First Round of Guidance Released on New Requirements for Deferred Compensation Plans

Prepared by: Jeffrey R. Capwell, Esq.

MCGUIREWOODS LLP

On December 20, 2004, the Treasury Department and Internal Revenue Service released initial guidance (Notice 2005-1) under Section 409A of the Internal Revenue Code. Section 409A imposes new requirements for nonqualified deferred compensation plans (NDCPs) and will generally apply to all amounts deferred after December 31, 2004 and amounts deferred prior to 2005 that remain unvested as of January 1, 2005. A summary of the most significant aspects of this guidance follows.

Most employers will not need to take any further action before the end of 2004 to comply with this guidance, which has flexible transition provisions. However, there is no transition relief for certain offshore rabbi trusts or for trusts or other arrangements which require segregation of an employer’s assets to pay NDCP benefits in the event of a change in the employer’s financial condition. Employers with these kinds of arrangements will need to act before December 31, 2004 to avoid potential current income inclusion and interest under Section 409A. See the end of this piece for more information

Additional rounds of guidance are expected in 2005. It is not clear at this time exactly when such guidance will be issued. It appears that the Treasury and IRS are expecting to gauge initial reaction to this guidance before issuing follow-on guidance. Significant new guidance is marked in bold.

Section 409A in General	Amounts deferred under a NDCP are currently includable in income if not previously included and not subject to a “substantial risk of forfeiture,” unless the requirements of Section 409A are satisfied.
Consequences of Section 409A Noncompliance	If a NDCP (or a related funding arrangement, such as a rabbi trust) does not satisfy the requirements of Section 409A, amounts deferred under the NDCP will be included in income in the year in which they are no longer subject to a substantial risk of forfeiture. These amounts will also be subject to interest and a penalty tax of 20%.
Definition of “Nonqualified Deferred Compensation Plan”	A NDCP does not include tax-qualified plans, Section 403(b) annuities, eligible Section 457 plans (see below), certain welfare plans (vacation, sick leave, disability, death benefit, etc.), health savings accounts (HSAs) or flexible spending accounts (FSAs). A “plan” for NDCP purposes can include any agreement, method or arrangement, including an agreement, method or arrangement with respect to a single individual. Special Note: Individual, Aggregated Plans for Penalty Purposes. For purposes of applying the penalty provisions (see above), each employee is treated as having his or her own separate plan. For example, if payment is made to a participant in a nonqualified supplemental retirement plan at an impermissible date under Section 409A, only that employee will be liable to the 20% penalty tax described above. Other participants in that plan will not be adversely affected so long as the rules are not violated with respect to their plan benefits. However, also for purposes of the penalty provisions, if an employee is a participant in (i) more than one account balance plan, (ii) more than one nonaccount balance plan, or (iii) more than one plan which is neither an account balance nor a nonaccount balance plan (such as a discounted stock option or SAR), then all of the employee’s plans within that category will be aggregated and treated as a single plan. Thus, to use the example above, if the supplemental retirement plan is an account balance plan and the employee is also a participant in an account balance-based voluntary deferred compensation plan, then the employee will be subject to the penalty provisions with respect to deferred amounts in both of those plans, even if the impermissible distribution was only with respect to one plan.
Definition of “Deferred Compensation”	Compensation is deferred when the “service provider” (generally employee) has a “legally binding right” to compensation from the service recipient (generally employer) which is payable in a later year. However, there are two important exceptions: Exception #1: Section 409A does not apply to “customary payment timing arrangements,” i.e., compensation paid after the last day of the employee’s taxable year pursuant to the timing arrangement under which the employer normally compensates employees. Example: X Company customarily pays its employees on a biweekly basis; thus, under this exception, compensation paid January 3, 2005 for services rendered in 2004 will not be treated as deferred for purposes of Section 409A. Exception #2: Section 409A does not apply to “short-term deferrals,” i.e., compensation not subject to an election which is paid within 2 ½ months of the end of the later of the employee’s or the employer’s taxable year.
Definition of “Service Provider”	A “service provider” (typically an employee) generally only includes an individual or a personal services corporation. Exception: Section 409A does not apply to a service provider “actively engaged in the trade or business of providing substantial services” other than as an employee or a director of a corporation, where such services are provided to at least two unrelated employers. For example, a self-employed accountant who receives fees from 50 clients is not subject to Section 409A.
Stock Options and Restricted Stock	Incentive stock options under Section 422 and qualified employee stock purchase plans under Section 423 are not subject to Section 409. Employee stock purchase plans that do not meet the qualification requirements of Section 423 are not exempt from Section 409A and will need to comply. Nonstatutory stock options are generally exempt from Section 409A if (1) the exercise price of the option is never less than the fair market value of the stock on the date the option was granted, and (2) the option does not include any feature which would permit the deferral of compensation. Example: an impermissible deferral feature might include stock appreciation rights that are granted in tandem with the stock option or provisions which permit the participant to defer the date on which shares will be delivered when the option is exercised. Restricted stock is also generally exempt from the Section 409A rules. However, a legally binding right to receive delivery of stock in a future year (such as under a restricted stock unit) may be deferred compensation subject to the rule.
