United States: IRS Issues Transitional and Other Guidance Relating to New Requirements for Non-Qualified Deferred Compensation Arrangements

By Marian Tse, Matt Guiliani, Dan Condon, Kris Wardwell and Lynda Galligan

Originally published December 23, 2004

As was described in our October 2004 article*, the recently enacted American Jobs Creation Act of 2004 added new Section 409A to the Internal Revenue Code. Section 409A substantially changes the federal income tax treatment of non-qualified deferred compensation ("NQDC") arrangements maintained for employees, directors, and other individuals who provide services. Failure to comply with the new requirements will result in early taxation of NQDC, as well as a 20% penalty tax and additional interest payable to the IRS. These new rules generally are effective January 1, 2005, but the statute grants the IRS authority to issue transition rules and to provide guidance regarding a number of significant issues concerning the new requirements.
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On December 20, 2004, the IRS issued Notice 2005-1 (the "Notice"), which provides important transitional relief that extends the time frames during which action must be taken to comply with the new rules. Notably, under the Notice, no action (e.g., adoption of plan amendments) needs to be taken by December 31, 2004. The Notice also clarifies to some extent the scope of the new requirements and their application to certain specific types of arrangements. Significantly, the Notice indicates that the IRS intends to issue additional guidance in 2005 to address a number of open issues under the new law.

This article highlights a number of the most important features of the Notice.1 While the Notice does provide some breathing room for employers to evaluate their NQDC arrangements and to respond to the new requirements, employers must nevertheless move promptly to avoid the potential substantial adverse tax consequences of noncompliance. At this time, employers should be taking steps to identify their NQDC arrangements and planning an appropriate reaction to the new law. 2 However, depending upon the types of arrangements maintained and the goals of the employer, it is possible that final decisions on plan design and amendments will need to be deferred until the IRS issues further guidance.

The Notice provides guidance regarding the types of arrangements that will be considered NQDC plans that must comply with the new rules.

• Subject to certain specific exceptions, the new requirements apply broadly to all arrangements that defer compensation for any person who provides services – including employees, directors and other independent contractors, and partners.

• For this purpose, an arrangement generally provides for the deferral of compensation if the individual obtains a legally binding right in one year to receive compensation to be paid in a future year.

• However, an arrangement is not considered to be a NQDC plan subject to the new rules if the arrangement requires payment of an amount to the individual no later than two and one-half (2 ½) months after the end of the tax year of the individual in which the individual becomes vested (or, if later, two and one-half (2½) months after the end of the employer’s tax year in which the individual becomes vested).
• While the new rules do not apply to eligible Section 457(b) plans of taxexempt or governmental organizations, they are applicable to Section 457(f) plans and arrangements of tax-exempt entities, including those that were grandfathered in the past against Section 457 requirements.
• A NQDC arrangement is subject to the new rules even if it covers only one individual (e.g., under an employment agreement).
• At least for 2005, a severance pay arrangement will not be required to satisfy the Section 409A requirements if it is either collectively bargained or covers no key employees (as defined by the rules applicable to tax-qualified plans), and is amended to conform to Section 409A no later than December 31, 2005. For this purpose, a severance pay arrangement includes (for example) any arrangement under which payments are made within two years of termination, do not exceed twice the individual’s annual compensation before the termination, and are not conditioned on retirement. In light of this limited exception for severance pay arrangements, it appears that severance pay to key employees in publicly-traded companies would be considered NQDC subject to Section 409A and therefore may not be paid until at least six months after termination of employment.

As noted above, an amount is not considered to be NQDC (and is not subject to the new rules) if it is paid at the time that the rights of the individual first become "vested" – or, in the language of tax law, when those rights are "no longer subject to a substantial risk of forfeiture." The Notice provides some guidance regarding the meaning of this term in the context of the new rules.

• In general, compensation is subject to a substantial risk of forfeiture (and therefore is not vested) if entitlement to the compensation is conditioned on the performance of substantial future services by any person or the occurrence of a future event.
• Any extension of a vesting period by election of the individual or by agreement is disregarded (i.e., so-called "rolling vesting" arrangements will not be recognized as a substantial risk of forfeiture).
• An amount is not considered to be subject to a substantial risk of forfeiture solely because it is subject to a non-compete condition (or other requirements to refrain from providing services).
• In general, salary deferrals will not be considered to be subject to forfeiture unless, under the relevant arrangement, the individual will become entitled to a materially greater amount (e.g., an employer match) when his rights vest.

