United States: Navigating The Code § 409A Transitional Rules

In Notice 2005-1, the IRS and Treasury first announced transition rules governing the treatment of deferred compensation arrangements under the American Jobs Creation Act of 2004 (the "Act"), which enacted new Code § 409A. A recently proposed Treasury regulation (the "proposed rule") furnished additional guidance expanding some but not all of the Notice 2005-1 transition rules. This client advisory explains the Code § 409A transition rules as embodied in both Notice 2005-1 and the proposed rule.

Code § 409A applies to compensation that is deferred on or after January 1, 2005 and to all deferred compensation under a non-qualified deferred compensation plan that is materially modified after October 3, 2004. Compensation is considered "deferred" for these purposes if the service provider has a legally binding right to be paid the compensation (even if such right is conditional), and the right to the compensation is "earned and vested." An amount is not "earned and vested" if it is subject to a substantial risk of forfeiture. Currently exercisable stock rights that terminate upon separation from service are treated as earned and vested. Amounts to which a participant has no legally binding right, or which are not earned and vested before January 1, 2005, are subject to the new rules.

Generally, "material modification" means the enhancement of any benefit or right (existing as of October 3, 2004) or the addition of any new benefit or right. Notice 2005-1 cites as an example of a material modification a plan amendment adding "a provision that payments may be allowed upon request if participants are required to forfeit 10 percent of the amount of the payment" (i.e., a "haircut"). Neither the freezing of pre-2005 benefits, nor the amendment of a plan to bring the plan into compliance with the provisions of Code § 409A, is treated as a material modification. According to the proposed rule, neither establishing a rabbi trust nor adding a notional investment measure based on a reasonable benchmark rate of interest will result in a material modification.

Without transitional relief, many existing plans and deferral elections would have been in immediate violation of the new rules on January 1, 2005. For example, Code § 409A requires that deferral elections be made in the year before the year in which the compensation subject to deferral is earned. Commonly encountered plan provisions requiring that participants make deferral elections before they perform the services giving rise to compensation would not satisfy this standard. Congress understood this conundrum and directed the regulators to adopt appropriate transitional relief.

The basic Notice 2005-1 transitional rule treats a plan as satisfying the requirements of Code § 409A during 2005, provided that it is:

• operated in accordance with the Notice, or in accordance with a good faith interpretation of the new law with respect to matters not covered in the Notice; and

• amended before January 1, 2006 to conform to the new law.

Now, good faith compliance includes operating the plan in accordance with the provisions of the proposed rule as well. To meet this "good faith" standard, the operation of the plan must be consistent with the terms of the plan (to the extent they conform to the Act’s requirements) and neither the plan sponsor nor the participant may exercise discretion over the payment of benefits. The proposed rule extends the good faith compliance date to December 31, 2006, and also imposes for the first time a requirement that the plan be embodied in a written plan document, which must generally be adopted on or before December 31, 2006.

Set out below is a summary of the key Notice 2005-1 transition rules as modified by the proposed rule:

Plans to which no contributions are made after December 31, 2004 and which are not materially modified after October 3, 2004 are not subject to Code § 409A—they are "grandfathered." Some plan sponsors may prefer to terminate their plans rather than comply with Code § 409A. For a grandfathered plan that contains pre-October 4, 2004 provisions allowing termination, termination is not a material modification, and the plan can be terminated at any time so long as it is timely frozen. Otherwise, Notice 2005-1 allows a sponsor of a grandfathered plan adopted before January 1, 2005 to terminate the plan and make taxable distributions in 2005 without experiencing a material modification. (Without this relief, a plan that does not by its (pre-October 4, 2004) terms allow for termination would trigger an impermissible acceleration of benefits upon termination.) The proposed rule does not extend this relief.

The proposed rule exempts from the reach of Code § 409A stock options where (i) the exercise price can never be less than the fair market value of the stock on the date of grant, (ii) the number of shares subject to the arrangement is fixed as of the date of grant, (iii) the arrangement does not contain any further deferral rights or features, and (iv) the stock that is the subject of the option is common stock of the service recipient. Similar rules apply to stock appreciation rights (SARs).

Under Notice 2005-1, a plan is not deemed to be materially modified where a Code § 409A-covered stock option (e.g., a discounted stock option) or SAR is replaced during 2005 with an option or SAR that is exempt from Code § 409A. To be able to take advantage of this rule:

• the number of shares which form the basis of the new stock option or SAR must correspond directly to the number of shares subject to the original stock option or SAR; and

• the new stock option or SAR must not provide any additional benefit to the service recipient.

The proposed rule extends this transition rule until December 31, 2006, but only if the replacement does not result in the cancellation of a deferral in exchange for cash or vested property in 2006.

Plans adopted before December 31, 2005 must be operated in good faith compliance with the provisions of Code § 409A and Notice 2005-1 during calendar year 2005. Notice 2005-1 also required that plans be amended to conform to the provisions of Code § 409A with respect to amounts subject to Code § 409A on or before December 31, 2005. With one exception (described below, relating to cancellation of deferrals and termination of participation), the proposed rule extends both the good faith compliance period, and the documentary compliance date by which plan sponsors must adopt amendments, from December 31, 2005 to December 31, 2006.