Stock Appreciation Rights (SARs)	SARs are generally subject to Section 409A, unless: (i) the SAR exercise price may never be less than the fair market value of the underlying stock on the date the right is granted; (ii) the underlying stock is traded in an established securities market; (iii) the right is redeemable only for such underlying stock; (iv) the right does not include any feature which would permit the deferral of compensation; and (v) subject to further guidance, the stock received upon exercise is not subject to an employer’s option to repurchase. Exception #1: SARs with an exercise price which may never be less than the fair market value of the underlying stock on the date the right is granted, if granted on or before October 3, 2004, can be vested and exercised at any time, for stock or cash, without penalty under Section 409A. Excpetion #2: The notice also recognizes that SARs can be made to comply with the new rules by amending their terms to require payout (either in cash or in stock) at the time the SAR vests or when it would otherwise expire.
Section 457 Plans (for State and Local Governments and Tax-Exempt Organizations)	Section 457 plans which are not eligible under Section 457(b) are generally subject to the requirements of Section 409A in addition to the requirements of Section 457(f). Special Note: the definition of “substantial risk of forfeiture” (see below) in Section 457 is not necessarily consistent with the definition of the same term for Section 409A; thus, for instance, although a salary deferral will generally not be treated as subject to a “substantial risk of forfeiture” under Section 409A, the same might not be true under Section 457.
Partnership Interests	Subject to further guidance, the issuance of profits and equity interests to partners in a partnership may be subject to Section 409A if such interests would otherwise constitute deferred compensation. This rule would presumably also apply to profits and equity interests in limited liability companies electing to be taxed as partnerships. Until additional guidance is issued, however, taxpayers can treat the issuance of partnership interests or of options to purchase partnership interests under the same tax principles which govern the issuance of stock.
Definition of “Substantial Risk of Forfeiture” under Section 409A	A “substantial risk of forfeiture” exists with respect to deferred compensation if the compensation is conditioned on (i) the performance of substantial further services or (ii) the occurrence of a condition related to the purpose of the compensation (for example, the attainment of a prescribed level of earnings). Exception #1: an addition of a substantial risk of forfeiture after the beginning of the relevant service period or the extension of a period during which the compensation is subject to a substantial risk of forfeiture are each disregarded for purposes of Section 409A. Exception #2: compensation is not subject to a substantial risk of forfeiture merely because it is conditioned upon an agreement not to perform services, such as a non-competition agreement. Exception #3: compensation is generally not subject to a substantial risk of forfeiture beyond the time when the employee could have elected to receive it (for instance, salary deferrals are generally not subject to a substantial risk of forfeiture), unless, however, the amount subject to the substantial risk of forfeiture is materially greater than the amount the employee could have elected to receive. Special Note: the fact that an employee controls a significant portion of the voting power or value of the employer may negate the substantiality of a claimed risk of forfeiture.
Definition of “Change in Control” under Section 409A	A “change in control” generally constitutes a permissible distribution event under Section 409A. The guidance provides a three-part definition to “change in control”: (i) a change in ownership of the employer (or of the employer’s parent or any corporation higher in the chain, or of the corporation which is ultimately liable for the deferred compensation payment); (ii) a change in effective ownership of the employer (or other corporation as above); or (iii) a change in ownership of substantial assets of the employer (or other corporation as above). A “change in ownership” generally occurs when a person (or group of people pursuant to a merger or similar transaction) acquires more than 50% of the total fair market value or total voting power of the employer’s stock. A “change in effective ownership” generally occurs when (i) a person (or group of people as above) acquires (or has acquired during a 12-month period) 35% or more of the total voting power of the employer’s stock or (ii) a majority of members of the corporation’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the preexisting board of directors. A “change in ownership of substantial assets” generally occurs when a person (or group of people as above) acquires (or has acquired during the preceding 12-month period) assets totaling more than 40% of the gross fair market value of all the employer’s assets. The acquiring person (or group) can not be related to the target corporation.
Acceleration of Payments	Section 409A generally forbids the acceleration of the time or schedule of any payment under a NDCP. Exception #1: In general there is no acceleration of the time or schedule of a NDCP payment if the employer waives or accelerates the satisfaction of a condition constituting a substantial risk of forfeiture, provided the requirements of Section 409A are otherwise satisfied. Example: A certain NDCP provides for a lump sum payment of vested benefits at separation from service. The benefits vest after 10 years of service. The employer reduces the vesting requirement from 10 years to 5 years of service. This does not constitute an impermissible acceleration under Section 409A. Exception #2: Acceleration of the time or schedule of a NDCP payment is also permitted if: (i) pursuant to a domestic relations order, (ii) necessary to comply with a certificate of divestiture for government service; (iii) needed to pay income taxes due upon a Section 457 plan vesting event; (iv) pursuant to an amendment to allow for de minimis (less than $10,000) cash-out payments or to require such amounts to be paid in a lump sum; or (v) needed to pay federal employment taxes on deferred amounts.
