Twenty-six years of silence by the Internal Revenue Service and Congress regarding deferred compensation has ended. Since 1978, the IRS has been prohibited from issuing new rules on deferred compensation, and Congress generally has been silent on the issue.

All of that has changed in dramatic fashion. The American Jobs Creation Act of 2004 adds new Internal Revenue Code §409A, prescribing very strict rules for amounts deferred under "nonqualified deferred compensation plans." Because of the broad definition of "nonqualified deferred compensation plan" and the harsh penalties that may apply to participants if a plan fails to comply with the new rules, companies should begin planning how to comply.

(The new §409A does not apply to "qualified" retirement plans such as 401k plans and "qualified" pension plans.)

The following questions and answers discuss key provisions of the new §409A, identify some of the issues likely to arise and recommend what to do now:


When are the new rules effective?

The rules generally apply only to amounts deferred after December 31, 2004, and earnings on those amounts. For purposes of §409A, an amount is considered "deferred" at the time that it was earned and would have been paid but for a deferral election. For example, salary or bonus payments that a participant will earn in 2005 but defers pursuant to an election filed in 2004 is considered deferred in 2005 and will be subject to the new rules. Amounts deferred before 2005 and related earnings will become subject to the §409A rules if the deferral arrangement was materially modified after October 3, 2004 (unless the modification is pursuant to IRS guidance). The legislative history indicates that a "material modification" includes the addition of any benefit, right or feature (for example, accelerating vesting).

The Act requires the Treasury Department to issue guidance regarding several provisions of §409A, including providing a limited transition period during which a company may amend a plan adopted before December 31, 2004: (1) to provide that a participant may terminate participation in the plan or cancel an outstanding deferral election for amounts to be deferred after December 31, 2004, but only if the amounts subject to the termination or cancellation are includible in income when earned or when no longer subject to a substantial risk of forfeiture; and (2) to conform to the requirements of §409A.

The legislative history indicates that Congress expects the Treasury Department to provide exceptions to certain §409A requirements during the transition period and to provide a reasonable time during the transition period for companies to amend their plans. The Treasury Department may allow companies to amend plans in early 2005, effective as of January 1, 2005.


What plans are covered?

The new rules cover any "nonqualified deferred compensation plan," which includes any plan, agreement or arrangement (including those that cover only one person) that provides for the deferral of compensation. The rules cover arrangements with employees and non-employees, including directors. They cover the typical elective deferral compensation plans; supplemental pension plans; employment agreements with deferral provisions; certain awards under equity compensation plans, such as options issued with an exercise price below fair market value; possibly stock appreciation rights (SARs) and other forms of equity compensation; possibly severance payments; and any other arrangements that provide for the deferral of compensation.

The rules do not cover: (1) qualified employer plans; and (2) bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans. The legislative history indicates that the rules also do not cover options issued with an exercise price at least equal to fair market value, incentive stock options, employee stock purchase plans described in Code §423, and annual bonuses or other annual compensation paid within 2½ months after the close of the taxable year during which the services were performed.


What are the new requirements for deferred compensation?

A nonqualified deferred compensation plan will not result in deferral of taxation unless the plan satisfies all of the following requirements both in form and operation:

Distributions: The plan may not distribute amounts earlier than: (1) separation from service or, for key employees as defined in Code §416 (i) of a public company, six months after separation from service; (2) disability; (3) death; (4) a specified time, pursuant to a fixed schedule or a time designated by the plan at the date of the deferral of the compensation (an event, such as a child going to college, is not a specified time); (5) a change in control but only as provided in regulations to be published; or (6) an unforeseeable emergency, all as defined in the Act.

The new rules generally would prohibit plan provisions allowing early distributions with a reduction ("haircuts") and other changes that would result in accelerating the time or form of payment.

