Employers Must Review Nonqualified Deferred Compensation Plans In Light of the American Jobs Creation Act of 2004
 
December 29, 2004
 
David O'Leary - Chicago

In response to actual and perceived abuses of nonqualified deferred compensation plans by companies such as Enron Corporation, Congress has enacted sweeping changes to deferred compensation plans. Much like ERISA significantly changed the design and operation of qualified plans 30 years ago, the American Jobs Creation Act of 2004 (the Act) will have a profound impact on the design and operation of nonqualified deferred compensation plans. While the Act imposes certain restrictions and limitations on nonqualified plans, it also eliminates some of the uncertainty and will hopefully provide clear guidance as to how such plans should be designed and administered.

The Act adds Section 409A to the Internal Revenue Code. Section 409A is effective January 1, 2005, and affects all employers, whether public, private or tax-exempt. It provides that all amounts deferred under a nonqualified deferred compensation plan or arrangement for all taxable years are currently includable in an employee’s gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are satisfied. Many of the requirements are similar to the qualification requirements for qualified plans.

For purposes of the Act, “substantial risk of forfeiture” means that a participant’s right to compensation is conditioned on the participant’s future performance of substantial services. The IRS is instructed to issue regulations setting forth certain situations in which a “substantial risk or forfeiture” will be disregarded, such as when it is used to manipulate the timing of the inclusion of income or when it is illusory.

Arrangements Covered by 409A

Section 409A applies to “nonqualified deferred compensation plans.” The Act defines this broadly to include any plan, agreement, or arrangement that provides for the deferral of compensation. This includes:

• traditional elective deferral plans

• supplemental executive retirement benefits (SERPs)

• plans that cover only one person, such as employment agreements and severance agreements

• stock options having a below-market exercise price

• stock appreciation rights

• restricted stock, phantom stock, and deferred shares

The following are excluded from the rules of 409A:

• tax-qualified retirement plans, such as pension, profit sharing, 401(k), ESOP, simplified employee pension and SIMPLE plans

• tax-deferred annuities

• any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan

• governmental eligible deferred compensation plan (Section 457 Plan)

• Code Section 422 incentive stock option plans (ISOs)

• Code Section 423 employee stock purchase plans (ESPPs)

• stock options with an exercise price that equals or exceeds the fair market value of the underlying stock on the date of the grant, if such arrangement does not include a deferral feature

• annual bonuses or other annual compensation amounts paid within two-and-one-half months after the close of the tax year in which the services were performed

The new rules apply not only to employees but also to arrangements with directors and independent contractors. There are many unanswered questions as to whether certain types of plans will be included or excluded from the definition of plans subject to the requirements of 409A. Congress has instructed the Internal Revenue Service to issue regulations under 409A prior to December 22, 2004. Hopefully, these regulations will provide additional guidance.

Requirements That Must Be Satisfied

Restrictions on distributions – The plan must provide that compensation deferred under the plan cannot be distributed earlier than:

• the participant’s termination of employment, death or disability, unless the participant is a key employee of a publicly traded corporation; the distribution to a key employee of a publicly traded corporation must be delayed until six months following separation from service; key employees are defined using at least one of the following criteria:

• officers with annual compensation in excess of $130,000 (adjusted for inflation and limited to 50 employees)

• five-percent owners

• one-percent owners with annual compensation in excess of $150,000

• a time specified, or a schedule fixed, under the plan as of the date of the deferral of the compensation (amounts payable on the occurrence of an event, such as a child’s graduation from college, are not treated as payable at a specified time)

• a change in the ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation

• the occurrence of an unforeseen financial emergency

Common provisions that are no longer allowed include:

• “haircut” provisions allowing a participant to voluntarily take a withdrawal at any time subject to a small penalty

• distributions at the discretion of the plan administrator

Acceleration of benefits – The plan may not permit the acceleration of the time or schedule of payment under the plan, except as provided in IRS Regulations. Acceleration of payments to participants in the event of deterioration of the employer’s financial condition is prohibited.

Election requirements – The plan must provide that deferral elections:

• generally must be made in the tax year preceding the year in which the services are performed, or within 30 days of becoming an eligible plan participant

• must be made not later than six months before the end of the performance period if the award is performance-based (i.e., an incentive bonus); any subsequent election must be made at least 12 months after the initial election and must defer receipt for at least five years in the future, except in the case of death, disability, or unforeseen emergency

• cannot be made less than 12 months before the date of the first scheduled payment for any election related to a payment made at a specified time or under a fixed schedule

Use of rabbi trusts – Rabbi trusts may still be used, but use of offshore rabbi trusts is prohibited. Also prohibited are rabbi trusts that are convertible into secular trusts.

Penalties for Failure to Comply With the New Rules

Failure to comply with the new rules may result in substantial penalties for employees covered by these plans. However, if the failure relates to specific employees, only those specific employees will be subject to the penalties. Deferred compensation of other employees will not be affected. Affected employees may be liable for the following:

• income taxes on all amounts deferred in the current and prior years

• interest on the tax from the date the amount was first deferred or vested

• additional penalties equal to 20 percent of the deferred amounts included in the employee’s income

Effective Date

The new rules are effective for amounts deferred or amounts which become vested in tax years beginning after December 31, 2004. Earnings on amounts deferred before the effective date are not covered by the new rules unless the deferral amounts become covered. Amounts deferred under a plan during tax years beginning prior to December 31, 2004, are subject to the new rules if the plan is materially modified after October 3, 2004.

The IRS is directed to issue guidance prior to December 22, 2004, providing a limited period of time during which current plans can be amended to conform to the new requirements and participants can terminate participation in the plan or modify or cancel an outstanding deferral election.

Employers Sponsoring Nonqualified Deferred Compensation Plans Should Take Immediate Action

For most employers, the new rules become effective January 1, 2005. It is likely that the IRS will provide additional time for plan sponsors to amend their plan documents and will provide transitional relief for deferral elections. However, if an employer has any nonqualified deferred compensation plans or agreements, they should take immediate action. We suggest employers do the following:

• review all of their compensation plans and agreements as soon as possible and determine which have deferral features that may be subject to the new rules

• decide whether to make changes to their existing plans or agreements or “freeze” them and adopt new plans or agreements that are designed to comply with the new rules

• do not make any “material” changes which would cause existing plans to become subject to the new rules, without the advice of counsel

• if necessary, contact covered employees and obtain new election forms prior to December 31, 2004 (or such later date authorized by IRS Regulations)

• if a public company, determine whether shareholder approval is required to modify or terminate an existing agreement

The new rules are complex and confusing, and time is of the essence for employers to make changes to affected deferred compensation plans. Having experienced attorneys review your company’s plans and develop creative and cost-effective strategies for compliance, as well as the right solution for your individual needs, is prudent.

For more information, e-mail David O’Leary at david.oleary@hklaw.com or call toll free, 1-888-688-8500.