United States: Treasury Department and IRS Release Transition Guidance on New Non-Qualified Deferred compensation Requirements - no Action is Required by 2004 Year End

On December 20, 2004 the Treasury Department and IRS released Notice 2005-1, which is the first guidance with respect to the application of Section 409A of the Internal Revenue Code of 1986 (the Code). Section 409A, which was added to the Code by the American Jobs Creation Act of 2004 (the Act), significantly changes the rules for the taxation of nonqualified deferred compensation arrangements, effective for deferrals of amounts earned and vested on and after January 1, 2005. (See Pillsbury Winthrop’s October 14, 2004 Client Alert at www.pillsburywinthrop.com/topics/sample.asp?id=000068822341). The new rules also apply to deferrals of amounts earned or vested before January 1, 2005 if those deferrals are materially modified after October 3, 2004.

Notice 2005-1 provides guidance, in Question and Answer format, on the application of the Section 409A effective date provisions and transition relief for amounts deferred in 2005 (and for amounts deferred prior to 2005 that are subject to Section 409A due to material modifications made after October 3, 2004). Also, Notice 2005-1 –

• Addresses the scope of coverage under Section 409A, including, for example, the treatment of stock appreciation rights, and other definitional issues;

• Describes the circumstances under which a plan may permit the acceleration of the time or schedule of plan payments, including upon certain change in control events;

• Provides preliminary guidance on the information reporting requirements applicable to deferred amounts.

With respect to issues not covered in Notice 2005-1, the Notice provides that until further guidance is issued, taxpayers should apply a good faith, reasonable interpretation of Section 409A taking into account its purpose, including a consideration of its legislative history. To the extent that future guidance adopts a position on an issue covered by Notice 2005-1 that is less favorable to taxpayers than provided in the Notice, the Treasury Department and IRS have indicated that they expect any such position to be applied on a prospective basis only, with adequate transition relief to allow modifications of plans to comply with the new position.

The following is a brief summary of the issues addressed in Notice 2005-1 that should be of particular interest to plan sponsors. The full text of the Notice is available at www.treas.gov/press/releases/reports/notice2005_1.pdf.

Pre-January 1, 2005 deferrals are grandfathered under the old rules and are not subject to Section 409A unless such deferrals are materially modified after October 3, 2004. In applying the grandfathering rules, Notice 2005-1 clarifies that an amount is considered deferred prior to January 1, 2005 if, as of December 31, 2004, the service provider has a legally binding right to be paid the amount in a later year and the right to the amount is earned and vested.

• Legally Binding Right. Notice 2005-1 explains that a service recipient does not have a legally binding right to receive payment if the payment is subject to the service recipient’s discretion to reduce the amount, which is a common feature of many performance bonus plans.

• Earned and Vested. Under the Notice, an amount is earned and vested as of December 31, 2004 if the amount is not subject to a substantial risk of forfeiture or the requirement to perform future services after December 31, 2004.

Thus, for example, the deferral of a 2004 performance bonus that is otherwise payable in 2005 would be grandfathered only if (i) the bonus amount is not subject the negative discretion of the employer and (ii) the service provider does not have to work past December 31, 2004 in order to receive the bonus.

Comment: The Notice applies different standards for determining whether an amount is subject to a substantial risk of forfeiture for purposes of determining whether an amount is grandfathered versus determining the date of income inclusion for deferrals that do not meet the requirements of Section 409A. For purposes of the former, the Notice applies the Code Section 83 standard while for purposes of the latter, the Notice applies a more rigid standard that does not take into account forfeitures due to violations of non-compete agreements, additions of new forfeiture risks after the beginning of a service period or extensions of the period during which the compensation is subject to the forfeiture risk.

A pre-January 1, 2005 deferral will lose its grandfathered status and become subject to Section 409A if the deferral is materially modified after October 3, 2004. For this purpose, Notice 2005-1 provides that a modification to a plan is a material modification if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit is added. The Notice provides the following examples—

• Material Modifications.
• Amendment of a plan to add a new in-service distribution right (with or without a "haircut" penalty).
• Service recipient’s exercise of discretion to accelerate vesting of a plan benefit to a date on or before December 31, 2004.
• Amendment of a plan to add a new benefit or feature permitted under Section 409A (e.g., addition of unforeseeable emergency distribution or second elections regarding distributions) that was not available under the plan as of October 3, 2004.

