Contents
- What Must Be Done Now to Address the New Legislation?
- How Does the New Legislation Affect Deferred Compensation?
- When Will the New Legislation Be Effective?
- What Compensation Arrangements Will Be Affected?
- What Requirements Need to Be Satisfied to Maintain Deferred Tax Treatment?
What Should I Do Now?
On Friday, October 22, 2004, the President signed the American Jobs Creation Act of 2004. This new legislation significantly affects the tax benefits and flexibility of nonqualified deferred compensation arrangements widely used by public and private companies to attract and reward key management personnel and directors by providing tax deferral and/or supplemental retirement benefits. The new legislation provides that amounts deferred under a plan or agreement that does not meet certain design and operational requirements will be subject to current taxation, interest, and penalties. The new legislation becomes effective January 1, 2005, but in certain circumstances affects compensation deferred prior to that date.
What Must Be Done Now to Address the New Legislation?
You should immediately review all compensation arrangements to determine whether they are affected by this significant new legislation. We urge you to contact your attorney at Piper Rudnick, or a member of the Employee Benefits and Executive Compensation practice area listed below, to discuss what compensation arrangements will be affected by this new legislation, determine what steps must be taken to bring the arrangements into compliance, and determine how to work with third-party service providers and communicate with participants regarding the implementation of the changes to your deferred compensation arrangements.
How Does the New Legislation Affect Deferred Compensation?
The legislation creates new Section 409A of the Internal Revenue Code (the Code). Under Section 409A of the Code, if at any time during a taxable year a "nonqualified deferred compensation plan" fails to meet and be operated in accordance with strict requirements, each participant to whom the failure relates will be immediately taxed on all of his or her compensation deferred under that plan for all taxable years, unless such compensation is subject to a substantial risk of forfeiture or was previously included in gross income. In addition, the participants will be assessed interest and a 20 percent penalty.
When Will the New Legislation Be Effective?
The new legislation applies to all amounts that are deferred or become vested after December 31, 2004, and to compensation deferred on or before this date under any deferred compensation plan that is materially amended after October 3, 2004. Treasury is expected to issue guidance within 60 days of the date of enactment of the new legislation to provide transition rules to bring existing nonqualified deferred compensation plans into compliance and to provide opportunities for participants to withdraw from participation in existing plans without violating the deferred compensation provisions. A comprehensive review of your deferred compensation arrangements now will enable you to act quickly and take full advantage of the transition provisions provided by Treasury.
What Compensation Arrangements Will Be Affected?
The new legislation defines "nonqualified deferred compensation plan" broadly to include any plan, agreement, or arrangement (including an arrangement that includes one person) that provides for the deferral of compensation, other than a qualified employer plan or any bona fide vacation or sick leave, compensatory time, disability pay, or death benefit plan. Qualified employer plans generally include taxqualified retirement plans, tax-deferred annuities, simplified employee pensions, simple retirement accounts, and eligible deferred compensation plans of certain state and government employers and tax-exempt organizations. The broad definition creates uncertainty regarding what compensation arrangements are covered by the legislation. Although regulations issued by Treasury could narrow this definition, we believe that the legislation, as currently written, could potentially apply to:
- deferred compensation plans
- excess and supplemental retirement plans
- severance agreements
- director fee deferral arrangements
- stock appreciation rights
- restricted stock units
- deferred stock awards
- phantom stock
- deferral of gain on stock option exercises
- discounted stock options
- any agreement, such as an employment or severance agreement, that includes the right to defer compensation
What Requirements Need to Be Satisfied to Maintain Deferred Tax Treatment?
In order to continue to qualify for deferred taxation under the new legislation, nonqualified deferred compensation plans, agreements, and arrangements must satisfy specific limitations, including the following.
Timing of Deferrals - Elections to defer compensation must generally be made no later than the close of the taxable year prior to the taxable year in which the compensation is earned. However, the legislation provides two exceptions to this general rule: (i) in the first year that employees become eligible to participate in a nonqualified deferred compensation plan, the deferral elections may be made within 30 days of becoming eligible to participate; and (ii) in regard to "performance-based compensation" that is based on services performed over a period of at least 12 months, deferral elections may be made no later than 6 months prior to the end of the service period. The legislative history of Section 409A provides that "performance-based compensation" is expected to be defined by Treasury to include compensation to the extent it is (i) variable and contingent on the satisfaction of pre-established organizational or individual performance criteria; and (ii) not readily ascertainable at the time of the election. The legislative history also provides that "performance-based compensation" will be required to meet certain requirements similar to those under Section 162(m) of the Code.
No Acceleration of Distributions - A nonqualified deferred compensation plan cannot permit the acceleration of the time or schedule of payment of benefits. For example, this requirement precludes accelerated vesting of restricted stock units and the use of "haircuts" (where a participant’s account is reduced by a fixed percentage if he or she elects to receive an early distribution). The legislative history provides that Treasury is expected to issue guidance regarding the limitations on accelerated distributions.
Distributions - Distributions are only permitted upon separation from service, disability, death, a specified time or pursuant to a fixed schedule under the plan at the date of deferral, certain changes in control, and unforeseeable emergencies. In addition, key employees of public companies may not receive a distribution until six months after termination of employment (other than due to death). For purposes of this limitation, key employees include (i) the top 50 officers with annual compensation greater than $135,000 in 2005; (ii) 5 percent owners; and (iii) 1 percent owners with annual compensation greater than $150,000. Treasury is expected to issue guidance regarding the definition of a "change in control" for this purpose.
Changes to Elections - A plan may allow subsequent elections to change the timing or form of distributions if the plan requires that the subsequent election does not take effect until 12 months after the date the election is made, the plan requires that the additional deferral is for a period of at least 5 years from the date the payment otherwise would have been made (except in the case of death, disability, or unforeseeable emergencies), and the plan requires that an election regarding a distribution to be made upon a specified time must be made at least 12 months prior to the date of the first scheduled payment.
Certain Funding Arrangements - The new legislation provides that compensation deferred under nonqualified deferred compensation plans will be immediately taxable to participants if the plan is funded through an offshore rabbi trust. In addition, deferrals will be immediately taxable on the earlier of the date a nonqualified deferred compensation plan provides that funding of the plan is triggered by a change in the employer’s financial health, or the date assets are set aside due to such a change.
What Should I Do Now?
Carefully review your compensation arrangements. If you believe you have compensation plans, arrangements, or agreements that involve deferred compensation, please call your Piper Rudnick contact or one of the partners listed below for assistance in complying with the new legislation.
This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.
