September/October 2005

Congress added section 409A to the Internal Revenue Code as part of the American Jobs Creation Act of 2004. Section 409A intends to curb a variety of perceived abuses in the use of "nonqualified deferred compensation" plans by imposing strict requirements on when deferral elections can be made, limiting distributions to certain specified events, prohibiting the "acceleration" of benefits, and restricting the types of vehicles used to fund such plans. Section 409A became effective beginning on January 1, 2005.

Due to the breadth of section 409A – some consider it to be as significant a piece of legislation in the compensation arena as was the enactment of ERISA in 1974 – the tax community has awaited guidance on exactly how to implement the many new mandates of this provision. This guidance initially came in the form of Notice 2005-1, in which the Internal Revenue Service generally allowed employers until December 31, 2005 to amend their plans to comply with the new law, provided that they were operated in "good faith compliance" with these rules in the interim. As a result of some significant delay in issuing proposed regulations, released only recently, the IRS has extended the general period to comply with section 409A until December 31, 2006.

Despite the extension of time in which employers may amend their plans, the proposed regulations do not extend other forms of transition relief offered in Notice 2005-1. As a result, we strongly recommend that employers freeze or terminate certain plans and permit employees to cancel certain late deferral elections no later than December 31 of this year (2005).

This article provides a brief overview of section 409A, highlights some significant developments in the proposed regulations and concludes with several recommendations on how to take advantage of the transition relief in Notice 2005-1 and the proposed regulations.

Scope of Section 409A
What Arrangements are Subject to Section 409A?

Section 409A applies to any "nonqualified deferred compensation plan". In general, a nonqualified deferred compensation plan is any "plan" providing for the deferral of compensation. 

A "plan" includes any arrangement covering employees, directors, board members, trustees and certain independent contractors (referred to as "service providers"). A plan provides for the "deferral of compensation" to the extent that it creates a legally binding right to have compensation earned by a service provider in one taxable year (but not actually or constructively received or included in income) paid in a future taxable year.

If the employer (referred to as the "service recipient") has unilateral discretion to reduce or eliminate payments, the plan does not provide for the deferral of compensation unless the facts and circumstances indicate that it is unlikely that the service recipient will exercise this discretion.

The broad scope of section 409A makes it applicable to a variety of arrangements that have not traditionally been considered deferred compensation, such as bonus plans, certain shadow equity arrangements (restricted stock units and phantom stock plans), and certain severance pay arrangements.

What about Bonus Plans and Other Short-Term Deferrals?

A plan does not provide for the deferral of compensation to the extent that it is paid by the later of 2-1/2 months from: (a) the end of the service provider's taxable year or; (b) the date on which it is no longer subject to a "substantial risk of forfeiture". Practically, this applies to most bonus plans, including multi-year bonus plans and fiscal year bonus plans where the amount of the bonus is unknown, so long as bonuses are paid within this 2-1/2 month period.

Note: Section 409A provides for a special definition of "substantial risk of forfeiture". Under this special definition, a non-competition agreement is not considered to create a substantial risk of forfeiture. As a result, many plans, including "457(f)" plans, which rely on a non-competition agreements must be amended. This definition, however, also provides a planning opportunity to combine a "substantial risk of forfeiture" with a short-term deferral and avoid application of section 409A.

What Plans are Exempt from Section 409A?

As a general rule, the following are exempt from section 409A: 

• qualified plans; 
• "457(b)" plans; 
• SEP plans and SIMPLE-IRAs; 
• bona fide vacation, sick leave, disability pay or death benefit plans; 
• certain stock rights, including fair-market value stock options and fair market value stock appreciation rights; 
• grants of incentive stock awards ("ISOs") and under employee stock purchase plans ("ESPPs"); 
• certain separation payment plans 
• transfers of restricted property; 
• grants of partnership profits interests; 
• routine business payments between accrual taxpayers; 
• grants of restricted property; 
• split-dollar insurance arrangements; and 
• medical reimbursement arrangements.

What About Stock Plans?

The proposed regulations clarify that fair market value stock rights are not subject to section 409A. For these purposes, "stock rights" include both stock options and stock appreciation rights.

