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New law changes tax treatment of deferred compensation

The JOBS Act has implications for how and when participants in some compensation plans can claim benefits. Companies should be ready to amend their plans, warns Joseph Yaffe of Latham & Watkins

As recently enacted, the American Jobs Creation Act of 2004 (the Act), contains provisions that will significantly affect the operation of non-qualified deferred compensation plans by limiting the flexibility available for participants to alter the form and timing of the distribution of their benefits, as well as timing of deferral elections and funding mechanisms. Companies should be aware of the potential impact of this legislation on their non-qualified deferred compensation plans, equity compensation plans and other compensation arrangements. The Act requires both operational and form compliance. As a result, most non-qualified deferred compensation plans will need to be amended to comply with the new requirements. Additionally, in some cases deferral procedures may need to be modified before 2005.

Deferred compensation provisions

The intent of the Act is to both address perceived abuses by corporate executives participating in deferred compensation arrangements as well as establish clearer rules for the taxation of non-qualified deferred compensation arrangements. The deferred compensation provisions of the Act modify current law by subjecting vested deferred compensation to income tax unless deferral, election and non-acceleration requirements are satisfied. The Act broadly defines a non-qualified deferred compensation plan as any plan that provides for the deferral of compensation other than a qualified employer plan or a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. A plan includes any agreement or arrangement, including an agreement or arrangement that covers just one person.

The Act's legislative history notes that a non-qualified deferred compensation plan does not include the grant of employer stock options with an exercise price that is not less than the fair market value of the underlying stock on the date of grant, if such arrangement does not include a deferral feature other than the right to exercise the option in the future. The negative implication of the legislative history is that an employer stock option with an exercise price that is less than the fair market value of the underlying stock on the date of grant is subject to the Act's provisions. It is unclear how the new legislation will impact other forms of equity compensation, including stock appreciation rights and restricted stock units, but practitioners should expect that they may be treated as forms of deferred compensation subject to taxation at vesting. Forthcoming Treasury Department regulations are expected to provide guidance with respect to these matters.

The Act amends section 409 of the Internal Revenue Code (IRC) by adding new section 409A which provides that vested deferred compensation will be taxed on a current basis unless the grant meets certain requirements. In addition to immediate taxation on vested deferred compensation, participants will be required to pay a 20% additional income tax and, potentially, interest at the Internal Revenue Service underpayment rate plus 1%. Immediate taxation, interest and the additional income tax only apply to each participant for whom the requirements are not met, rather than all plan participants. To avoid this treatment for individuals under the Act, a non-qualified deferred compensation plan must meet several key requirements described below.

It is worth noting that new IRC section 409A does not replace existing law. Section 409A imposes additional requirements. As a result, deferred compensation arrangements must now satisfy both existing law and section 409A to avoid adverse tax consequences.

Distributions

A non-qualified deferred compensation plan may not distribute deferred compensation at any time before the occurrence of one of the following events:

  • a time (or times) specified under the deferred compensation plan at the date of the deferral of such compensation;
  • the participant's separation from service (as provided by Treasury regulations); provided, however, that a non-qualified deferred compensation plan of a publicly-traded company may not make a distribution to a "key employee" until at least six months after his or her separation from service. "Key employee" is defined in section 416(i) of the Code as an employee who, at any time during the plan year, is (i) an officer of the employer having an annual compensation greater than $130,000, (ii) a 5-percent owner of the employer or (iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000.

For purposes of clause (i), no more than 50 employees (or, if lesser, the greater of 3 or 10% of the employees) are treated as officers. Although further explanation of this provision is expected from Treasury, it is hoped that whether an individual is a "key employee" will be measured as of the date of his or her distribution, although guidance could include a "look-back" provision. Although this provision has an impact on only "key employees" of publicly-traded companies, private plan sponsors should also consider providing for this restriction to be effective in the event they subsequently become public;

  • upon the participant's death;
  • the participant's disability. A participant is considered disabled if, due to any medically determinable physical or mental impairment expected to result in death or to last for a continuous period of at least 12 months, the participant is either unable to engage in any substantial gainful activity or is receiving income replacement benefits for a period of at least three months under the employer's accident and health plan. This provision is narrower than many found in deferred compensation plans and, among other things, may preclude plan sponsor discretion in determining whether a participant is disabled;
  • a change in ownership or effective control of the corporation or in ownership of a substantial portion of the assets of the corporation to the extent provided in Treasury regulations. It is unclear whether guidance regarding the scope of the "change in control" distribution event will be provided in the initial guidance the Treasury Department will issue. While there have been some indications that guidance may be patterned in part on guidance under IRC section 280G, the legislative history to the Act indicates that the definition of change in control will be more restricted for purposes of the Act, which government officials have indicated means fewer transactions will constitute a change in control; or
  • an unforeseeable emergency, defined as a severe financial hardship to the participant resulting from an illness or accident of the participant, or the participant's spouse or dependent, a loss of the participant's property due to casualty or other similar extraordinary and unforeseeable circumstances due to events beyond the participant's control.

These restrictions effectively prohibit the early distribution of deferrals subject to a "haircut" clause or forfeiture penalty. These restrictions also would prohibit the distribution of deferred compensation upon the termination of a plan. In addition, these restrictions appear to prohibit plan provisions that extend the deferral of distributions until such time as the distributions are fully deductible under IRC section 162(m).

Although not entirely clear, it appears that plans and deferred compensation arrangements may include some but not all of section 409A's permissible distribution events. Practitioners have also requested that Treasury make it clear that plans may provide for distributions upon the earlier of one or more of the distribution events (for example, upon the earlier of separation from service or a specified time).

