On 22 October 2004, the American Jobs Creation Act of 2004 (AJCA) was enacted as a legislative response to public cries for executive compensation reform. In an attempt to stem future abuses by making fundamental changes to the U.S. tax rules for deferred compensation, AJCA created the new Section 409A of the Internal Revenue Code, which is being viewed by many as one of the most significant U.S. employee benefit developments since the passage of the Employee Retirement Income Security Act (ERISA) in 1974. The new rules will severely contract the previously wide-open universe of nonqualified deferred compensation, principally by establishing deadlines by which deferral elections must be made and by regulating both distribution practices and funding methods.
Broad scope of Section 409A coverage
Compliance with Section 409A presents a unique challenge to U.S. employers because it applies to more than just traditional nonqualified deferred compensation (NQDC) plans. Individual agreements, stock options, and other benefits (including severance) that employers generally have not considered deferred compensation may all potentially be covered. Accordingly, every employer with U.S. operations needs to analyze how Section 409A will affect not only its employees but also its directors, partners, independent contractors, and the employer itself.
Harsh penalties make noncompliance extremely costly
Due to the broad coverage of the new rules and the radical nature of the required changes, few employers will escape having to take proactive steps to achieve compliance by the end of 2005. Noncompliance is not an option as it carries the imposition of significant tax penalties—income taxation in the later of the deferral or vesting year, a 20% excise tax, and interest penalties. While such penalties would be levied against the recipients of deferred compensation, their unanticipated imposition will create significant issues for employers (e.g., tax reporting and withholding issues as well as demands for tax penalty gross-ups).
Guidance to date—Notice 2005-1
As of the date this article was written, the IRS has only issued one installment of guidance, IRS Notice 2005-1, a long set of questions and answers that also provides initial guidance and temporary relief from a number of new requirements imposed on many existing NQDC arrangements by AJCA. Although transitional relief is provided through 2005, plan sponsors must still operate their NQDC plans in "good-faith compliance" with provisions of Section 409A and the guidance contained in the notice during 2005. AJCA is effective for amounts deferred after 31 December 2004. While the IRS may extend IRS Notice 2005-1's transition relief, it has not yet indicated whether it will do so. Consequently, employers must act under the assumption that the current 31 December 2005 deadline will remain.
In addition to providing transitional relief under section 409A, Notice 2005-1 protects certain deferrals under "grandfather" rules and explains the conditions for terminating NQDC arrangements. However, it remains silent on several key details, including funding restrictions, deferral elections, and distribution requirements. It also offers no insights into how defined benefit supplemental executive retirement plans (SERPs) and other nonaccount balance plans should calculate amounts to be included in income.
Other significant areas addressed by the IRS guidance include:
- Deferred Compensation Definition. To be considered deferred compensation and subject to the section 409A rules, an individual must have a legally binding right to payment in the future that has not yet been actually or constructively received and included in income. As long as such amounts are subject to a substantial risk of forfeiture, they will not be included in income. If amounts are paid within 2-1/2 months of vesting (including bonuses for the current year paid after year-end) or if an employer has the right to unilaterally reduce or eliminate the compensation, there is no deferral. Based on the guidance currently available, it appears that a "plan" covered under Section 409A is any arrangement that effectively defers compensation by creating a legally enforceable right to receive compensation that would be taxed in a later year (e.g., it may be an oral promise that does not even remotely resemble a “traditional” deferred compensation plan and may be a promise made to just a single individual).
- Substantial Risk of Forfeiture. Because the existence of a substantial risk of forfeiture effectively defers taxation, the IRS will closely examine whether arrangements containing such a provision are "real" and whether it is actually enforced. "Rolling" risks of forfeiture and “noncompete” agreements, as well as risk of forfeiture elected by the employee, are all deemed not to entail a substantial risk of forfeiture.
Why is it so important to identify plans now?
Note: The payment under the nonqualified plan must begin or be made before 31 December 2005.
- Written and Operational Compliance Required: Plans must comply not only in operation with the new law (beginning 1 January 2005) but by 31 December 2005, they must also comply in "form" (i.e., if they are covered by Section 409A, they must now have a formal plan document that conforms to all of the provisions of Section 409A).
- Expiration of Transitional Relief Period: Section 409A prohibits any acceleration of payments whether in form (e.g., switching from a 10-year payout to a five-year payout or from a two-year payout to a lump sum) or timing (electing to receive a distribution earlier than the originally elected payment date). In addition, Section 409A also includes other restrictions on the timing of distributions under the plan and the participant’s ability to change them. Likewise, under the new rules, plan sponsors are prevented from terminating their plans and immediately distributing benefits to employees.
However, the transitional relief provided in Notice 2005-1 allows the plan sponsor or an individual to terminate all or a portion of their participation in a NQDC plan or cancel an outstanding election for 2005 by 31 December 2005, provided the plan is amended and effective before 31 December 2005, and all amounts subject to cancellation or termination are includible in the individual’s income in the taxable year in which the amounts are earned and vested.
Thus the 31 December 2005 deadline represents the end of the 2005 transitional relief period for distributions and distribution election changes. Consequently, it will be the last chance for plan sponsors that wish to terminate their plans to be able to immediately distribute benefits upon such termination. Furthermore, it will also represent the final opportunity for individuals to elect to: (a) immediately receive a distribution of all or any portion of their deferred amount; (b) change their distribution election currently in effect (including changes that result in acceleration—e.g., going from installments to lump sum) without having to comply with the Section 409A rules that will severely limit these elections beginning 1 January 2006.
- SERPs: Until 31 December 2005, an election as to the timing or form of a payment under a nonqualified plan that is controlled by the election under a qualified plan (i.e., a plan meeting the requirements of Section 401(a) of the Internal Revenue Code) will not violate Section 409A, provided the election is made in accordance with the terms of the nonqualified plan as of 3 October 2004.
What should employers be doing now?
- Inventory all benefits programs. (In many cases no single individual within an employer will be able to identify all of the employer's plans. Therefore, a representative group of knowledgeable individuals drawn from each of the employer's units probably should compile plan lists and then work collectively to aggregate them into a single comprehensive plan list that will serve as a starting point for the employer.)
- Determine which plans are exempt from Section 409A.
- Identify programs or arrangements to which Section 409A apply.
- Determine whether all or any portion of the non-exempt plans are not compliant with Section 409A.
- Begin process of addressing how to bring such programs into compliance.
- Make sure plans are in operational compliance for 2005.
- Begin amendment process to bring written documents into 409A compliance (for those arrangement where little or no documentation was previously in effect, make sure that a Section 409A compliant document is created).
- Wait until additional guidance is available before finalizing and officially adopted the new 409A compliant document(s).