Deferral Elections: Participants must elect to defer compensation for services performed during a taxable year before the beginning of that taxable year. There are two exceptions: (1) a 30-day election period applies to newly eligible participants; and (2) for performance-based compensation based on services performed over a period of at least 12 months, the participant must elect deferral no later than six months before the end of that period.

The time and form of distributions must be specified at the time of initial deferral. A plan may satisfy this requirement by allowing participants to elect the time and form of payment at the time of initial deferral, or the plan may contain default provisions that specify the time and form of payments attributable to a distributable event. For example, a plan could specify that payments upon separation of service will be made in a lump sum within 30 days of separation.

A plan may allow subsequent elections by participants to delay a payment or change the form of payment (but in no event accelerate the payment) if the plan provides that: (1) the election does not become effective for at least 12 months; (2) with respect to distributions on account of separation from service, a specified time (or pursuant to a fixed schedule), or for a change in control, the re-deferral is for at least five years from the date the amount would otherwise be paid; and (3) with respect to payments at a specified time (or pursuant to a fixed schedule), the participant elects at least 12 months before the date of the first scheduled payment.

Funding: Assets set aside in an offshore trust for purposes of paying deferred compensation, whether or not available to satisfy claims of general creditors, are taxed under Code §83 at the time set aside or the time transferred. Related earnings are treated as additional transfers of property. In addition, if assets and related earnings will become restricted upon a change in the employer's financial condition so that they can only be used for payment of benefits, participants will be taxed as of the earlier of: (1) the date an arrangement provides that assets become restricted upon a change in the employer's financial condition; or (2) the date assets become so restricted.


What are the consequences of failing to comply with the new rules?

If a nonqualified deferred compensation arrangement fails to comply with §409A in either form or operation at any time during a taxable year, all compensation (including earnings) deferred under the arrangement for the taxable year and all preceding taxable years (but only with respect to participants to whom the failure relates) is immediately taxable except to the extent those amounts are subject to a substantial risk of forfeiture or were previously included in income. The includible compensation is subject to an additional 20 percent tax and interest. If the failure relates to a plan provision affecting all plan participants, then all participants will owe taxes, interest and penalties.


What issues are companies likely to face?

The implications of these changes are enormous. Some companies may have dozens of arrangements that will be considered "nonqualified deferred compensation plans." The Treasury Department may address many of these issues in the required guidance, but companies may want to begin addressing the requirements of §409A before any such guidance is issued.

Nonqualified Deferred Compensation Plans: Identifying all nonqualified deferred compensation plans will be difficult. Many covered arrangements are obvious. For example, traditional elective deferral plans, traditional supplemental pension plans, equity compensation plans allowing delayed delivery of stock associated with an award and plans allowing directors to defer director fees or stock awards are covered.

Other covered arrangements are less obvious. Many individual employment agreements and bonus plans with deferral features will be covered. Change of control arrangements and severance plans may be covered. Only a careful analysis of all compensation arrangements will identify all covered arrangements.

Employment Agreements: Individual employment contracts will cause significant difficulties because each agreement may include numerous problematic provisions, including special deferral provisions, acceleration provisions and severance provisions. The new rules almost certainly will affect change of control benefits included in such agreements, and other severance payments may be covered by the new rules. If covered, a severance payment triggered by a change of control could theoretically end up subject to both the excise tax on golden parachutes and the 20 percent additional tax on deferred compensation. Broadly written tax gross-up provisions triggered by a change of control might inadvertently also cover the 20 percent additional tax, with significant adverse consequences for companies. Some companies may consider including special deferred compensation gross-up provisions to protect executives in appropriate circumstances. At a minimum, all executive employment agreements will require a careful and thorough review.

Equity Compensation Plans: Section 409A will affect certain equity compensation awards. The legislative history indicates the new law covers options with an exercise price below fair market value and possibly SARs. It also may cover other popular forms of equity awards, such as restricted stock units (RSUs). As a result, companies will need to review and possibly modify their equity compensation plans. Any such revisions, however, also must take into account stock exchange shareholder approval requirements and possible changes (now delayed for six months) in the accounting treatment of such awards. The proposed accounting changes have caused many companies to consider using SARs, but those awards now may be "nonqualified deferred compensation plans," subject to new Code §409A.

