THE BRAVE NEW. New Rules on Deferred Compensation and Severance

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1 THE BRAVE NEW WORLD OF 409A New Rules on Deferred Compensation and Severance 1

2 HISTORY The American Jobs Creation Act of 2004 signed into law section 409A of the Internal Revenue Service code (the Code ). 2

3 ENRON DEBACLE Executives deferred $150 million in 4 years Prior to bankruptcy withdrew $50 million 3

4 DEFERRED COMPENSATION A legally binding right during a taxable year to compensation that has not been actually or constructively received and included in income and is payable in a later year. 4

5 PRIOR LAW Unfunded Non-Qualified Deferred Compensation (NQDC) taxed employees only when amounts were actually received in income rather than when the promise was made or the right was actually vested. 5

6 THE MOST SIGNIFICANT CHANGE Unless specific requirements are met in regard to elections to defer compensation and its distributions, all amounts deferred for all tax years are currently includable in gross income as long as they are not subject to a SUBSTANTIAL RISK OF FORFEITURE 6

7 SUBSTANTIAL RISK OF FORFEITURE Entitlement to the NQDC is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose p of the compensation (such as substantial future services), and the possibility of forfeiture is substantial. 7

8 WHAT IS A CONDITION Code Section 409A s definition of substantial risk of forfeiture, however, is very different from the definition of substantial risk of forfeiture under Code Section 457(f). Not conditioned on execution of a waiver or release Not conditioned on presence of a restrictive covenant 8

9 EMPLOYEE PENALTIES Besides being immediately taxed, all plans that do not comply will incur: an interest charge 20% excise tax (the penalty for non- compliance) an additional 1% interest penalty 9

10 SUBJECT TO 409A Amounts Deferred after 12/31/04 unless modified after 10/3/04: Deferred Compensation plans Certain equity plans and stock appreciation rights Severance Plans 10

11 DEFERRED COMPENSATION PLANS Deferral election must be made prior to the start of the year during which the service begins Any election to change distribution must be made 12 months prior and season for 12 months Performance based compensation election must be made 6 months before the end of the year in which the service was performed 11

12 DEFERRED COMPENSATION PLANS Distributions have limitations but the following are the exceptions: Separation Death Disability Unforeseeable and extreme circumstances Change in control 12

13 DEFERRED COMPENSATION No acceleration (different with stock and options) Key employees of publicly traded companies more restricted Section 416 (i) officers earning more than $145,000 where there are no more than 50 officers earning that, 5% owners, 1% owners earning more than $150,000 13

14 CERTAIN EQUITY PLANS Discounted incentive stock options (ISO s) and non-qualified stock options (NSO s) Issued with an exercise price less than fair market value at grant Further deferral beyond exercise However, option exercise date can be extended as long as the exercise period is not extended beyond the earlier of the original maximum term of the option or 10 years from the original grant of the stock right. SARs with exercise prices less than fair market value 14

15 SEPARATION PAY Pre-409A IRS rules defined separation payments as payments made by an employer to an employee relating to dismissal from employment. These payments constituted wages for income tax, Federal Insurance Contributions Act (FICA), and Federal Unemployment Tax Act (FUTA) withholding purposes. 15

16 SEPARATION PAY POST 409A SEPARATION PAY Compensation to which the employee s right is conditioned d upon a separation from service (including a separation from service due to death or disability) and not to compensation the employee could receive without separating from service (such as an amount also payable upon a change in control). 16

17 SEPARATION PAY Exempt from 409A 1. Collectively bargained for plans 2. Involuntary terminations and window programs The lesser of 2 X the employee s annual compensation (or 2X $225,000 (07) qualified retirement amount)(exclusion applies up to the limit, even where the entire amount of aggregated separation pay exceeds the limit) Paid no later than 12/31 of the 2 nd calendar year after termination 3. Short Term Deferral Paid 2 1/2 months from termination 4. Limited reimbursements 5. De minimus payments under section 402(g)(1)(B) ($15,000 for 2006) 17

18 SEPARATION PAY REIMBURSEMENTS (must be incurred by the employee no later than the end of the second year following the year in which the separation occurs) Reimbursement by employer for expenses incurred by employee must occur no later than the end of the third year following the separation Excludible from gross income Deductible by employee as business expense Reasonable outplacement Reasonable moving expenses (including the reimbursement for the loss incurred to a sale of primary residence in connection with a separation from service) Limited medical expenses COBRA Reimbursement In-kind benefits Legal fees 18

19 SEPARATION FROM SERVICE TERMINATION DEFINED: A leave of more than six months Employment agreement to continue employment but only doing insignificant service: 20% or less of the average level of services provided during the previous three years NOT SEPARATED 50% or more of service provided during the past three years 19

20 SEPARATION PAY Payments subject to 409A can be compliant if: Fixed schedule Controlled by employer Modified d by regulation 20

21 SEPARATION PAY Key employees- Public Company 6 month waiting period Unless can be paid out within the short term deferral (2 ½ months), or Can get the limited amount allowed within the safe harbor upon an involuntary termination during the first six months 21

22 GOOD REASON The final regulations treat a good reason resignation as involuntary, which means separation payments payable on a good reason termination are not vested until the GR event. It provides: A general facts and circumstances rule A safe harbor definition of GR includes notice and opportunity to cure and the time and form of payment to be the same as for involuntary separation. GR is limited to: Material diminution in base compensation, authority, duties or responsibilities, in the budget under employee s control, a material change in geographic location of work, or a material breach by the employer of the EA. 22

23 CHANGE IN CONTROL New Definition: A Change in Control of the Company shall be deemed to occur at the occurrence of any of the following: any person (or group) acquires ownership of the stock of the Company that, together with stock held by such person or group, constitutes more than 50% of the total fair market value or the total voting power of the stock of the Company; any person (or group) acquires (or has acquired within a twelve (12) month period ending on the date of most recent acquisition by such person) ownership of stock of the Company possessing 30% or more of the total voting power of the stock of the Company; a majority of the members of the Company s Board of Directors is replaced during any twelve months period by directors whose appointment or election is not endorsed by a majority of the members of the Company s Board of Directors before the date of the appointment or election; any person (or group) acquires (or has acquired within a twelve (12) month period ending on the date of most recent acquisition by such person) assets from the Company that have a total gross fair market value equal to or more than 40% of the total gross fair market value of all of the assets of the Company immediately before such acquisition or acquisitions; Gross-ups must comply with 409A 23

24 TRANSITIONAL GUIDANCE Good Faith Compliance through December 31, 2007 Plans brought into compliance Last opportunity to change or modify NEW RULES ELIMINATE REQUIREMENT TO RETROACTIVELY AMEND DOCUMENTS SUFFICIENT FOR DOCUMENTS TO BE AMENDED EFFECTIVE FOR PERIODS BEGINNING G ON OR AFTER JANUARY NOTE: APPLIES TO EMPLOYMENT AND SEVERANCE AGREEMENTS 24