• Non-Material Modifications.
• Service recipient’s exercise of discretion over time and manner of payment, but only if such discretion is available under the terms of the plan as of October 3, 2004.
• Change of plan investment measure.
• Participant’s exercise of a right permitted under the plan as in effect on October 3, 2004.
• Reduction of an existing benefit (e.g., elimination of a "haircut" provision).
• Amendment of a plan to bring it into compliance with Section 409A (unless the amendment adds a new benefit or feature that is permitted under Section 409A, but was not available under the plan as of October 3, 2004).
• Amendment of plan on or before December 31, 2005 to terminate the plan and immediately distribute the deferred amounts, provided that the distributed amounts are included in income in the taxable year in which the termination occurs.

Comment: This is a plan sponsor’s only chance to amend a plan to add a termination cash-out feature. After December 31, 2005, any such amendment would be a material modification that would cause the plan to be subject to Section 409A, and implementation of the new cash-out feature would be an impermissible acceleration under Section 409A.

• Substitution of non-compliant stock options (i.e., discounted options or options with a deferral feature) and SARs (see below) with stock options and SARs that meet the requirements of Section 409A, provided that such replacement occurs before December 31, 2005.

To the extent that Section 409A applies to a plan adopted any time before December 31, 2005 (i.e., a plan that is not grandfathered), Notice 2005-1 provides that the plan will not be treated as violating Section 409A so long as the plan is operated in good faith compliance with Section 409A and Notice 2005-1 during all of 2005 and the plan is amended before December 31, 2005 to conform with the requirements of Section 409A, to the extent such requirements are applicable.

• Good Faith Compliance. A plan will be operated in good faith compliance if it is operated in accordance with (i) Notice 2005-1, (ii) a good faith, reasonable interpretation of Section 409A with respect to issues not addressed in Notice 2005-1 and (iii) the terms of the plan, to the extent consistent with Notice 2005-1 and Section 409A. A plan will fail to be operated in good faith compliance if either the plan sponsor or participant is permitted to exercise discretion under the plan that does not meet the requirements of Section 409A (e.g., permitting subsequent elections changing the form or timing of distributions that do not meet Section 409A requirements with respect to such elections).

• Transition Rules for 2005.
• Initial Deferral Elections. With respect to deferrals of amounts attributable to services performed before December 31, 2005 (including non-grandfathered deferrals of 2004 bonuses payable in 2005), the timing requirements for deferral elections under Section 409A will not apply provided that all of the following requirements are met—

• New Distribution Elections. With respect to amounts subject to Section 409A, a plan sponsor may amend the plan to provide for new distribution elections for amounts that were previously deferred. The new distribution election will not be treated as a change in the form and timing of a payment under Section 409A provided that the election and plan amendment are each in place before December 31, 2005.
• Termination of Participation or Deferrals. A plan adopted before December 31, 2005 may be amended to allow a participant, at any time during 2005, to either terminate participation in the plan or cancel a deferral election with respect to amounts subject to Section 409A and receive a distribution of the deferred amounts in 2005 (or, if later, the year in which the amount is earned and vested), provided that (i) the amendment is in place before December 31, 2005 and (ii) the full amount of the distribution is included in the participant’s income in 2005 (or, if later, the year in which the amount is earned and vested).

Comment: Provided that the plan is amended accordingly by December 31, 2005, the transition rules regarding new distributions elections and termination of participation, when read together, appear to allow plan sponsors to permit a participant to elect at any time during 2005 to either (i) receive an immediate cash out or his or her entire plan benefit (or only the portion of the benefit subject to Section 409A) and cease further participation in the plan or (ii) receive his or her distribution upon the occurrence of any of the distribution events permitted under Section 409A and stay in the plan.