Effective Date. The new rules generally apply to amounts deferred after December 31, 2004 as well as any amount deferred before January 1, 2005 if the plan under which the deferral was made is "materially modified" (as described below) after October 3, 2004.

• An amount is considered deferred before January 1, 2005 if the individual is vested in the amount at that time -- i.e., there is no requirement for the performance of future services or any other substantial risk of forfeiture. Amounts which are not vested before January 1, 2005 are considered to be deferred after December 31, 2004, and so will be subject to the new Section 409A requirements.

Determination of Pre-2005 Deferrals. The amount deferred for any individual before January 1, 2005, is equal to:

• for plans under which benefits are based on account balances, the vested portion of the individual’s account as of December 31, 2004;
• for equity-based plans, the amount as determined above, less any exercise price or other payment required of the individual;
• for non-account balance plans (such as a typical defined benefit SERP), the present value of the vested benefit to which the individual would be entitled if the individual voluntarily terminated employment on December 31, 2004 and received payment of benefits as soon as possible thereafter; and

• earnings on amounts deferred before January 1, 2005 and the increase in value of a benefit accrued before January 1, 2005 due to the passage of time are also considered to be deferred prior to January 1, 2005.

Material Modification. A plan is considered "materially modified" if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added whether by amendment or by the exercise of discretion already provided for under the plan (e.g., to accelerate vesting). It is not a material modification for the individual to exercise a right or option existing under a plan as of October 3, 2004 or for an employer to exercise discretion over the time and manner of distribution to the extent such discretion is provided for as of October 3, 2004.

• Amending a plan to stop future deferrals at any time is not a material modification.
• Terminating a plan before December 31, 2005 and distributing the benefits thereunder will not be considered to be a material modification provided all the benefits are included in the recipients’ taxable income for the year in which the plan termination occurs. Note: Distributions of amounts subject to the new law made upon plan termination in future years will be restricted.
• It is not a material modification to replace a stock option or stock appreciation right treated as deferred compensation (see the discussion of "Equity-Based Compensation," below) as long as the replacement award is for the same number of shares and there are no new benefits added. For example, replacing a discounted stock option with a stock option that has an exercise price equal to the stock’s fair market value as of the date of the original grant is not a material modification.

Transitional Operation Requirements. A NQDC plan in existence before December 31, 2005 will not be treated as violating the requirements of the new law if the plan is operated in good faith compliance with the provisions of the new law and the plan is amended on or before December 31, 2005 to conform to the requirements of the new law.

Special Pre-2006 Election Changes. NQDC plans may be amended to allow for new payment elections for amounts previously deferred provided the plan amendment and any payment election by an individual in accordance therewith is made before January 1, 2006.

Participation and Election Terminations. A NQDC plan adopted before December 31, 2005 may be amended to allow a participant to terminate participation in the plan or cancel or reduce a deferral election with respect to amounts deferred after December 31, 2004, provided that the amounts are properly included in income. The ability to terminate participation in a plan may be granted to all participants in a plan or on a participant-by-participant basis.

Special Extended Deferral Election Deadline. Deferral elections made with respect to amounts to be earned prior to January 1, 2006, may be made at any time on or before March 15, 2005, provided (1) that such an election may only apply to amounts which have not yet been paid or payable, (2) the relevant plan was in existence on or before December 31, 2004, and (3) the plan is operated in good faith compliance and is timely amended to comply with the requirements of the new law by December 31, 2005.

Interim Guidance Regarding the Deferral of Bonus Payments. Until further guidance is issued, deferral elections with respect to bonus compensation that relates to services performed over a period of at least twelve months may be made up until six months before the end of the relevant service period. So, for example, if a bonus for services performed in calendar year 2005 is expected to be paid in January 2006, the election to defer amounts from such bonus may be made up until June 30, 2005. For this purpose, bonus compensation means compensation that is based on the satisfaction of certain organizational or individual performance criteria where such criteria are not substantially certain to be met at the time the deferral election is made.

