Future shock has come to the world of nonqualified deferred compensation. What had been walled off as a regulatory "no-fly" zone since 1978 has become a scene of upheaval worthy of an aircraft dogfight. With nearly sixty years of case law now preempted, it is almost difficult to overstate the magnitude of change that new Code section 409A imposes on companies’ compensation practices. Intentionally and strikingly sweeping in scope, new Code section 409A is the Sarbanes-Oxley Act of nonqualified deferred compensation. And it is arriving at a speed that rivals Enron’s collapse. With a fuse that triggers January 1, 2005, companies are climbing a learning curve that tilts close to vertical. In turn, the Treasury Department faces one of its biggest challenges in recent memory, as it strives to meet a congressional deadline for guidance within 60 days and addresses questions that have the potential to disrupt critical compensation structures.

This Legal Alert reviews section 409A, which was included as a revenue offset in the American Jobs Creation Act of 2004, a bill that has passed both the House and Senate and that is expected to become law. The Alert begins by outlining key features of section 409A, it then reviews section 409A’s immediate implications for important categories of compensation, and it closes by highlighting particularly sensitive calls that Treasury will need to make in the near future. In addition to summarizing information from formal sources, the Alert includes informal information about the likely direction of upcoming Treasury guidance, information that derives from our work on the emerging legislation.

I. Section 409A: The Basics

To say that section 409A codifies standards for nonqualified deferred compensation is almost misleading, because section 409A defines nonqualified deferred compensation ("NQDC") so broadly that it covers far more than what is traditionally thought of as NQDC. Except as noted below, any arrangement that defers taxable compensation for employees or service providers is covered, including nonelective plans, severance plans, long-term incentive plans, stock appreciation rights and discount stock options (other than section 423 employee stock purchase plans).

Excepted Arrangements: Not covered are – (i) payments of annual compensation not later than 2½ months into the next year, (ii) plans providing vacation or sick leave, disability pay or death benefits, and (iii) qualified plans, similar arrangements (including 403(b) annuities, SIMPLE plans, SEPs and governmental plans) and eligible section 457(b) plans.

Effective Date: Section 409A applies to deferred amounts unless they are earned and vested prior to January 1, 2005. However, pre-2005 deferrals become covered if there is a material modification to the related deferral plan after October 3, 2004. Accelerating vesting will be treated as a material modification and, therefore, will not succeed in avoiding the effective date.

Initial Elections: An initial election to defer compensation for services generally must be made in the year before the services are rendered.

  • Performance-Based Compensation: An election with respect to performance-based compensation may be made as late as six months prior to the end of the performance period if the compensation is – (i) for services of 12 months or more, (ii) variable and contingent upon satisfying pre-established written performance standards that are adopted no later than 90 days into the service period, and (iii) not reasonably ascertainable at the time of the election. While these rules are intended to be patterned after section 162(m), we understand objective performance standards are not required (nor are shareholder and compensation committee approval).
  • New Participants: Initial elections by newly eligible participants may be made within 30 days of eligibility, but only with respect to compensation for services rendered after the election.
  • Regulatory Relief: The conference report allows Treasury to permit later elections.

Security Arrangements: Section 409A bars security triggers based on the employer’s financial health that restrict assets to the payment of NQDC. (This originally appeared aimed at "rabbicular" trusts – rabbi trusts that become secular trusts automatically based on a financial health trigger; however, the conference report indicates it will also apply to a springing rabbi trust.) Section 409A also bars funding NQDC through a trust outside the U.S., except when substantially all the related services are performed in the trust’s jurisdiction. Treasury guidance may create additional exceptions.

Distributions: Section 409A only permits event-based distributions in connection with death, disability (as specially defined), unforeseeable financial emergency, change of control and severance from service, i.e., no more "when my child goes to college" elections. Distributions based on a date are also permitted, however, and it appears participants may freely choose payment dates permitted under the plan when making an initial election. Multiple dates are permitted, and the earlier (or later) of a date and an event are reportedly permissible.

Key Employee Distribution Delay: In the case of key employees, distributions tied to separation from service must be delayed at least six months beyond separation, but not later than death. (This is intended to prevent key employees from obtaining funds from a failing company in advance of creditors.) Key employees are officers earning at least $130,000 – but not more than the top 50 officers, ranked by current year compensation – and certain owners.

Redeferral/Form of Payment Elections: Once an original deferral period and form of payment is established by plan terms or an initial participant election, participants may make one or more elections to extend the deferral period or select a different form of payment. In general, these elections must be made 12 months before the original payment date, and they must extend the deferral period at least five years (a five-year extension is not required relative to payout dates tied to death, disability and unforeseeable financial emergency). The conference report authorizes Treasury to permit a choice between actuarially equivalent annuities without regard to the five-year extension requirement.