However, if a stock right contains a feature for the deferral of compensation, it may nevertheless be subject to section 409A. A stock right includes a feature for the deferral of compensation if the:

• Option may be settled in stock other than of the service recipient, or the appreciation is measured by appreciation in stock other than of the service recipient;

• Amount required to purchase the stock is or could become less than the fair market value of the stock on the date of the grant, or compensation payable under the appreciation right is or could be greater than the difference between the stock value on the date of grant and the value on the date of exercise;

• Stock right permits the recipient to receive compensation other than cash or stock of the service recipient on the date of exercise and such additional rights allow for the deferral of compensation; or

• Stock right permits the recipient to receive an amount equal to all or part of the dividend declared and paid on the underlying stock upon exercise, unless set forth in a separate agreement conforming to the rules of Section 409A

The proposed regulations adopt a generous definition of "stock of the service recipient" by applying the affiliated company and common control definitions by substituting a 50-percent (or, for legitimate business reasons, 20-percent) ownership test. 

Due to some differences in the transition relief granted in Notice 2005-1 and the proposed regulations, employers maintaining stock plans that do not comply with section 409A are advised to amend these plans to cancel deferrals or terminate awards no later than December 31, 2005.

What About Severance Pay Plans?

The proposed regulations indicate that "separation pay" plans are generally subject to section 409A unless the plan provides for separation pay only upon an actual involuntary separation from service or pursuant to a window program and is either:

• Collectively bargained; or

• Paid no later than two years from the separation from service and does not exceed the lesser of twice the service provider's compensation or twice the section 401(a)(17) limit for the year ($210,000 in 2005).

We recommend that severance pay plans and similar arrangements be reviewed prior to December 31, 20005 to determine whether such plans should be amended to comply with section 409A or be terminated and replaced by a new or different arrangement.

What About Independent Contractors and Directors?

Section 409A does not apply to arrangements between service recipients and independent contractors if, during the taxable year, the independent contractor provides significant services to two or more unrelated service recipients. 

Note: Directors – even directors who are independent contractors with respect to multiple unrelated corporations – are not eligible to take advantage of the independent contractor exception. 

Operation of Section 409A
What Changes Does Section 409A Require to My Plans?

Section 409A requires employers to make several significant changes to their deferred compensation plans. These changes require that:

• Employers maintain their nonqualified deferred compensation plans in writing.

• Participants elect to defer: (a) non-performance based compensation no later than December 31 of the prior calendar year; and (b) performance based compensation no later than six months before the end of the performance period;

• Distributions from plans be made only upon the occurrence of one of the six specified events of distribution described in the statute; 

• Distributions to certain key employees of public companies be delayed by six months; and 

• Plans be amended to restrict the ability of participants to: (a) accelerate the receipt of benefits; or (b) make later elections to further defer distributions.

In addition, section 409A prohibits employers from using certain "offshore" trusts to hold plan assets or trust documents containing "financial health" triggers.

What Are the Penalties for Not Complying with the New Rules?

If a plan violates the rules discussed above, section 409A imposes substantial penalties against the participant. As a result, service providers have a significant vested interest in ensuring that their employers comply with section 409A. 

The failure of a plan to comply with section 409A requires that the participant include all previously deferred amounts under the plan in gross income and pay on this amount: (1) income taxes, (2) employment (Social Security and Medicare) taxes; and (3) a 20-percent penalty tax. In addition, the participant will also be responsible for interest on this amount at the underpayment rate plus 1-percent and any underpayment penalties that may be imposed.

Neither Notice 2005-1 nor the proposed regulations provides an exception from these penalties for good faith plan drafting errors or operational failures that are fully and promptly corrected upon discovery. 

How Are Multiple Plans Treated?

Significantly, the proposed regulations aggregate all nonqualified deferred compensation plans of a service recipient in which an service provider participates. Practically, this means that an operational failure with respect to any single plan is deemed to trigger an operational failure in all other plans of that service recipient in which the service provider participates.

Transition Relief
When Does Section 409A Take Effect?

Section 409A applies to any "amount deferred" on or after January 1, 2005 or any plan that was "materially modified" after October 3, 2004. An amount will be treated as deferred before 2005 (and, as a result, exempt from these new rules) so long as the service provider has a legally binding right to receive the amount, and the amount is both earned and vested. For this purpose, an amount is earned and vested only if not subject to either a: (a) substantial risk of forfeiture; or (b) requirement to perform further services. 

Technically, this means that participants should have made elections to defer compensation earned or vesting in 2005 by December 31, 2004 and plans should have been amended to conform to these rules by the same date. However, the Internal Revenue Service has provided transition relief for employers to bring their deferred compensation plans into compliance with section 409A. 

This transition relief provides that:

• Any deferral elections required to have been made by December 31, 2004 were deemed timely only if made by March 15, 2005; 

• Participants may cancel deferral elections made in 2005 or terminate participation in a plan only until December 31, 2005; 

• Participants may change their distribution elections to comply with section 409A until December 31, 2006; and

• Plans may be amended to comply section 409A until December 31, 2006, so long as operated in good faith compliance with the new law until such time.

