|January 14, 2005|
Previously published on January 2005
Under new federal legislation signed into law by President Bush on October 22, 2004, new limitations may apply to your company's non-qualified deferred compensation arrangements. The new rules create Internal Revenue Code section 409A, which affects the timing of deferral elections and distributions under deferred compensation plans -- which are broadly defined to include most payments due in years after the years in which the compensation was earned -- and restrict provisions designed to protect assets set aside for deferred compensation payments in case of a sponsoring employer's financial distress.
Violation of the new limitations can cause retroactive inclusion of the vested deferred compensation into employees' taxable income, causing significant income tax liabilities, including penalties and a new additional tax of 20 percent on the amounts deferred. Companies should carefully examine all of their deferred compensation arrangements to determine whether they are affected by the new law and, if so, whether amendments are needed to bring the arrangements into compliance or freeze existing arrangements. Under proposed regulations issued by the Internal Revenue Service on December 20, 2004, employers have until December 31, 2005, to bring their plans up to date; however, they must administer their plans in good faith compliance with the new law during 2005.
The new law applies to all amounts deferred after 2004 under non-qualified deferred compensation plans, and to pre-2005 deferrals under plans that are materially modified after October 3, 2004. The rules apply whether the funds are provided by employers (such as under a supplemental executive retirement plan or SERP, or pursuant to multi-year severance pay arrangements) or by the employees (such as under a non-qualified elective deferral plan).
Exempt from the new rules are bona fide vacation, sick leave, death and disability plans, as well as statutory stock option plans. Non-statutory stock option plans are only exempt if the exercise price for the stock is not less than its fair market value on the grant date and there is no deferral of income after the option is exercised. Under the proposed regulations, stock appreciation rights are only exempt from the new law if the exercise price can never be less than the underlying stock's fair market value on grant date, and if the plan relates to publicly traded stock.
Under the new law, all deferral elections under affected plans must be made prior to the tax year in which the services giving rise to the compensation are performed, except that newly eligible participants have a 30-day period to make an election. Another exception is that deferral of performance-based compensation, the amount and payment of which is based on meeting pre-established criteria, may be made as late as six months prior to the end of the relevant performance period (which must be at least 12 months), as long as the amount and payability of the bonus is not ascertainable at the time the deferral election is made.
With respect to distributions under deferred compensation plans, the new law only permits payments at the pre-established time table set forth in the plan document or upon the participant's separation from service, death, disability or unforeseen emergency (which is narrowly defined in the new law) or the employer's change in control. Distribution timing generally cannot be accelerated absent one of the required events, even if a penalty must be paid by the participant for accelerating the distribution timing; however, the proposed regulations permit acceleration for certain reasons beyond the participant's control such as domestic relations orders or legal divestiture requirements.
Similarly, the law restricts the delay of scheduled distributions, permitting an amendment or election to defer the distribution only if the change is made at least 12 months before the date of the scheduled distribution, and the payment is delayed at least five years. In addition, the deferral election, once made, cannot take effect until at least 12 months after the election is made.
As to protecting the payment of assets set aside to satisfy an employer's obligations under deferred compensation plans, the new law forbids holding the assets in an offshore trust. Similarly, provisions that trigger the restriction of the assets to plan benefit payments upon a change in the employer's financial health will also be disallowed if the employer wants to defer taxation on the compensation being deferred.
Any amounts deferred after 2004 are subject to these new rules. If an amount is set aside for or promised to the employee prior to 2005, but the amount is not free from a substantial risk of forfeiture (i.e. vested) until 2005, the amount will be considered deferred after 2004 and will be subject to the new law. In addition, pre-2005 deferrals are subject to this law if the plan under which the deferred compensation is payable is materially modified after October 3, 2004. Amendments that bring the plans into compliance with the new laws are not considered material modifications. However, any other modification of a right, benefit or feature of the plan, particularly any change affecting the timing of deferral elections or distributions under the plan will likely be considered a material modification.