Recently enacted Internal Revenue Code section 409A established new requirements for employee elections to defer compensation under nonqualified deferred compensation plans. (For additional information regarding the new law, see our October 13, 2004, October 15, 2004 and December 28, 2004 Client Alerts, posted on our website.) In general, elections to defer compensation earned in a taxable year must be made before the beginning of that year. A special rule applies for performance-based compensation, however. An election to defer performance-based compensation that is based on services performed over a period of at least 12 months must be made at least 6 months before the end of the performance period. Therefore, June 30, 2005 is the deadline for an election to defer performance-based bonus compensation payable with respect to a performance period of at least 12 months in length that ends on December 31, 2005.

Under Notice 2005-1, issued by the Treasury Department and the Internal Revenue Service, to be considered performance-based compensation, a bonus must meet the following requirements:

  • Payment of the compensation or the amount of the compensation is contingent on the satisfaction of organizational or individual performance criteria; and
  • The performance criteria are not substantially certain to be met at the time the deferral election is permitted.
  • The performance criteria may be either objective or subjective. Subjective criteria are acceptable, however, only if:
  • They relate to the performance of the nonqualified plan participant, or the performance of a group of participants or a business unit that includes the participant (the entire employer organization may be the business unit for this purpose); and
  • Neither the participant nor a member of his or her family may make the determination as to whether the subjective criteria have been satisfied.

Notice 2005-1, however, provides that bonus compensation is not considered performance-based, under any circumstances, if the compensation is payable (i) regardless of performance, or (ii) based on performance criteria that are substantially certain to be met at the time the criteria are established, or (iii) based solely on the value of, or appreciation in value of, the employer or the stock of the employer.

The Treasury Department and IRS indicated in Notice 2005-1 that they anticipate future guidance will establish more restrictive requirements for compensation to be considered performance-based. Finally, remember that, under Notice 2005-1, an employer must amend all nonqualified plans that are subject to Section 409A by December 31, 2005 in order to comply with the requirements of the new law.

This discussion is not intended to constitute a complete analysis of all tax considerations relevant to the proposed guidance. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This discussion does not meet those requirements. Accordingly, this discussion was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties that may be imposed on the taxpayer in connection with transactions described in the proposed guidance.

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.