• Performance Bonus Deferrals. Notice 2005-1 provides interim guidance regarding what constitutes "performance-based compensation" for purposes of applying the Section 409A rule that deferral elections with respect to performance-based compensation based on services performed over a period of at least 12 months be made at least 6 months before the end of the service period. Until further guidance regarding this issue is released, the six month election rule will apply to deferrals of "bonus compensation", which Notice 2005-1 defines as compensation (i) the payment of which is contingent on the satisfaction of organization or individual performance criteria and (ii) for which the performance criteria are not substantially certain to be met at the time the deferral election is permitted.

Comment: Unlike performance-based compensation for purposes of Code Section 162(m), "bonus compensation" for purposes of the Section 409A transition rule can be based on subjective criteria, provided that (i) the subjective criteria relates to the performance of the participant, or a group or business unit (which may include the entire organization) in which the participant belongs and (ii) the determination as to whether the subjective criteria has been met cannot be made by the participant or a member of the participant’s family. There is no requirement that the performance criteria be approved by the compensation committee.

Comment: The Treasury Department and the IRS have indicated in Notice 2005-1 that they anticipate that any subsequent guidance issued concerning what constitutes performance-based compensation for purposes of Section 409A will be more restrictive than the transition guidance contained in Notice 2005-1.

• Distributions Linked to Qualified Plans. Distributions made between January 1, 2005 and December 31, 2004 under a non-qualified deferred compensation plan that are linked to distribution elections made under a qualified plan will not violate Section 409A provided the linked distributions are made in accordance with the distribution provisions of the non-qualified deferred compensation plan in effect as of October 3, 2004.

Comment: The non-qualified deferred compensation plan must already provide for the linked distribution as of October 3, 2004 in order for this transition rule to apply. The transition rule does not apply to linked distributions on or after January 1, 2006. Presumably the plans will need to be de-linked and a separate distribution election made prior to that time.

• Severance Plans. The Notice provides a limited exemption from the requirements of Section 409A in 2005 for plans that provide severance pay benefits. The exemption applies only to severance pay plans that (i) are either collectively bargained plans or cover no key employees (as defined in the top-heavy plan provisions of the Code’s qualified plan rules) and (ii) are amended before December 31, 2005 to conform to the provisions of Section 409A (presumably with respect to tax years beginning after December 31, 2005, as the plans would be exempt from these requirements for 2005). For this purpose, "severance pay benefits" include amounts that qualify as severance pay under Department of Labor regulations (i.e., payments that are not conditioned on retirement, do not exceed two times annual pay and cannot be paid over a period exceeding 24 months) and benefits payable only upon an involuntary termination of employment, regardless of whether the foregoing Department of Labor requirements are satisfied.

• Definition of "Plan". The term "plan" is defined very broadly in Notice 2005-1 to cover any agreement, method or arrangement, including those that apply to a single individual, which may be either adopted unilaterally by the service provider or negotiated.
• Plan Disaggregation For Each Service Provider. For purposes of applying the requirements of Section 409A, including application of the penalty provisions, a separate plan or plans is deemed to be maintained for each service provider. Thus, failure to satisfy Section 409A with respect to one service provider will not cause other service providers to be in violation (unless the failure independently affects such other service providers).
• Plan Aggregation of Each Plan Type. For most purposes under Section 409A, all plans of the same type (i.e., account balance plans, non-account balance plans and plans that are neither account balance or non-account balance plans, such as certain equity-based compensation) in which a service provider participates are aggregated. Consequently, a violation of Section 409A with respect to one plan of a particular type in which a service provider participates will result in immediate taxation and assessment of interest and a 20% penalty tax on all non-grandfathered deferrals under each plan of the same type in which that service provider participates. The plan aggregation rule does not apply, however, for purposes of (i) determining whether a plan has been materially modified after October 3, 2004, (ii) application of the Section 409A non-acceleration rule or (iii) elections by participants to terminate participation or cancel deferrals under the 2005 transition rules.

Comment: The plan aggregation rule prevents plan sponsors from limiting the impact of the Code Section 409A penalties by splitting a plan into several plans covering limited time periods plans (e.g., annual plans).

