- Executive Deferred Compensation: The Game Has Changed
- March 8, 2005 | Author: Erik T. Hoover
- Law Firm: Blank Rome LLP - Philadelphia Office
Recent corporate scandals have cast a harsh light on executive compensation practices -- including deferred compensation plans benefiting officers, directors and high-level executives. As part of the American Jobs Creation Act (the Act), signed by President Bush on Oct. 22, 2004, Congress added Section 409A to the Internal Revenue Code (IRC). Section 409A imposes numerous restrictions on non-qualified deferred compensation plans (NQDCs) and will introduce a new compliance regime in the executive compensation arena. The new rules are generally effective for deferrals on and after Jan. 1, 2005.
Arrangements Subject to 409A
The Act provides that base, bonus and equity compensation deferred pursuant to a NQDC will be subject to taxes, interest and penalties, unless the design and operation of a NQDC satisfies the requirements of Section 409A and guidance issued by the Treasury Department and the IRS. Notice 2005-1 (Notice), released Dec. 20, 2004, broadly defines NQDCs to encompass arrangements with employees, directors, independent contractors, partners or other individuals (collectively "participants") to defer payment for services rendered. Accordingly, the following arrangements, or certain aspects thereof, will be subject to Section 409A:
- Deferred compensation programs;
- Supplemental employee retirement plans;
- Individual employment agreements which permit the deferral of compensation;
- Certain non-statutory stock options and stock appreciation rights (SARs);
- Arrangements to defer profits interests; and
- 457(f) "ineligible" deferred compensation plans of governmental and tax-exempt entities.
The following plans, programs and arrangements are not considered NQDCs:
- 401(a) qualified employer plans (eg, 401(k), ESOP and profit-sharing plans);
- 403(a) contracts and 403(b) annuities;
- 408(k) simplified employee pensions and 408(p) simple retirement accounts;
- Bona fide vacation, sick leave, compensatory time, disability and death benefits;
- Annual bonuses payable within 2.5 months after close of the relevant determination period; and
- Statutory stock options (ISOs).
SARs are exempt from Section 409A provided that:
- The purchase price is not less than the fair market value of the stock at the time of grant;
- The option does not permit the further deferral of compensation beyond the exercise or disposition of the option;
- The stock subject to the SAR is traded on an established securities market; and
- The SAR must be settled in stock.
Similarly, a non-statutory stock option is exempt from Section 409A if it meets requirements (1) and (2) above and its receipt, transfer or exercises is taxable under Section 83 of the IRC.
Penalties For Noncompliance
If a NQDC violates any provision under the Act, amounts deferred or payable under the NQDC will be deemed taxable. Interest equal to the IRS underpayment rate plus 1% will be imposed on the tax liability that would have been incurred had the deferred amount been includable in compensation when originally deferred (or if later, when the deferred amount became vested.) Additionally, any amount to be included in income under Section 409A will be subject to a penalty equal to 20% of the tax liability.
Section 409A focuses primarily on three areas: 1) compensation deferral; 2) conditions, form and timing of distributions; and 3) funding restrictions.
Compensation Deferral Election Rules
The Act provides that a base compensation deferral election must be made in the calendar year preceding the year in which the compensation is earned. For new arrangements, the deferral election must be made within 30 days after the individual first becomes eligible to participate in the arrangement.
Performance Bonus Compensation
In the case of any "performance-based compensation" such as annual bonuses, the election must be made at least 6 months prior to the end of the service period during which the performance is measured provided that the bonus determination period is at least 12 months. Notice 2005-1 defines bonus compensation as compensation that is: 1) contingent on the satisfaction of individual or organizational performance criteria; and 2) based on criteria which is not substantially certain to be met at the time of the election. The Notice would suggest that discretionary bonuses are not considered performance-based for purposes of the 6-month election rule.
