Internal Revenue Issues General Transitional Guidance for Nonqualified Deferred Compensation Plans
By Employee Benefits, ESOPs & Executive Compensation
Section 409A of the Internal Revenue Code, recently enacted as part of the American Jobs Creation Act of 2004 (the "Jobs Act"), imposes onerous new requirements on nonqualified deferred compensation arrangements and other executive compensation arrangements, effective for amounts deferred on or after January 1, 2005, and unvested amounts deferred before 2005. Failure to comply with Section 409A will result in immediate income taxation to the executive of all amounts deferred under the arrangement, plus a 20% additional tax and interest, even if amounts are not currently payable under the plan. The new law applies to deferral arrangements with employees and independent contractors, including board members.
On December 20, 2004, the IRS issued its first installment of guidance implementing section 409A. The guidance clarifies several ambiguities in section 409A and provides liberal transitional relief with a December 31, 2005, deadline for amending plan documents to become compliant with the new requirements. Additional guidance under the new law is expected throughout 2005.
Key provisions of the IRS guidance are:
What Actions Should Be Taken Now?
- Good-Faith Compliance Required Immediately. As a general rule, all nonqualified deferred compensation arrangements must be operated in good-faith compliance with section 409A beginning on January 1, 2005.
- Free Pass for 2005 Deferral Elections. Participants may make deferral elections with respect to compensation earned in 2005 (and, in some circumstances, compensation earned in 2004 but not payable until 2005) until March 15, 2005, so long as the elections are made prior to the applicable payment date under a written plan document in place on December 31, 2004.
- Plan Amendments and 2005 Opt-Out Elections. Plan sponsors have until December 31, 2005, to amend existing plans to conform to the provisions of section 409A. Amendments may permit participants to make new distribution elections with respect to amounts previously deferred, cancel existing deferral elections, or completely terminate participation in a plan, as long as such elections are made prior to December 31, 2005.
- Plan Aggregation. For each individual, amounts deferred under separate plans or arrangements will be aggregated and considered to have been deferred under, at most, three different "plans" for purposes of section 409A. The significance of this aggregation is that a violation of 409A under any individual arrangement will trigger immediate taxation and penalties with respect to amounts deferred not only under that arrangement, but also under every other arrangement of the same type in which the individual participates. For this purpose, all defined contribution-like account balance plans are aggregated together as a single plan; all defined benefit-like arrangements are aggregated together as a single plan; and all SARs or other equity-based compensation arrangements are aggregated together as a single plan.
- Plans Sponsored by Tax-Exempt and Governmental Employers. The guidance confirms that existing 457(f) arrangements are not grandfathered because all deferrals by their terms are subject to forfeiture and are not vested. The guidance specifically defines substantial risk of forfeiture for purposes of 409A, and the definition is not entirely consistent with the tax code definition that traditionally has been applicable for purposes of 457(f). As a result, it is unclear at this point how the two definitions will be applied. For example, the new 409A definition provides that elective salary deferrals may not be made subject to a substantial risk of forfeiture, meaning that these deferrals could be treated as vested for purposes of 409A, and therefore subject to all 409A distribution and plan document requirements, but not vested (that is, not currently taxable) for purposes of 457(f). Therefore, plan sponsors are advised to wait for additional guidance before implementing elective deferral programs. One thing is clear - the new definition of substantial risk of forfeiture does not permit the extension of an original existing vesting date or the use of rolling vesting dates in 457(f) plans.
- Stock Appreciation Rights. The guidance confirms that 409A applies to stock appreciation rights ("SARs"), with one limited exception. The exception is for SARs granted by publicly traded companies that meet specific criteria, including the requirement that the SARs are payable only in the form of publicly traded securities.
- Change in Control. The guidance includes a complex definition of a "change in ownership or effective control," one of the permissible distributable events specified in 409A. This will require a change in the definition used in almost all deferred compensation plans and agreements that may not conform to the definition used for other purposes, such as stock option plans or Golden Parachutes.
- Acceleration of Payments. As a general rule, 409A provides that a scheduled payment date may not be accelerated by either the plan sponsor or the participant. The guidance provides limited exceptions to this rule. Acceleration will permitted (1) to meet the requirements of a domestic relations order; (2) to comply with Code section 1043 certificate of divestiture; (3) to pay income taxes due upon a vesting event under a 457(f) plan; (4) to permit certain de minimis payments under $10,000; and (5) to pay FICA taxes on amounts deferred under the plan.
- Reporting and Withholding Requirements. 409A requires that all compensation (and earnings thereon) deferred in a particular year will need to be reported on either a 1099-Misc. or Form W-2, whether or not the amounts are includible in gross income that year. The requirement applies to amounts deferred under SERPS and other defined benefit type arrangements as well as individual account plans. In addition, income tax withholding will now be required for amounts includible in gross income whether or not the amount is actually paid. The guidance describes the application of these rules in detail, but does not provide a method for calculating the amount of deferrals for a year.
- Employees May Opt Out of 2005 Deferral Elections (If Permitted by Plan Sponsor). The IRS Transition Guidance provides that an employee may cancel his or her 2005 deferral elections (made before March 15, 2005) and receive any amount deferred during 2005, provided the applicable plan document is amended before December 31, 2005, to permit the cancellation, and any amounts previously deferred during 2005 are includible in the employees 2005 income. This "opt-out" avoids the 20% penalty and is intended to allow employees time to become familiar with the new law during 2005.
- Employers May Terminate and Pay Out Existing Plans by December 31, 2005. One of the biggest changes under the new law is the prohibition of an employers right to terminate a plan and accelerate the payout of benefits to all employees. Termination of an otherwise grandfathered plan will constitute a "material modification" of that plan, subjecting all participants who receive payouts to the 20% penalty tax. To provide transitional relief from this draconian change in the law, the IRS guidance allows employers to terminate their existing plans and distribute all benefits by December 31, 2005. After that date, unless further guidance relaxes this rule, termination and early payment of plan benefits will result in the 20% penalty tax on all participants.
- Still Unaddressed. This first round of guidance makes clear that additional IRS guidance is anticipated in 2005 concerning such issues as the method of calculating the amount of deferrals for purposes of all deferrals to which 409A applies, and the method of determining what compensation qualifies as "performance-based" compensation. Further guidance is also expected with regard to plan document requirements. Treasury officials have advised plan sponsors to wait for the issuance of such guidance before adopting any formal plan documents or amendments.
Compliance with 409A will require both time and careful planning. Employers should:
- Become familiar with the requirements of 409A, since the guidance provides that all nonqualified deferred compensation arrangements must be operated in good-faith compliance with these rules effective January 1, 2005.
- Consider adoption of plan amendments (i) terminating existing arrangements and distributing all deferred amounts in taxable year 2005; (ii) permitting participants to terminate participation in existing nonqualified deferred compensation arrangements; or (iii) permitting participants to change distribution elections under existing arrangements. Any such amendments and/or elections permitted by the transitional guidance need to be made by December 31, 2005.
- Make Elective Deferrals for 2005. As soon as possible, inform participants of the March 15, 2005, deadline for making deferral elections for the 2005 taxable year.
- Communicate with plan participants. Inform participants of any pending plan amendments or terminations and advise participants of their right (if the employer chooses to make this right available) to cancel their participation or change existing distribution elections by December 31, 2005.