Publicly-Traded Companies: The six-month waiting period for distributions applies only to key employees of publicly traded companies. It is not clear whether this rule would apply to companies or affiliates of companies traded only on a foreign exchange.

Plan Amendments: Many companies may discover that they cannot change certain provisions without participant consent. Because of the possible difficulty amending existing plans, it may be easier to freeze existing plans and create new plans for deferrals after 2004. Amending individual employment agreements will require individually negotiated changes.

Distributions: The new rules prohibit acceleration of distributions but allow new elections to delay distributions, so that participants who initially elect installments or annuities may not later change to elect a lump sum. Companies must clearly inform participants of these restrictions and may consider having lump sums either be the only form of distribution or the form that will be used unless the administrator decides otherwise. Some plans contain distribution provisions that merely refer to distribution provisions contained in a related qualified plan. Those provisions must be changed to avoid impermissible acceleration or other improper election changes.

W-2s: The new law will require annual reporting on Form W-2 of the amounts deferred. Although this requirement probably will not affect any employees until they receive their 2005 W-2s, companies should consider notifying plan participants that deferred amounts will appear on those W-2s. Companies also should begin considering how to measure and track the amounts that they must report. Given recent pronouncements from senior Securities and Exchange Commission officials, it also is possible that companies will need to report these same amounts in their annual executive compensation disclosures in proxy statements and Form 10-K.


What should companies do now?

1.	Companies should immediately review all of their compensation arrangements to determine which ones are affected. In particular, companies must carefully review all existing executive contracts to determine the extent to which they will be covered. Some plans or arrangements are clearly covered, some are clearly not covered, and some may or may not be covered depending on Treasury Department guidance. This review also should include other documents, such as trust agreements, that relate to the compensation arrangements and may contain relevant provisions.
2.	Companies should compare the provisions of covered plans with the requirements of the new law to determine what changes are required.
3.	Companies should immediately begin considering whether to comply with the new provisions by amending their existing arrangements or freezing those arrangements and creating new plans for periods after 2004. If the required changes are minor and the plan allows such changes, companies may decide to incorporate the new provisions into existing plans. If the changes are significant or if the plans cannot easily be amended (for example, because the plan requires participant consent), companies may decide to freeze existing plans and create new plans for periods after 2004. Finally, for plans that are "nonqualified deferred compensation plans" only because they contain one or two provisions, such as a provision allowing option grants with an exercise price below fair market value, companies should consider eliminating those provisions to avoid §409A entirely.
4.	Companies should not amend any existing plans or establish new plans after October 3, 2004, without first considering the impact of the new rules.
5.	To allow time to evaluate the impact of the Act, companies should consider delaying the period during which elections will be made for 2005. If participants already have filed 2005 elections, companies should notify them as soon as possible because the new rules will apply to amounts deferred by those elections.
6.	Companies should begin planning for the upcoming amendments by considering when directors will be able to review and approve the changes and whether shareholders must approve any changes.
7.	Although the Act requires the Treasury Department to issue regulations covering numerous issues, some companies may want to adopt new plans or amend existing plans before that guidance. Those companies could strictly construe the new rules and adopt very conservative plan provisions, or they could adopt more liberal provisions but include fail-safe language. Given the need to decide what to do about deferrals before 2005 and the desire to address elections already made or about to be made for next year, companies may be reluctant to wait for such guidance.

If you would like to receive legal reports and updates more quickly, by e-mail, click here and fill out the mailing list form.

For more information about the issues covered in this report, please contact Benjamin I. Delancy in our Washington, D.C. office at 202-508-4081 or at bdelancy@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.





©2004 Thelen LLP