Equity-Based Compensation Elections
Neither the Act nor the Notice clearly address the timing for deferral elections with respect to non-statutory options and SARs. It is likely that definitive guidance will be offered in future releases from the Treasury Department. It is interesting to note, however, that with respect to the "grandfathering" rules (discussed below) the Notice provides that amounts are deemed "deferred" if earned and vested prior to Jan. 1, 2005. Thus, it is possible that a similar approach will be taken with respect to the deferral of equity-based compensation and permit the deferral election prior to the vesting of the option or SAR.
Conditions, Form and Timing of Distributions
The Act permits a distribution from a NQDC only upon:
- Separation from service;
- Death of the participant;
- Disability of the participant;
- A specified time or pursuant to a fixed schedule (determined at the service provider's election or under the terms of the plan);
- An "unforeseeable emergency"; or
- Change in control of the employer.
Both the commencement date and the form of distribution must be designated at the time of the initial compensation deferral election. Alternatively, the plan or program may specify the time and form of distribution. The initial distribution elections may be reinstated provided: 1) these revisions do not become effective for at least 12 months after the date on which the subsequent election was made; 2) if the revision defers the distribution commencement date, such deferred date must be at least 5 years after the original distribution commencement date specified in the initial election; and, 3) any subsequent election changing the timing or form of a distribution must be made no later than 12 months prior to the date of the original distribution commencement date specified in the initial election.
Acceleration of Distributions
The Act prohibits any change in the form or timing of distributions that has the effect of accelerating distributions. For example, a participant cannot request a change in the form of distribution from an annuity payout to a single sum. Additionally, the prohibition against acceleration will effectively eliminate "haircut" provisions commonly found in NQDCs. Under a haircut provision, a participant receives a partial distribution from the NQDC but a portion of the distributed amount (typically 10%) is forfeited. Such a provision would be deemed an acceleration and prohibited under the Act.
The Notice permits acceleration in limited circumstances, including:
- Compliance with the domestic relations order;
- Compliance with divestiture requirements under applicable conflict of interest laws;
- Payment of income taxes due upon a vesting event in a 457(f) plan;
- Payment of FICA and other applicable payroll taxes; and
- Payment of a de minimus amount (less than $10,000), provided that 1) it is paid upon separation from service, and 2) it represents the participant's entire account.
Special Distribution Cases
The Act sets forth certain special conditions and restrictions that impact the timing of distributions.
Distributions to 'Specified Employees'
If a distribution obligation arises from a separation from service, and the participant is a "specified employee," the distribution cannot be made until at least 6 months after the participant's separation date. The Act defines specified employee to include: i) officers (limited to the 50 highest paid employees) earning more than $130,000; ii) 5% owners; and iii) 1% owners earning more than $150,000 (as adjusted).
Distributions due to Change in Control
The Act provides that a plan may permit a benefit distribution upon occurrence of a change "change in control" as defined in Treasury Department guidance. The Notice provides that a "change in control" for purposes of Section 409A includes a change in the ownership of the corporation, a change in the effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation:
- A change in the ownership of a corporation occurs on the date that any one person or group acting in concert acquires more than 50% of the total fair market value or total voting power of the stock of such corporation.
- A change in the effective control of a corporation occurs on the date that either: 1) any one person or a group acting in concert acquires 35% or more of the total voting power of the stock of such corporation; or 2) a majority of the members of the corporation's board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the of board prior to such replacement.
- A change in the ownership of a substantial portion of a corporation's assets occurs on the date that any one person or a group acting in concert acquires 40% or more of the total gross fair market value of all of the assets of such corporation immediately prior to such acquisition.
Many employers currently fund NQDCs through trust vehicles commonly known as "rabbi trusts." Under such trusts, assets allocated to pay participant benefits remain subject to the claims of creditors of the employer in the event of its bankruptcy or insolvency. Such assets cannot, however, be used for the general operating purposes of the employer. Congress noted that many employers establish rabbi trusts or other funding vehicles outside of the United States in order to frustrate or avoid the reach of creditors. The Act effectively prohibits this practice by providing that any assets allocated to a non-U.S. funding vehicle are deemed to be transfers to such employee and therefore subject to immediate taxation.