Effective Date / Grandfathering	Section 409A applies with respect to compensation which is deferred in taxable years beginning on or after January 1, 2005. Compensation is considered to be deferred before January 1, 2005, if the employee has a legally binding right to it and the right is earned and vested on or before December 31, 2004. A right to deferred compensation is “earned and vested” if it is not subject to a substantial risk of forfeiture and not dependent upon the performance of further services. Section 409A also applies with respect to compensation which is deferred before January 1, 2005, if the relevant NDCP has been “materially modified” on or after October 4, 2004 (see below).
Material Modification	A NDCP has been “materially modified” if a benefit or right has been enhanced or a new benefit or right has been added. A material modification can occur either by an amendment or by the employer’s exercise of discretion, even if such discretion was exercised pursuant to the terms of the plan. Example: Employer X maintains a NDCP which permits, pursuant to its terms, the employer to accelerate the vesting of plan benefits at its discretion. On October 31, 2004, Employer X exercised its discretion to accelerate the vesting of certain benefits to December 31, 2004. This constituted a “material modification” for purposes of Section 409A. As a result, assuming the plan does not otherwise meet the requirements of Section 409A, the deferred compensation of all employees who received the accelerated benefit is includable in income in 2004 and subject to the 20% penalty tax, plus interest. Exceptions: in general it is not a “material modification” if: (i) an employer exercises discretion (permitted under the terms of the NDCP as of October 3, 2004) with respect to the “time and manner” of a benefit payment; (ii) an employer changes the notional investment measure to qualify as a predetermined actual investment; (iii) an employee exercises a right permitted under the NDCP as of October 3, 2004; (iv) the employer amends the plan to bring it into compliance with Section 409A (unless such amendment enhances or adds a benefit; for example, by creating a new permissible distribution event, such as an unforeseeable emergency or a change in control); (v) an employer amends a NDCP to reduce an existing benefit (such as eliminating a “haircut” provision); (vi) an employer adopts an arrangement or grants an additional benefit which is consistent with the employer’s “historical compensation practices”; (vii) an employer amends a NDCP to stop future deferrals or to terminate the plan and distribute payments prior to December 31, 2005; or (ix) an employer replaces a stock option or SAR otherwise subject to Section 409A with a stock option or SAR which would be exempt from Section 409A (because it meets the requirements discussed further above).
Transition Guidance	A NDCP will not be considered to violate Section 409A if operated in “good faith compliance” with Section 409A during calendar year 2005 and if amended on or before December 31, 2005 to comply with Section 409A. A NDCP may be amended on or before December 31, 2005 to provide for new payment elections (including with respect to stock option and SAR payments) to be made during calendar year 2005 with respect to amounts deferred prior to the election. A NDCP may be amended on or before December 31, 2005 to allow a participant to terminate in whole or in part participation in any plan or to cancel in whole or in part any deferral election or nonelective deferral with respect to deferred compensation subject to Section 409A, provided such termination or cancellation is made during calendar year 2005. Any payments pursuant to such a termination or cancellation must be included in the participant’s income in 2005. Participants in NDCPs in existence as of December 31, 2004 can make deferral elections on or before March 15, 2005 with respect to unpaid compensation for services to be performed during 2005.
Severance Pay Plans	Plans that provide severance pay benefits are generally subject to Section 409A. There is a limited exception, however, for such plans which during calendar year 2005 (i) are collectively bargained or (ii) do not cover any “key employees.” Employers with broad-based severance arrangements may want to consider creating a carve-out plan just for key employees to avoid having to make changes to the plan that will affect other employees.
Bonus Compensation	Bonus compensation based on services performed over a period of at least 12 months will be treated as meeting the requirements of Section 409A if the deferral election with respect to such compensation is made at least six months prior to the end of the applicable service period. “Bonus compensation” is defined to include compensation which is contingent on the satisfaction of organizational or individual performance criteria, which criteria is not substantially certain to be met at the time the deferral is made. Such criteria may be subjective but must be related to the employee’s performance and can not be determined to have been met by the employee or any family member. Such criteria do not need to be approved by the employer’s board of directors or shareholders.
Qualified Plan Distribution Elections	For periods ending on or before December 31, 2005, a participant’s payment election under a qualified retirement plan may control the timing and form of a payment under a NCDP without violating Section 409A, provided such election is in accordance with the terms of the NDCP as of October 3, 2004.

