American Jobs Creation Act Changes Nonqualified Deferred Compensation Rules
David Mittelstadt, Fish & Richardson P.C.
Introduction: A Changed Landscape for Nonqualified Deferred Compensation.
Section 885 of the American Jobs Creation Act of 2004 enacted a new Code section 409A, regulating nonqualified deferred compensation plans effective January 1, 2005. Given the largely common law rules that existed prior to section 409A, the new provisions represent the greatest statutory regulation of nonqualified deferred compensation plans to have taken place thus far. That said, section 409A essentially provides an "overlay" on the existing rules rather than to effect a wholesale replacement, even though the changes can be quite dramatic. The old rules are still important -- a deferral will still be invalid if it is invalid under the old rules. However, section 409A imposes additional "hoops" that an affected deferral plan must jump through in order to be effective.
The penalty for failure to comply with section 409A is significant: A loss of deferral of all amounts under the particular plan for the affected participant(s) plus interest and a 20% additional tax on the triggered amounts. Thus it's important that employers immediately review all nonqualified deferred compensation plans and agreements for compliance with section 409A. In addition to the statute, Notice 2005-1 provides some preliminary guidance to consider in determining how and when existing plans should be amended to ensure compliance with the statute.
Primary Areas of Substantive Change.
The primary areas changed by section 409A relate to the timing of distributions; acceleration of benefits (which is generally not allowed except in accordance with as yet unissued regulations); the timing of initial and modifying deferral elections; and certain offshore funding arrangements. While the new provisions look simple, they make changes that can be dramatic in effect, and the provisions apply to a broad array of deferral arrangements.
"Deferred Compensation Plan:" Broad Definition. The application of section 409A isn't limited only to "traditional" nonqualified, cash deferred compensation plans. The section defines "nonqualified deferred compensation plan" merely as "any plan that provides for the deferral of compensation, other than (A) a qualified employer plan, and (B) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan." When originally enacted, this rather open-ended statutory definition caused some uncertainty as to how far beyond traditional cash compensation plans section 409A might apply. The definition is further refined in Notice 2005-1, which provides additional guidance. The Notice indicates, among other things, that:
- The term "nonqualified deferred compensation plan" is not limited to employer-employee arrangements, and may therefore extend to independent contractor or even partnership arrangements. A "plan" does not have to cover more than one person (although, of course, it may and often will). Currently, Notice 2005-1 contains quite liberal carve-outs for straight profits interests in partnerships, as well as for arrangements with independent, non-employee service providers who are actively engaged in the trade or business of providing substantial services, where such service provider has two or more unrelated customers for such services. However, Notice 2005-1 expressly notes that further guidance in these areas is to be expected.
- Nonqualified stock options, stock appreciation rights, and other equity based arrangements will often fall within the scope of section 409A. Nonqualified options generally will be considered to fall within section 409A if the option is granted at a discount from fair market value at the time of issuance, or if the option includes deferral features that go beyond the mere nature of an option itself. SARs will generally be subject to section 409A unless issued by a public company (or subject to a grandfather rule) and certain other requirements are met, such as that the SAR may only be satisified in employer stock, and the SAR threshold is not less than the fair market value of the stock at the date of grant. The application of section 409A to nonqualified options and SARs will turn practice upside down in this area. First, many nonqualified options are issued at a discount from fair market value at the time of grant. Furthermore, many if not most such options are issued in illiquid companies, in a start-up environment, where no formal valuation is obtained. In future, it will be necessary to provide for exercise prices no less than fair market value or otherwise succumb to the provisions of section 409A, but even then, in a typical start-up situation where no formal valuation is undertaken, there may always be scope for argument with the IRS over just what the market value actually was at the time. In addition, all existing option plans must be reviewed immediately to see if any existing options are jeopardized by section 409A. As for SARs, section 409A may effectively kill them off, if a significant raison d'tre for having them in the first place is to allow the holder a discretionary period after vesting within which to exercise the SAR. It may be difficult to square the provisions of most SAR plans (or phantom share plans drafted in substance as SARs) with the section 409A(a)(2)(A)(iv) notion that amounts must be specified to become payable at a specified time or pursuant to a fixed schedule. The same difficulty would seem to apply to nonqualified options that fall within the scope of section 409A.
- Nonqualified deferred compensation plans under section 457(f) are subject to section 409A.
The inclusion of SARs of non-publicly traded companies (and non-compliant SARs of public companies) will likely come as a shock to many employers. Most SAR plans (which include many plans described as phantom share plans but which in substance provide only appreciation rights) will contain exercise provisions which will be invalid under section 409A, because of the ongoing discretion to defer payment beyond vesting.
As far as what may fall outside the scope of section 409A:
- Subject to future guidance, short term deferrals of less than 2-1/2 months after the end of the taxable year in which vesting occurs, pursuant to normal payroll practices and not subject of a deferral election, will not be considered "deferred compensation."