Under Notice 2005-1, plans can be amended during 2005 to permit a participant to change payment elections, without resulting in an impermissible subsequent deferral or acceleration. The proposed rule extends this rule through December 31, 2006, with an important exception: A participant cannot in 2006 change elections with respect to payments that he or she would otherwise receive in 2006, nor may he or she elect to cause payments to be made in 2006. As a result, a participant could not make an election in 2006 to further defer compensation that would otherwise be payable in 2006, nor may he or she elect to accelerate amounts that would have been payable in a later year into 2006. Similar relief is accorded to stock rights that are subject to Code § 409A, which may be amended to provide for fixed payment terms or to permit holders of such rights to elect fixed payment terms.

Notice 2005-1 allows a plan adopted before December 31, 2005 to be amended on or before December 31, 2005 to allow a participant to terminate participation in the plan or cancel a deferral election without violating Code § 409A, provided that the amounts subject to the termination or cancellation are includible in the participant’s 2005 income, or if later the taxable year in which the amounts are earned and vested. The exercise of a stock option, SAR, or similar equity right that provides for a deferral of compensation, on or before December 31, 2005, will be treated as a cancellation of a deferral. The proposed rule does not extend this provision. Also, plan amendments permitting elections under this rule must be adopted before January 1, 2006.

Notice 2005-1 generally permits initial deferral elections with respect to deferrals relating all or in part to services performed on or before December 31, 2005 to be made on or before March 15, 2005. The proposed rule does not extend this provision.

Where contributions and/or distributions under a non-qualified deferred compensation plan are linked to contributions and/or distributions under a qualified plan, a change in the elections under the qualified plan can have a corresponding effect on the non-qualified plan. If an election change under the qualified plan increases the amounts credited under the non-qualified plan, the result is a non-compliant deferral election under the non-qualified plan. On the other hand, if the election change under the qualified plan operates to decrease amounts credited to the non-qualified plan, the Code § 409A’s bar against acceleration of benefits might be violated. Similarly, plan provisions in a non-qualified plan tying distributions to qualified plan distributions could violate the Code § 409A requirements respecting the time and form of benefits.

Notice 2005-1 provides relief for non-qualified deferred compensation plans where the time and form of payment is controlled by the time and form of payment elected by the service provider under a qualified plan. Because these sorts of arrangements are commonplace, many were hoping for a blanket extension of this rule. The proposed rule extended this relief to December 31, 2006, and it also contains permanent relief under which linked elections are allowed within limits.

To better understand how the transition rules work, consider the following example (based in a representative pre-Act plan design):

Under a non-qualified deferred compensation plan for its senior executives, Employer X credits to the accounts of participants the lesser of $50,000 or 10% of base salary annually. Participants are also permitted to defer all or a portion of their annual bonuses by making an election before the last quarter of the Employer X’s fiscal year (which is the calendar year). Employer contributions credited to the accounts of participants vest ratably over a period of 10 years. Elective deferrals are immediately and fully vested. All amounts are credited with earnings at an established benchmark rate of interest. A participant’s vested account balance is paid to him or her in the case of his or her death or disability (with respect to which vesting is accelerated in each case) or separation from service. Distributions are made in cash, in a single lump sum within a reasonable period of time following the occurrence of the distribution event. A participant may, however, elect to receive his or her benefit in the form of a 5 or 10-year term certain annuity if the election is made during the year prior to the year in which distributions are to commence. Participants can elect a lump sum distribution of their vested account balance at any time if they are willing to take a 10% reduction in the amount to which they are otherwise entitled.

Faced with the need to comply with the provisions of new Code § 409A, Employer X’s options include the following:

Plan Termination. Employer X might decide to terminate the plan and make taxable distributions in 2005. If the plan does not have a termination provision, formal action would be required before January 1, 2006. Because termination during 2005 is not treated as a material modification, the plan is not subject to the requirements of the new law.

Freeze Plan Accruals. Employer X could freeze pre-2005 accruals and operate the plan as a grandfathered plan. Employer X could at the same time (or at some later time) decide to establish a new Code § 409A-compliant plan going forward.

Amend the Plan to Comply with Code § 409A. If Employer X neither terminates nor freezes the plan, then it will need to operate it in accordance with a good faith interpretation of Code § 409A. One way to do this is to comply with the requirements of Notice 2005-1 and the proposed rule. In this case, distributions could not be made under the plan’s haircut provisions. Employer X could, however, permit participants to change payment elections during 2005 and 2006 (except that no such election could result in payment in 2006). Participants could also be permitted to terminate plan participation and/or cancel deferral elections during 2005, provided that a plan amendment permitting cancellation is adopted before January 1, 2006.

What is clear from this discussion of the transition rules that apply under Code § 409A is that plan sponsors must act before the close of 2005 with respect to some important plan design issues. While documentary compliance has been delayed in most instances, certain elections must be made by year-end. The proposed rule’s transition guidance is generally favorable, but it has its limits, and failure to act in a timely fashion could result in the loss of valuable planning opportunities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.