ACTIONS REQUIRED BEFORE JANUARY 1, 2005—FOREIGN OR FINANCIAL DISTRESS RABBI TRUSTS

The government has basically kept its promise that no action would be needed before the end of 2004, with one major exception. The one potential problem area is for some rabbi trusts (and for plans that have certain provisions relating to rabbi trusts built into the plan document). Affected rabbi trusts are those located outside of the US or which have certain financial triggers.

Foreign Trusts: Section 409A provides special rules for assets set aside in a trust located outside the United States for the purpose of paying NDCP benefits. To the extent an NDCP participant is vested, if the trust has assets or the employer transfers assets to a foreign trust as a way of securing the benefits, the participant will be taxed under Section 83 on the amount transferred. This rule does not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualfied deferred compensation relates are performed in that jurisdiction.

Financial Distress: If, in connection with a change in an employer’s financial health, trust assets are restricted to the provision of benefits under an NDCP, vested participants are taxed on the value of the assets in the trust. The Conference Report on Section 409A indicates that this requirement will apply in the case of a plan which provides that assets will be transferred to a rabbi trust upon a change in the employer’s financial health.

For both of these situations, the Notice does not provide any relief to allow nonconforming trusts to be amended in 2005 to comply with the new rules. There is pending technical correction legislation on some aspects of the foreign trust rules but it has uncertain prospects. Therefore, under current guidance, it appears that:

· Any financial distress trigger in a plan or trust should be removed before January 1. This would include a provision for springing funding of the trust. The statute appears to apply EVEN IF THE TRIGGER HAS NOT OCCURRED. Because “change in financial health” has not been defined, it is possible that some change in control definitions could be swept into this provision.

· Retaining assets in any rabbi trust which covers US employees and is located outside of the US after January 1 risks immediate taxation of those assets.

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