What Is "Good Faith Compliance" With Section 409A?

Plans will be operated in good faith compliance with section 409A so long as operated in accordance with the principles in either Notice 2005-1 or the proposed regulations. 

Note: The exercise of discretion by the service recipient or provider in a manner that causes a plan to violate section 409A will not be considered good faith compliance. However, such actions will not cause the plan to fail to be operated in good faith compliance with respect to the other participants.

What Should I Do About My Existing Plans?

The actions that employers should take in response to section 409A depend on the type of deferred compensation plans maintained.

(a) Fully Vested Plans

Generally, section 409A is not applicable to deferred amounts that were fully earned and vested by December 31, 2004. This means that all services for accrual and vesting of all benefits under the plan have been performed. Thus, fully-earned and vested plans are grandfathered under the old law. As a result, an employer should take no action with respect to an existing deferred compensation plan that no longer accepts deferrals and all previously deferred amounts under which are fully vested.

(b) Existing Plans Still Accepting Deferrals

An employer maintaining an existing deferred compensation plan still accepting deferrals that were not vested by December 31, 2004 should consider freezing this plan with respect to previously deferred amounts that were fully vested as of December 31, 2004 to preserve the prior, more favorable, tax treatment of the plan. Employers must be careful not to "materially modify" the plan, otherwise they risk jeopardizing the plan's grandfathered status.

The employer may permit participants to continue making deferrals into the existing plan, as employers have until December 31, 2007 to amend their plans. Under this transition rule, the existing plan will be deemed to comply with section 409A so long as: (a) deferral elections for 2005 were made by March 15, 2005; (b) deferral elections for 2006 are made by December 31, 2005; (c) the plan is amended to conform to section 409A by December 31, 2007; and (d) the plan is operated in good-faith compliance with section 409A and Notice 2005-1 or the proposed regulations until such time.

(c) New Plans

The release of proposed regulations address many concerns about the operation of new nonqualified deferred compensation plans under section 409A. As such, employers are free to establish such new plans and operate them in good faith compliance with section 409A and applicable IRS guidance. 

Note: The plan termination rules in the proposed regulations require that employers terminating any single plan to terminate all like plans, distribute the plan assets within two years and refrain from establishing replacement plans for a period of at least five years. In addition, the adoption of a new plan to circumvent the rules of section 409A with respect to existing plans indicates a lack of good faith compliance with respect to that plan. 

To this extent, we caution employers to think carefully and consult with counsel before establishing any new arrangements until the operation of section 409A is fully understood.

What Actions Must I Take in 2005?

Certain complexities in the transition relief require that the following actions be taken no later than December 31, 2005:

• Terminate Certain 2005 Deferrals. Section 409A requires that participants elect to defer non-performance based compensation no later than December 31 of the year preceding the year in which compensation is to be paid. Practically, this means that an election to defer a calendar year 2005 bonus must have been made by December 31, 2004 (extended to March 15, 2005 for compensation payable in 2005 only). As a result, any participant who made an election to defer compensation under a deferred compensation plan after March 15, 2005 must cancel this deferral by December 31, 2005. Similarly, participants must defer certain performance-based compensation no later than six months before the end of the performance period. Practically, this means that an election to defer a performance payment payable on December 31, 2005 must have been made no later than May 31, 2005, and must be canceled by December 31, 2005 to avoid application of section 409A. 

• Terminate Plans. Employers who do not wish to maintain plans subject to section 409A may terminate these plans and distribute plan assets to participants, who include the amounts distributed in gross income when they become vested. Any employer who wishes to cancel a deferred compensation plan (or any participant who wishes to cease participating in such a plan) must do so by December 31, 2005.

• Amend Discount Stock Plans. Section 409A applies to any "discount" stock plans (stock option or stock appreciation plan). Employers who wish to amend these plans by substituting fair market value stock or stock rights must do so by December 31, 2005.

• Certain Other Stock Plans. Section 409A applies to any stock plan (stock option or stock appreciation plan) that that is payable in other than cash or employer common stock (e.g., non-employer stock, preferred stock etc.) Employers who wish to amend these plans to provide for payments in cash or employer common stock must do so by December 31, 2005.

Note: Section 409A provides special termination rules requiring that, if an employer terminates a plan, all other plans must be terminated with respect to all other participants and the employer cannot establish a new plan for five years. As a result, December 31, 2005 is the last best opportunity for employers to terminate non-conforming plans.