Initial election

A non-qualified deferred compensation plan must require participants to make an initial deferral election (including timing and form of distribution elections, if applicable) in the taxable year before the year in which services to which the deferred compensation relates are performed. For example, if a participant wants to defer a portion of salary earned in 2005, he or she must elect to defer such salary amount before the end of 2004. Elections with respect to performance-related compensation based on services performed over a period of at least 12 months may be made up to six months before the end of the service period. Treasury guidance is expected with regard to the scope of this special rule for performance-related compensation and government officials have indicated informally that this guidance may look to the regulations underlying IRC section 162(m). The Act is unclear with regard to off-calendar year salary and performance bonus deferrals, but practitioners should not assume that that they may delay deferral elections until after December 31 2004 with regard to deferrals intended to be effective for fiscal years commencing in 2005.

Newly-eligible participants in a deferred compensation plan may make an initial deferral election within 30 days of their date of eligibility. Government officials have indicated informally that this initial election rule will likely be construed narrowly.

Changes to timing and form of payment

A non-qualified deferred compensation plan may allow subsequent elections to delay payment or change the form of payment only if certain requirements are met. The election must be made at least 12 months in advance of the scheduled payment date, cannot be effective until at least 12 months after the election date and must defer receipt of the payment by at least five years from the otherwise applicable date (except in the case of distributions related to death, disability or unforeseeable emergency). For example, if a participant's scheduled payment date is December 2007, an election to delay payment must be made by December 2006 for a new payment date of December 2012 or later (and such election will not be effective until a year after the date the election is made).

No-acceleration

A non-qualified deferred compensation plan may not permit the acceleration of previously scheduled distributions, except as may be provided by Treasury regulations. For example, if a participant had previously elected to receive distributions at the later of separation of service and age 65, the participant cannot subsequently elect to receive distributions upon the earlier of separation of service and age 65. Likewise, it appears that a participant that originally elects distributions in instalments commencing as of a specified date may not subsequently elect a lump sum commencing at the same date.

Offshore trusts

The new legislation substantially curtails the funding of deferred compensation through off-shore trusts. Participants will be subject to immediate taxation of any assets held in an off-shore trust (even if such assets are subject to the claims of general creditors) unless substantially all of the services to which the nonqualified deferred compensation relates are performed in a foreign jurisdiction, or as otherwise provided by Treasury regulations.

Financial health triggers

Deferred compensation is taxable on a current basis if a trust's assets become restricted to the provision of deferred compensation benefits due to a decline in the employer's financial health. The tax event is the earlier of either when the assets are restricted or when the plan provides the assets will be restricted. For example, if a plan provides that upon a change in the company's financial health, assets will be transferred to a rabbi trust, such assets will be subject to immediate taxation.

Reporting requirements

For future enforcement purposes, amounts deferred will be required to be reported on the participant's Form W-2 (or Form 1099) for the year deferred, even if the amount is not currently includible in income for that taxable year.

Amounts includible in income under the Act are subject to Federal income tax withholding requirements and are required to be reported on the participant's Form W-2 (or Form 1099) for the year includible in income.

Effective date

The Act is effective with respect to amounts "deferred" after December 31 2004. Present law applies with respect to amounts deferred before January 1 2005, as long as there was no material modification to the plan after October 3 2004, but amounts deferred in taxable years beginning before January 1 2005 will be subject to the new legislation if the plan was materially modified after October 3 2004. The addition of any benefit, right or feature is a material modification. The exercise or reduction of an existing benefit, right or feature is not a material modification.

Amounts deferred, but not vested before January 1 2005 will likely be subject to the Act. While the Act itself provides that its requirements apply to "amounts deferred after December 31, 2004", the summary of the conference committee report specifies that an amount is considered deferred before January 1 2005 if the amount is earned and vested before such date.

The effective date of the Act with regard to unvested compensation may be especially troublesome for individuals holding unvested stock appreciation rights or discounted stock options. If expected Treasury guidance clarifies that these arrangements are subject to the Act and that they are not grandfathered to the extent unvested as of January 1 2005, plan sponsors must consider amending outstanding grants to comply with 409A or the holders will suffer the tax consequences described above. Of course, such outstanding awards may often be amended only with the existing holders' consent.

Congress directed Treasury to issue guidance within 60 days of enactment of the Act. Thus, guidance is expected by December 21 2004. Guidance is expected to include transition rules regarding amendment of plans to conform to the Act with respect to amounts deferred after December 31 2004 and to allow participants to terminate their participation or cancel outstanding elections for amounts earned after December 31 2004. Practitioners are hopeful that the guidance will include a transition period within which plan sponsors may modify existing arrangements retroactively to comply with the Act. The guidance is expected to address some of the Act's substantive provisions, including the definitions of "Separation from Service," "nonqualified deferred compensation plan" and the scope of the "change in control" distribution event.

What practitioners and plan sponsors should do

Plan sponsors should undertake a complete review of non-qualified deferred compensation plans as well as deferral election procedures in light of the new legislation before year-end 2004 to avoid any potential future adverse tax impact on participants. This review should include review of equity compensation arrangements, including "omnibus" equity plan provisions. Practitioners should also consider the scope of the "grandfathering" provisions in the Act and whether to preserve existing earned and vested deferrals under prior law. Ultimately, sponsors will likely need to amend at least one or more provisions of their plans in order to comply with the Act.

Joseph Yaffe(joseph.yaffe@lw.com) is a partner of Latham & Watkins LLP, Silicon Valley

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