Payment Elections Tied to Tax-Qualified Plans. For periods ending before January 1, 2006, an election as to the timing and form of payment under a NQDC plan that is controlled by a payment election to be made under a tax-qualified plan (such as a 401(k) plan or defined benefit pension plan) will not violate the terms of the new law, provided that the terms of the NQDC plan as in effect on October 3, 2004 control. It is expected that further guidance will place restrictions on the ability to tie the payment of nonqualified deferred compensation benefits to distribution elections made under tax qualified plans.

The Notice provides a number of special rules related to equity-based compensation arrangements. Under the Notice, the following types of equity-based compensation would not be considered NQDC subject to Section 409A:

• stock options, whether incentive or non-qualified, that are granted at fair market value, and that do not include any feature for the deferral of income upon exercise;
• stock options granted under a Section 423 employee stock purchase plan;
• stock appreciation rights ("SARs") that are granted at fair market value, are settled in shares of stock of a publicly-traded corporation, and do not include any feature for the deferral of income upon exercise;
• until additional guidance is issued, all SARs that are granted at fair market value pursuant to a program in effect on or before October 3, 2004 and that do not provide for the deferral of income upon exercise;

• restricted stock, even though taxation is delayed because of a substantial risk of forfeiture; and
• until additional guidance is issued, a profits interest in a partnership that is granted in connection with the performance of service that is properly treated under applicable guidance as not taxable upon grant.
• Types of equity-based compensation that would be considered NQDC subject to Section 409A include:
• stock options and SARs that are granted at a discount or that provide for a deferral of income upon exercise;
• SARs issued by a private company, and SARs issued by a public company if settled in cash, if granted pursuant to a program not in effect on October 3, 2004;
• stock options granted under a non-qualified employee stock purchase plan; and
• a legally binding right to receive equity or other property to be delivered in a future year.

However, the foregoing types of equity awards can avoid the 20% penalty tax imposed by Section 409A if they provide for a fixed payment date.

Section 409A generally does not permit the acceleration of the time or schedule of any payment of deferred compensation. If an employer waives or accelerates the satisfaction of a condition that constitutes a substantial risk of forfeiture (e.g., vesting), it is not an acceleration for this purpose as long as the new law’s other requirements are satisfied with respect to the deferral. Also, the Notice permits the acceleration and payment of certain de minimis deferred amounts credited to the accounts of participants who are completely terminating participation in a NQDC plan. This acceleration applies only to NQDC deferred amounts not exceeding $10,000 and requires that the de minimis amount be paid to the participant by December 31 in the year of the participant’s separation from service or two and one-half (2 ½) months after such separation from service, if later. In addition, the Notice permits the acceleration of payments under certain other limited circumstances, including:

• any acceleration necessary to satisfy a domestic relations order (e.g., certain divorce settlements);
• the acceleration under a Section 457(f) plan of the minimum amount necessary to satisfy income taxes due at the time of a vesting event; and
• the acceleration of the minimum amount necessary to satisfy FICA taxes due on deferred amounts and the income tax withholding related to such FICA amount.

Under Section 409A compensation deferred under a NQDC plan may be distributed only at certain times or upon the occurrence of specified events. One such event is a "change in control" of either the corporation that employs the NQDC plan participant or, generally, any other corporation in such employer’s chain of corporations. The new IRS guidance describes what constitutes a change in control of a corporation for this purpose and includes the following:

• the acquisition of more than 50% of the value or voting power of the corporation’s stock by a person or group;
• the acquisition in a period of twelve months or less of at least 35% of the corporation’s stock by a person or group;
• the replacement of a majority of the corporation’s board in a period of twelve months or less by directors who were not endorsed by a majority of the current board members; or
• the acquisition in a period of twelve months or less of 40% or more of the corporations’ assets by an unrelated entity.

The Notice does not address the change in control of entities other than corporations.

Plans may provide for distributions automatically upon a change in control or may permit the exercise of discretion to make payments within twelve months following a change in control.

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