Other Key Principles:

  • Plan Form Requirement: As noted by Bill Sweetnam, Treasury’s Benefits Tax Counsel, section 409A carries over certain qualified plan principles to NQDC. In particular, NQDC plans must at all times meet section 409A in form, i.e., plan terms must ensure compliance with 409A.
  • Impermissible Employer Discretion: Employer discretion to override plan terms that implement section 409A reportedly is barred.
  • No Payment Acceleration: A NQDC plan’s terms may not allow payment acceleration. Thus, "haircuts" are not permitted, and shifting from an annuity to a lump sum is generally not possible. Although hardship distributions are permitted for an unforeseeable financial emergency, the distribution must not exceed what is necessary for the emergency. The conference report authorizes Treasury to permit very limited accelerations, e.g., cashouts of small deferral balances at separation from service (except for key employees) and distributions required by federal conflict of interest rules and domestic relations orders.
  • Section 409A Only Accelerates Taxation: Section 409A adds to current law, and when section 409A and another tax rule both apply, whichever results in earlier taxation will govern.

Sanctions: Failing to meet section 409A results in a trio of sanctions for each participant to whom the failure applies – (i) taxation of all of an affected participant’s deferrals under the plan, (ii) cumulative interest on the underpayments resulting from not taxing each deferral from its deferral date (or vesting date, if later), and (iii) a 20% additional tax on the deferrals.

Reporting and Withholding: Withholding and information reporting (Form W-2 or 1099) apply when deferrals are includible in income. Information reporting is also required on deferrals for the year they are made.

Transition Relief: During a transition period to be announced by Treasury, the statute allows deferral plans adopted before December 31, 2004 to be amended to conform to section 409A without triggering a material modification. In addition, participants in these plans whose deferrals would be taxed when earned or vested may terminate plan participation and cancel an election relating to a post-2004 deferral. However, Treasury is expected to issue transition relief that goes well beyond this, e.g., including certain temporary relief from the advance election rules.

II. Immediate Implications for Employers

Employers need to promptly inventory their plans and arrangements that will be subject to section 409A and to consider if there are any short-term initiatives that will ease the transition to compliance (such as participant communications) while carefully avoiding a material amendment. Key considerations for employers and examples of possible initiatives are described below.

2004 Bonus: 2004 bonus payments conditioned on employment during 2005 are not deemed vested and, therefore, will be subject to the new rules. To the extent a 2004 bonus is subject to employer discretion to deny payment (e.g., unrestricted negative discretion applicable to section 162(m) executives), the staff has suggested that it too will be deemed unvested and, therefore, covered by section 409A.

  • Covered Bonuses: For covered 2004 bonuses, it is expected that there will be transition relief regarding the election timing rules of section 409A, at least with respect to plans in existence on October 3, 2004. Therefore, it does not appear too late to make 2004 bonus elections in accordance with existing plan terms.
  • Other Bonuses: For bonuses that are not covered by section 409A (and other grandfathered deferrals), current distribution provisions may be retained, earnings may continue to accrue under current plan terms, and redeferrals under existing terms will not cause section 409A to apply. However, current law standards will still apply, and the conference report encourages the IRS to be active in enforcing current law.

2005 Bonus: The later election deadline for performance-based bonuses will provide many employers with additional time to obtain 2005 bonus elections. Some employers who wish to pay bonuses without regard to satisfying performance criteria are considering elections prior to year end, but it may be sufficient to adopt alternative performance criteria based on subjective individual performance.

2005 Base Pay: Deferral elections for 2005 base pay are due by year end. Some employers have wondered if adopting a new plan to comply with section 409A would permit use of the new participant rule for elections (thereby permitting prospective elections in early 2005). However, Treasury staff do not feel access to the new participant rule normally should be available for replacement plans.

Communicating with Participants: Employers currently taking elections for deferrals covered by 409A may want to advise participants regarding key changes that will apply, e.g., limitations on withdrawals, the fiveyear minimum deferral extension for redeferrals, and the six-month delay for key employee distributions. In addition, because later form of payment elections will be subject to the five-year extension, employers may not want to default the form of payment in connection with initial elections.

Determining Key Employees: Because officers are ranked based on current year compensation when determining key employees status, the top 50 officers will not be known until after year end. Therefore, for large companies with more than 50 officers, accurately determining the affected officers may not be practical, and a broader group may have to be affected.

SERP Elections: Forms of payment under SERP arrangements that link to a qualified plan no longer may be based on the form elected under the qualified plan. In addition, form of payment elections made 12 months in advance of payment are subject to the five-year extension. These factors push employers toward obtaining form of payment elections for SERPs before benefits accrue.

III. Treasury Guidance Items

Treasury is facing an avalanche of issues as it rushes to issue section 409A within 60 days. Particularly important issues include the following.

