recast many different types of deferred compensation as severance benefits. This concern is not without some merit. Whether an arrangement provides for severance or deferred compensation is currently an issue under other provisions of the Code, including the exception from Section 457 deferral limitations for bona fide severance plans, the inapplicability of the Section 404(a)(5) deduction rules to payments of severance benefits and the exemption from the Section 419 welfare benefit plan deduction limits for severance benefits under a Section 419A(f)(6) plan. We suggest that employers evaluate whether severance plans that do not meet the U.S. Department of Labor’s definition of a severance plan under its regulations constitute nonqualified deferred compensation plans under Section 409A.

Other forms of compensation governed under specific Code sections may also be covered under Section 409A. For example, is a collateral assignment "equity" split dollar life insurance arrangement a nonqualified deferred compensation plan under Section 409A? What if the employer owned the policy subject to an endorsement to an employee? Is a profits interest in an LLC, which may be viewed to be a form of property under the Code, a nonqualified deferred compensation plan under Section 409A?

Section 409A is effective for deferrals of compensation on or after January 1, 2005. To prevent employers from taking action to increase the amount subject to the grandfather provision, the JOBS bill provides that a grandfathered nonqualified deferred compensation plan that is "materially modified" after October 3, 2004, (in a form not approved by the Treasury Department) will be subject to Section 409A. The only guidance currently as to what is a material modification is a statement in the Conference Report that it would be a material modification to add a benefit, right or feature (such as adding an accelerated, or "haircut", distribution feature) or to accelerate vesting under a plan after October 3, 2004. We recommend that employers should proceed cautiously before amending or modifying any existing nonqualified deferred compensation plans so as not to lose grandfathering status.

The JOBS bill further directs the Treasury Department to issue, within 60 days after enactment, guidance providing a "limited period" during which plans may be amended to conform to the requirements and to permit participants to terminate or change their deferral elections to comply with the statute. The Treasury Department may also provide exceptions to certain requirements during this limited period for plans coming into compliance with Section 409A. It is anticipated that this "limited period" will extend somewhere between three and six months.

Participants may only take advantage of any special transitional relief if, and only if, an election is outstanding before the end of this year. We recommend that employers proceed as usual at this time with deferral elections for 2005 compensation that is payable at a later time in order to ensure eligibility under this favorable transition rule. We also recommend that deferral elections notify participants of the coming transition guidance and its impact on participants’ elections.

The Conference Report takes a restrictive approach in defining when compensation is deferred for purposes of Section 409A. Contrary to its ordinary meaning, "deferred" is interpreted in the Conference Report to mean an amount that is both earned and vested. As a result, amounts that have been deferred in prior years but that will not vest according to their existing terms before January 1, 2005, will not be eligible for grandfathering treatment. According to the Conference Report, action by an employer to vest these amounts before the end of 2004 would be viewed as a "material modification."

The interpretation in the Conference Report regarding when compensation is "deferred" will be a particularly difficult issue to address with respect to unvested SARs that are "in the money." As noted above, SARs constitute a form of a nonqualified deferred compensation plan. If a SAR is unvested as of the end of this year, it appears that all appreciation as of January 1, 2005, under the SAR is taxable immediately — even if the participant has not exercised prior to that time. It remains to be seen if the Treasury Department will provide any transitional relief for unvested SARs.

Amounts of compensation deferred prior to January 1, 2005, and earnings on such amounts are exempt from Section 409A, assuming that there is no material modification to the plan underlying the deferrals after October 3, 2004. These deferrals remain subject to tax rules under current law. The JOBS bill provides that nothing in Section 409A shall be construed to prevent the inclusion of nonqualified deferred compensation in a participant’s gross income under other provisions of the Code (such as the constructive receipt rules under Section 451) for taxable years prior to effective date.

The JOBS bill amends Section 3401(a) of the Code to provide that amounts includable income under Section 409A are subject to federal income tax withholding requirements and are required to be reported on a participant’s W-2 (or Form 1099 in the case of an independent contractor) for the year includible in income. In addition, Section 6051(a) is amended to provide that amounts deferred will be required to be reported on a participant’s Form W-2 (or Form 1099) for the year deferred (subject to minimums that may be established by Treasury through regulations), even if the amount is not currently includible in income for that taxable year. We recommend that employers should notify their payroll functions of these changes immediately so that they may begin to make all changes required to comply with IRS rules, such as separately tracking grandfathered and non-grandfathered deferred amounts.

It is prudent for employers to begin planning now for the coming changes to nonqualified deferred compensation plans. Participants will also want to reconsider their financial planning in light of these new restrictions. We suggest that employers take the following actions immediately:

• Develop an inventory of plans, arrangements and agreements subject to Section 409A. Simply identifying plans subject to Section 409A may be a difficult task depending upon the size of the employer and the types of compensation programs.

• Evaluate which changes to these plans, arrangements and agreements present the best alternative to comply with Section 409A. Multiple approaches may be available to address compliance issues.

• Postpone making any plan amendments until the Treasury Department issues transitional guidance. Making any amendments that may be viewed to add rights, benefits or features to a plan may imperil grandfathering.

• Proceed with deferral elections for 2005 compensation under existing procedures. Taking this action is necessary in order to qualify for relief under anticipated transitional guidance.

• Communicate early and often with executives, directors and employees about the potential impact of this legislation on their benefits. Taking this action will help facilitate a smoother transition process and increase participant cooperation.

• Postpone granting stock appreciation rights and other questionable forms of compensation that are questionable under Section 409A until further guidance is available.

• Brief the Compensation Committee and the Board of Directors on the coming changes to nonqualified deferred compensation plans. Board members will need to be briefed as a matter of corporate governance before changes can be made.

• Obtain authority under company procedures to make changes as needed so immediate action can be taken without undue delay. It is possible, although not likely, that some actions may need to be taken before year end.

• Consider whether to freeze existing grandfathered plans and create new plans for future deferrals. This approach may be simpler and safer than amending existing plans in certain cases.

• Develop internal controls as needed to comply with the nonqualified deferred compensation rules. Noncompliance exposes the company to tax, securities law and corporate governance risks.

Taking these actions now will allow employers to be well-positioned to perform the work needed during a relatively short period of time to comply with the new requirements under Section 409A.

* For purposes of Section 409A, a "qualified employer plan" includes pension and profit sharing plans qualified under Section 401(a) of the Code, tax deferred annuities, eligible deferred compensation plans under Section 457(b) (but not ineligible arrangements under Section 457(f)), simplified employee pension and SIMPLE plans.

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