- The receipt of restricted property will not be considered deferred compensation merely because the property is not immediately includible in income on account of non-transferability and the existence of a substantial risk of forfeiture. Thus, for example, a plain vanilla restricted share plan without additional deferral features should still fall outside the scope of section 409A.
- ISOs and options granted under section 423 employee stock purchase plans will not fall within section 409A.
- Qualified employer plans (including section 457(b) plans) are not considered nonqualified deferred compensation plans for purposes of section 409A.
Acceleration Of Payments. As indicated, acceleration generally is prohibited. However, Notice 2005-1 indicates that acceleration will be allowed under section 409A as follows:
- To make payment to an individual other than the plan participant pursuant to a domestic relations order;
- Where necessary to comply with a certificate of divestiture (defined in Code section 1043(b));
- An acceleration of an amount sufficient to cover income tax withholding due upon a vesting event may be allowed; and
- A de minimis cashout payment of up to $10,000 may be permitted.
Election Timing. Section 409A restricts the time within which valid deferral elections may initially be made, or within which deferrals may be extended by modification.
- Generally, the initial deferral election must be made no later than the close of the year preceding the year in which the relevant income is to be earned. In the case of a first year election, however, the election may be made within 30 days of the date the participant becomes eligible, in respect of services to be performed after the election is made.
- In the case of performance based compensation based on services performed over a period of at least 12 months, the election may be made no later than 6 months before the end of the period.
- Subsequent modifications of the initial deferral election are restricted. Basically, any subsequent election to delay payment, or to change the form of a payment, must not take effect until at least 12 months after the date it is made (or at least 12 months before the first payment called for, where a payment date is specified in the plan). Further, except in cases of disability, death, or emergency, the election must cause the first payment to which it relates to be deferred for at least an additional five years. This is far more restrictive than is found in many existing plans.
Distributions. Section 409A(a)(2) restricts the timing of valid distributions under nonqualified deferred compensation plans. Compensation deferred under the plan may not be distributed earlier than:
Notice 2005-1 describes changes in ownership, control, or asset base of corporate service recipients that would qualify for purposes of the above.
Funding Limitations. The act invalidates the use of offshore trusts to fund nonqualified deferred compensation arrangements. Thus for purposes of section 83, such funding will be considered property transferred in connection with the performance of services whether or not such assets are legally available to satisfy the claims of the employer's general creditors. In addition, funding arrangements that arise upon a change in the employer's financial health are no longer valid.
Transitional Guidance Under Notice 2005-1
Certain substantive aspects of Notice 2005-1, including the scope of the definition of "nonqualified deferred compensation plan" have been addressed, above. Transitional and compliance-related highlights of Notice 2005-1 include:
- Amounts deferred and vested before December 31, 2004 may be grandfathered so that section 409A will not apply to such amounts. However, grandfathering will only be effective if the plan is not subject to a material modification after such date. A modification to a plan will be considered a "material modification" if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added. An amendment simply to bring the plan into compliance with section 409A will not be considered a material modification.
- Plans adopted before December 31, 2005 will not be treated as violating section 409A's distribution, acceleration, or election provisions if (i) the plan is operated in "good faith compliance" with section 490A during calendar year 2005, and (ii) the plan is amended on or before December 31, 2005 to conform to section 409A. "Good faith compliance" essentially requires that the plan be operated in accordance with Notice 2005-1, with a reasonable interpretation of section 409A itself, and, to the extent not inconsistent, with the terms of the plan. In this manner, for example, any discretionary provisions of a plan must be exercised (or not, as the case may be) consistently with section 409A. For example, a plan may allow an employee to elect a further deferral of already vested amounts in a manner that would violate section 409A if the election were made. Similarly, a plan may allow an employee to defer income to be earned in the same calendar year, albeit commencing with subsequent pay periods. To operate the plan in good faith compliance, the employee would generally have to refrain from making such violative elections during 2005 and the plan would have to be amended during calendar year 2005 to ensure that such non-compliant elections are no longer possible. (One exception is that as a transitional matter, an employee may make a 2005 deferral election for income to be earned in 2005, by March 15, 2005, provided the plan was in existence prior to December 31, 2004). Because of the risk that the good faith standard might inadvertently be failed (eg., because of employee activity), it is important that employers address immediately any areas where employees could inadvertently cause the plan to fail (the most likely problem areas being with deferral elections, whether initial or otherwise) and ensure that employees agree to act consistently with section 409A, or amend such provisions of the plan immediately.
- Plans adopted before December 31, 2004 may be amended during 2005 to allow a participant during 2005 to terminate participation in the plan or cancel a deferral election, without causing the plan to fail to conform to section 409A. Thus deferred compensation arrangements may be unwound as to specific participants without adverse tax consequences. However, termination of such arrangements will, of course, cause the terminating participant's hitherto deferred amounts to be brought into income.
- The American Jobs Creation Act of 2004 added new information reporting provisions in respect of nonqualified deferred compensation, which require deferrals for the year under a nonqualified deferred compensation plan to be separately reported on a form 1099 MISC or a W-2.