SARs: Treasury advocated including SARs as subject to section 409A, even though SARs are economically identical to options with a cashless exercise feature (because options are governed by section 83, while SARs are governed by section 451). The conference report authorizes Treasury to provide relief for SARs, which was all that could be accomplished in the final hours of legislative consideration. However, many members did not fully understand the SARs issue, and Treasury is likely to face increasing pressure to reconsider this issue more fully.

Plan Termination: A cornerstone of American benefit plans is the ability to terminate and unwind plans as circumstances dictate. Treasury staff have suggested that discretionary termination and unwind rights cannot be allowed, because they would permit accelerating payouts from troubled companies. Staff have suggested that triggers for termination would have to be "baked in" from the inception of a plan, such as by providing for termination and unwind upon change of control. However, this assumes an unrealistic degree of prescience with respect to circumstances that may develop over years or decades. Circumstances change and employers, like presidents, should "never say never." A six-month delay is deemed sufficient to avoid abuse in connection with key employee terminations. It should also do the trick for discretionary plan terminations. In addition, it should be clarified that termination of pre-2005 deferral plan is not a material modification that would apply section 409A (and thereby apply its sanctions to the subsequent "acceleration" of distributions).

International Plans: Many employers have funded international plans for employees who work outside the U.S. and outside their home country that are sitused in a single foreign jurisdiction. Absent relief from Treasury, these plans will run afoul of section 409A, because they cannot meet the exception for funded non-U.S. plans with substantially all the related services performed in the trust-situs jurisdiction. As a result, if a participant later acquires a green card, section 409A will apply sanctions to past plan accruals. Treasury should use its authority to provide relief for these plans that relate to multi-jurisdiction services.

Election Timing for 2004 Bonuses: Transition relief is expected to allow elections for covered 2004 bonuses to be made late in 2004, at least if this timing is consistent with the terms of a pre-October 3, 2004 plan. Late 2004 elections should be permitted for any plan adopted before December 31, 2004, and delayed elections should be permitted under pre-October 3, 2004 plans.

  • Pre-2005 Plans: The statute provides that transition relief should apply to all plans adopted before December 31, 2004. Adoption of a brand new plan between October 3, 2004 and December 31, 2004 should not be considered a material modification, because there is nothing to modify. The statute, therefore, supports allowing these new plans to take elections in late 2004.
  • Delayed Elections under Existing Plans: Existing plans should be permitted to take elections of 2004 bonus later than permitted under their October 3, 2004 terms. Given the upheaval caused by section 409A, many employers have not been able to complete elections when originally contemplated, e.g., additional time was needed for modified communications and forms. This election delay should not be considered a material modification.

Election Timing for 2005 Base: Employers need additional time to communicate the new rules that will be applicable to 2005 base pay deferrals. Thus, Treasury should allow elections to defer 2005 base pay to be made in early 2005, at least for base pay that relates to services after the election.

New Participant Elections: The requirement that new participant elections apply only to services after the election works well with respect to base salary, where the portion that is for services after the election is easily determined. However, for annual payments like bonuses, it is not clear how to determine the portion that relates to post-election services. A simple proration rule would suffice, but even that will cause pressure to race to make elections immediately at hire so that no deferral opportunity is lost. Moreover, for payments like new director retainer payments, the period of services to which the payments relate is not clear. At least in situations where substantial services remain to earn a single sum, it would appear reasonable to permit the deferral of the entire amount within 30 days.

SERP Elections: Many SERPs have not required form of payment elections for existing accruals e.g., because SERP payment followed the participant’s qualified plan election. Participants will need an opportunity to select a form of payment for accruals earned before 2005 and during a reasonable transition period in 2005.

Six-Month Delay in Paying Severance Pay: Applying section 409A literally, payouts of key employees’ severance pay would be delayed six months. Given the difficulty of accurately identifying key employees, this could deny reasonable income protection to a large number of employees. This seems an unintended consequence of section 409A and should be ameliorated.

Stock Option Deferral: The final bill (unlike earlier Senate versions) does not contain an outright ban on deferring equity awards. While section 409A thus appears to permit deferrals of option gains, questions remain regarding when a deferral election must be made. The status of stock options as performance based compensation under section 162(m) would suggest that section 409A’s special rule for performancebased compensation should apply. However, Treasury staff have suggested informally that this would not be the case. This basic question needs a definitive answer.

Conclusion

The final version of section 409A includes several important improvements over earlier versions – (i) no restrictions on phantom investments, (ii) equity awards may be deferred, and (iii) multiple redeferral elections. Still, with its wide range of new rules, section 409A will have a major impact on current compensation practices. At this point, the extent to which it ultimately proves disruptive depends on Treasury’s upcoming guidance, which needs to address the issues listed above in light of their considerable importance to companies.