• Coverage of SARs. Notice 2005-1 confirms that stock appreciation rights (SARs) generally are subject to Section 409A, unless all of the following requirements are met:
• The exercise price of the SAR may never be less than the fair market value of the underlying stock on the date the SAR is granted;
• The stock underlying the SAR is traded on an established securities market;
• The SAR may be settled only in shares of the underlying stock;
• The SAR does not include any deferral feature, other than deferral of income recognition until exercise of the SAR; and
• There is no agreement or arrangement under which the employer will purchase from the participant the shares issued in settlement of the SAR.

• Grandfathered SARs. Until further guidance is issued, SARs that are granted pursuant to a program in effect on or before October 3, 2004 will not be subject to the requirements of Section 409A, even if they can be settled in cash, provided that (i) the SAR’s exercise price may never be less than the fair market value of the underlying stock on the date the SAR is granted and (ii) the SAR does not include any deferral feature, other than deferral of income recognition until exercise of the SAR.

• Change in Control Events. Notice 2005-1 defines what constitutes (i) a change in the ownership of a corporation, (ii) a change in effective control of a corporation and (iii) a change in the ownership of a substantial portion of the assets of a corporation for purposes of the Section 409A rule permitting distributions to be made upon the occurrence of a change in control. To constitute a change in control event, the occurrence of the event, as defined in the Notice, must be objectively determinable and must relate to a corporation that is either (i) the service recipient, (ii) the entity liable for the payment of the deferred compensation, or (iii) a majority shareholder of the corporation described in (i) or (ii) or part of a chain of majority-owned corporations ending with a corporation described in (i) or (ii).
• Discretionary Plan Termination After a Change in Control. The Notice permits a plan sponsor to exercise discretion under the terms of a plan to terminate the plan after a change in control and distribute the entire plan benefit within 12 months of the change in control event. The Notice does not address whether the amendment of a plan to provide such discretion would be a material modification that would cause the loss of grandfathered status, although we presume that it would be.

Comment: Change in control events relating to entities other than corporations (e.g., partnerships, trusts, etc.) are not covered by Section 409A. Thus, a change in control event relating to any such non-corporate entity is not a permissible distribution event under Section 409A. An LLC taxed as a partnership would probably be treated as a partnership for this purpose.

• Acceleration of Plan Payments. Notice 2005-1 sets forth limited exceptions to Section 409A’s prohibition against acceleration of plan payments. These include –
• Accelerations of payments to individuals other than participants that are necessary to comply with domestic relations orders.
• Accelerations of payments that are necessary to comply with a certificate of divestiture.
• Accelerations of payments under a Section 457(f) plan in order to pay income taxes due upon a vesting event.
• Accelerations of payments in order to pay FICA taxes on compensation deferred under the plan.
• Cash-outs of de minimis amounts, provided that –

• Cash-outs of non-de minimis amounts below a threshold specified by the plan at the time the amounts are payable.

Comment: An amendment that adds this feature may only be applied prospectively to future deferrals.

A service recipient’s waiver or acceleration of substantial risk of forfeiture conditions (e.g., acceleration of vesting) is not considered a prohibited payment acceleration, provided the requirements of Section 409A are otherwise satisfied, even if the waiver of acceleration immediately vests the participant and qualifies him or her for an immediate payment in connection with a separation from service.

• Information Reporting Requirements. Notice 2005 provides interim guidance on information reporting requirements applicable to deferred compensation that is subject to Section 409A. Deferred compensation amounts must be reported in either box 12 of Form W-2 (using Code Y), in the case of service providers who are employees of the service recipient or in 15a of Form 1099-MISC in the case of service providers who are not employees. Amounts deferred prior to January 1, 2005 need not be reported, even if the amounts were not earned and vested as of December 31, 2004. In the case of non-account balance plans, reporting can be delayed until the amounts are reasonably ascertainable.

Additional Information

If you wish to obtain more information on the ramifications of the Section 409A nonqualified deferred compensation rules on your plans, please contact one of the members of the Pillsbury Winthrop executive compensation and benefits team. Questions regarding this article may be directed to Susan P. Serota or Peter J. Hunt in New York, Glenn Borromeo in San Francisco, Cindy V. Schlaefer in Silicon Valley and Jan H. Webster in Carmel Valley

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.