On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (the "Act"). The Act contains comprehensive changes to the federal tax laws governing nonqualified deferred compensation plans, including a broad expansion of the reach of such laws to cover certain forms of equity compensation.
The new rules, which are contained in new Section 409A of the Internal Revenue Code, are generally effective for (i) amounts deferred on or after January 1, 2005 and (ii) amounts deferred before that date if the plan is materially modified after October 3, 2004. The IRS has already issued guidance on several critical transitional issues, including what amounts will be treated as deferred before 2005, what constitutes a material modification, and what extensions of time will be provided to comply with the new rules.
For the most part, the transition rules are so complex that it is not helpful to repeat them here. There are certain aspects of the rules, however, that every taxpayer with a deferred compensation plan in place before the new legislation was enacted needs to know.
- Plans that existed before the effective date will probably need to be terminated, frozen, or brought into compliance by December 31, 2005.
- While this grace period may seem generous, it is quite deceiving, and most taxpayers should amend their plans as soon as possible for two reasons:
- Any plan that is amended to comply must also be operated in compliance with the new rules throughout 2005. Amending the plan early in the year will provide a simple way for taxpayers to learn how to operate the plan in accordance with the new rules.
- In most cases, for a plan that was in effect before December 31, 2004, deferral elections that relate to services performed on or before December 31, 2005 will be respected only if made on or before March 15, 2005.
The following steps should be taken immediately:
- prepare an inventory of existing and contemplated compensation plans, including equity compensation plans (for example, those involving stock appreciation rights, discounted options, and restricted stock);
- gather any related documentation; and
- contact legal counsel to review those plans in light of the new law.
Less aggressive plans will probably require only technical (as opposed to substantive) changes, such as revisions of the definition of "disability," "change of control," and "unforeseeable emergency." More aggressive plans may require substantive changes, such as the elimination of so-called "haircut" provisions and "financial health" provisions. The most significant changes, however, are likely to be in the area of equity compensation plans, which in the past generally had not been drafted to meet nonqualified deferred compensation requirements.
What follows is a more comprehensive presentation of the issues that you may need to address.
1. Identify Deferred Compensation Plans Affected by the Act. The Act applies to all plans and arrangements that provide for the deferral of compensation, with the exceptions of tax-qualified retirement plans and bona fide vacation leave, sick leave, compensatory leave, disability pay and death benefit plans. Certain types of equity compensation awards, such as stock appreciation rights (SARs), restricted stock units (RSUs) and options granted with exercise prices below fair market value, would be affected by the Act. An employer should identify all of its plans and arrangements that are or might be covered by the Act.
2. Consider Plan Revisions Required by the Act. Assuming that an employer will want to keep existing deferred compensation plans in place into 2005 and beyond, the following changes may be necessary:
- Deferral elections with respect to performance-based compensation covering services over a period of 12 months or more must be made at least 6 months before the end of the performance period; deferral elections for other deferred compensation (i.e., compensation not constituting performance-based compensation), as before, will need to be made before the taxable year when earned.
- Elections to defer payment or change the form of payment of a previously scheduled distribution must be made at least 12 months before both the effective date of the election and the first scheduled payment and must defer payment at least 5 years from the original payment date.
- So-called "haircut" provisions — provisions that permit in-service withdrawals upon forfeiture of a portion of the withdrawn amount (typically 10%) — will need to be deleted.
- "Key employees" of public companies will not be able to receive distributions within the first 6 months following separation from service.
- Plans that permit distributions on account of "disability" or "unforeseeable emergency" will need to take account of the Act's definitions of those terms.
- Plans that provide for distributions upon change of control events will need to comply with specific guidance from the Secretary of the Treasury as to the nature of such events and the manner in which distributions will be allowed.
- Provisions that, upon a change in an employer's financial health, restrict assets to pay deferred compensation benefits (for example, the funding of a rabbi trust, even though its assets remain subject to the claims of an employer's general creditors) will have to be eliminated.
3. Assess the Effect of the Act on Equity Compensation Practices. As noted above, the Act will affect certain equity compensation practices (particularly SARs and RSUs) that are starting to gain greater currency in light of anticipated changes in the accounting rules for equity compensation. Accordingly, the continued use of such types of awards, and the effect of the Act on unvested awards of these types, should be examined in light of the Act and subsequent guidance.
4. Consider Whether to Amend Existing Plans or Establish New Plans. The Act "grandfathers" amounts deferred under plans and arrangements prior to 2005. An amount is considered deferred prior to 2005 if it is "earned and vested" before that year; earnings on such grandfathered amounts are also grandfathered. However, grandfathering will be lost if the plan or arrangement is "materially modified" after October 3, 2004. Employers thus will need to decide how to preserve the grandfathered status of deferrals that are earned and vested prior to 2005. The choice would be either to freeze a plan as of the end of 2004 and create a new post-2004 plan or, through separate accounting within a single plan, to reflect the new rules as to post-2004 deferrals in the existing plan. Either choice will require close communication with plan administrators and employees. Attention should be given to restrictions on plan amendments contained in existing plans. Agreements with plan service providers and trustees of any rabbi trusts also may require amendment to reflect new plans or amendments to existing plans.
5. Consider the Manner and Timing for Plan Amendments or the Establishment of New Plans. Action by an employer's Board of Directors (or one of its committees, such as the Compensation Committee) may be necessary to amend plans in light of the Act or to establish new plans. Alternatively, consider delegating to one or more designated officers the authority to make changes to plans necessary under the Act to enable them to operate in 2005.
6. Consider Effect of New Rules in M&A Transactions. Various forms of deferred compensation plans (as broadly defined by the Act to include RSUs, SARs and options with below-fair market value exercise prices) are the subject of negotiated treatment in mergers and acquisitions. Deferred amounts often are accelerated as to vesting and exercisability or converted as to form. In light of the risk of losing the grandfathered status of a deferred compensation plan or arrangement through a material modification, care should be taken in the negotiation of M&A documents that will have any of these effects.
7. Establish Necessary Tax Reporting Systems. The Act requires that starting with 2005, deferred amounts must be reported on an individual's Form W-2 or Form 1099 for the year of deferral, even if the amounts are not currently includible in income for that taxable year.
8. Contact Your Attorney. This article necessarily does not specifically address the details of the reader's deferred compensation plans and arrangements. Legal counsel should be contacted to get the process started and to address the specific application of the Act to such plans and arrangements.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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