Financial Health Triggers
Another common practice used to frustrate creditors is a financial health trigger that provides that upon the occurrence of certain financial factors, identifiable assets will be restricted to the payment of plan benefits and cannot be used to pay creditors of the employer. In operation, if the employer begins to show financial distress, the asset conversion occurs and creditors have no recourse against such assets. With such funding triggers, it is unlikely that the employer's creditors will have access to such assets even in the event of the employer's bankruptcy or insolvency. Under the Act, a deferral under a NQDC that contains such a trigger is deemed a transfer of property and therefore subject to immediate taxation.
In General. Section 409A is effective with respect to amounts deferred in taxable years beginning after Dec. 31, 2004. Section 409A also applies to amounts deferred in taxable years beginning before Jan. 1, 2005 if the plan under which the deferral is made is "materially modified" after Oct. 3, 2004. An amount is considered deferred before Jan. 1, 2005 if the participant has a legally binding right to be paid the amount and the amount has been earned and vested. An amount is earned and vested only if the amount is not subject to either a substantial risk of forfeiture or a requirement to perform further services.
With respect to amounts deferred under a non-account balance plan (eg, a supplemental retirement plan), the amount of compensation deferred before Jan. 1, 2005, is equal to the present value, as of Dec. 31, 2004, of the amount to which the participant would be entitled under the plan if he or she voluntarily terminated employment without cause on December 31 of that taxable year.
Material Modifications. A plan is materially modified if a benefit or right existing as of Oct. 3, 2004 is enhanced or a new benefit is added. Examples in the Notice include:
- Amendment of a plan to add a new in-service distribution right (regardless of whether a "haircut" penalty applies to such distribution);
- The participant's exercise of discretion to accelerate vesting to a date on or before Dec. 31, 2004; and
- A plan amendment or exercise of discretion under the terms of the plan enhancing an existing benefit or adding a new benefit or right permitted under Section 409A.
New Distribution Elections. A plan may be amended to provide for new distribution elections with respect to amounts deferred prior to Jan. 1, 2005. The plan must be amended and the participant must make the election on or before Dec. 31, 2005. Likewise, an option or SAR subject to Section 409A may be amended to provide for fixed-payment terms or permit the holder to elect fixed-payment terms. Such amendment or election will not be treated as a change in the form and timing of payment provided the option or SAR is so amended and elections are made on or before Dec. 31, 2005.
Election to Terminate Participation or Cancel Election. A plan adopted before Dec. 31, 2005 may be amended to allow a participant to terminate participation in the plan or cancel deferral election during 2005, provided that the amendment is enacted and effective on or before Dec. 31, 2005 and the amounts subject to the termination or cancellation are includable income for the taxable year earned and vested.
Election with Respect to 2005 Amounts by March 15. With respect to deferrals relating all or in part to services performed on or before Dec. 31, 2005, the requirements of Section 409A relating to the timing of elections will not apply if any election with respect to such deferral is made on before March 15, 2005, and:
- The amount to which the election relates has not been paid or become payable at the time of the election;
- The plan was in existence on or before Dec. 31, 2004;
- The election to defer compensation is made in accordance with the terms of the plan in effect on or before Dec. 31, 2005;
- The plan is otherwise operated in accordance with Section 409A; and
- The plan is amended to comply with the requirements of Section 409A on or before Dec. 31, 2005.
Document Amendment Period. A plan adopted before Dec. 31, 2005, will not be treated as violating the election, distribution, or form and timing of payment requirements of Section 409A if it is operated in good faith compliance with the provisions of Section 409A and the Notice during 2005 and is amended or on before Dec. 31, 2005 to comply with such provisions.
Given the complexity of the rules, many topics were omitted from this discussion. It is safe to say, however, that the broad range of plans and programs subject to 409A will mandate a thorough review of compensation arrangements. Congress and the IRS have spoken. The game has in fact changed and the clock to Dec. 31, 2005 is ticking.