A Nixon Peabody LLP Publication Volume 18, No. 1 January 2005

Transcription

1 A Nixon Peabody LLP Publication Volume 18, No. 1 January 2005 The Backdrop New Code Section 409A, a creature of the American Jobs Creation Act of 2004 (the AJCA ), requires the maintenance of a new type of plan call it the qualified, nonqualified deferred compensation plan. Although the IRS has promised a stream of guidance over the course of 2005, its initial guidance (IRS Notice ) along with Section 409A, already provides a fairly complete picture of the requirements and the actions you need to take. If you think this new type of plan involves only the traditional executive salary or bonus deferral plan, the reach of Section 409A will be a jolt. In fact, deferred compensation is broad and because it consists of both benign and questionable arrangements, regulating it is a complex affair. Some examples of usually benign arrangements include annual bonuses, severance pay, retiree health, and pension benefits, and even executive benefit restoration plans that only give back what Code restrictions on qualified plan benefits take away. All of these benefits consist broadly of deferred compensation since the benefits typically are received in a year after the year an individual performs the services to which the benefits relate. Mixed with the benign, however, are some fairly aggressive practices structured primarily for tax purposes. These practices have at times become overly aggressive: for example, arrangements that defer some, or even most, of an executive s compensation for tax purposes but also leave open a door for him to access the money when desired. The Service has not been without a modest arsenal of weapons apart from Section 409A that it can use to attack the bad types of deferred compensation: (1) constructive receipt of income (if you really have control over the income you purport to defer, you will be deemed to have constructively received it and be taxed at that time even though you have not actually received it); (2) economic benefit (if the money deferred is so locked up for your sole benefit that you are, in truth, the only possible beneficiary (e.g., an annuity or trust fund with you as the owner and sole beneficiary), then you will be taxed on the current economic value of the arrangement); (3) assignment of income (if you earn the Nonqualified Deferred Compensation income, you will be taxed on it even if you have validly assigned receipt of it to another person, e.g., a child or other family member in a lower tax bracket); (4) cash equivalents (if you receive something that essentially can be used in the same manner as cash (e.g., a gift certificate), you will be taxed on the value of the cash equivalent currently even if it is not used until later); and (5) vested compensation credited to employees of tax-exempt employers in accordance with the provisions of Code Section 457(f). These existing doctrines proved not to be entirely effective, at least from the IRS s perspective. Over the years, executives and their tax planners became more and more aggressive, and the Service was unable to halt them until, finally, they reached too far. Specifically, the Enron meltdown galvanized Congress into action to curb the abusive deferred compensation practices witnessed in that scandal. Despite IRS rules intended to put executives in deferred compensation plans on the same footing as other general unsecured creditors of an employer, as Enron was sliding down its road to insolvency, its executives managed to get ahead of other creditors by taking distributions of their deferred compensation before their retirements or other scheduled payment dates. To compound the problem, while the executives were taking their deferred compensation benefits, rank and file employees were suffering huge losses in their 401(k) accounts. Hence, Section 409A was designed to plug perceived gaps in the prior enforcement scheme. When considering how to interpret the web of new rules under the AJCA, consider its basic purpose: to prevent executives from controlling exactly when they will receive income that relates to services performed at an earlier time. At the same time, keep in mind that Section 409A is additive. It does not repeal any of the other doctrines that the Service has had at its disposal to blow up deferred compensation. Section 409A merely imposes more rules one must satisfy to have a successful deferral of income. The Basic Requirements What we think we know from the face of new Code Section 409A and IRS Notice is the following: Copyright 2005 Nixon Peabody LLP. All rights reserved. BENEFITS BRIEFS is intended as an information source for the clients and friends of Nixon Peabody LLP. Its content should not be construed as legal advice, and readers should not act upon information in this publication without professional counsel.

2 A. Overview of Section 409A Qualification Requirements and the Consequences of Non-Qualifying Code Section 409A requires deferred compensation plans to satisfy, both in design and in actual operation, certain basic requirements, including (1) the time at which an election to defer must be made; (2) a requirement that the election include a fixed date or one of a limited number of statutorily prescribed triggering events for the payment of benefits; and (3) a prohibition on accelerating or, with one limited exception, further deferring payment from the initial triggering date or event. If these requirements are satisfied, an individual who has deferred income will be taxed on that income when it is ultimately paid (or when it is constructively received if the normal rules for avoiding constructive receipt of income are violated). If the qualification requirements of Section 409A are not satisfied, an individual will be taxed on the entire value of the deferred compensation benefit as of the date the plan fails to qualify and the benefit vests. In addition, the individual is subject to a 20% penalty tax plus interest pegged at 1% over the normal rate of interest the IRS charges for late-paid taxes. B. What Is a Deferred Compensation Plan? Under Section 409A, deferred compensation is defined to mean any deferral of compensation from the year in which the related services are performed to a subsequent year. This sweeping definition apparently reflects the IRS s concern that it will do no good to put a lid on one type of compensation arrangement only to have taxpayers achieve the same result using another type of compensation arrangement. Thus, in addition to applying to traditional plans that allow executives to defer bonuses or regular pay, Section 409A may apply to a severance plan, an equity compensation plan, a long-term incentive plan and other arrangements. At the same time, the term plan is used in a very different way than the term plan is used in the context of qualified retirement plans, i.e., 401(k), pension and profit sharing plans. In the latter context, one focuses on the entire arrangement that covers one or more groups of eligible employees. If a qualified plan fails to qualify, the whole plan implodes and all covered employees are affected. Section 409A, on the other hand, is concerned more with individual abuse than with group failure. Accordingly, it effectively defines a plan as all arrangements, grouped within one of three classifications under which one individual has deferred compensation: (1) account plans; (2) non-account plans; and (3) all others (e.g., equity-based compensation plans). For example, let s say an executive participates in the following compensation arrangements: can defer a bonus under a company s deferred bonus plan, can contribute a portion of his salary to a top-hat 401(k) plan, and is entitled to severance pay equal to two years base salary under his employment contract. These arrangements are all account plans, i.e., they all function like a defined contribution account, and one executive s interest in all three is treated as a single Section 409A plan. Why is this significant? Well, if the group of three benefits is a single plan and the executive violates Section 409A in one type of benefit for example he takes an early distribution from the 401(k) top-hat plan then all of his vested deferred compensation in all three arrangements becomes taxable, and is subject to the 20% penalty tax and enhanced interest charges. On the other hand, since other executives are not in this plan, they are not punished unless of course, there is a design or operational defect that affects each of their plans as well. Here are some other factors one should keep in mind about plans: (1) a plan can exist even if it covers only a single individual (e.g., the executive employment agreement mentioned in the preceding paragraph); (2) a plan can exist if it covers any type of worker, whether he is an employee, an independent contractor or a partner; and (3) a plan may exist under Section 409A even if it includes persons who are not executives or who otherwise do not fit the definition of highly compensated employees. Discussions of Section 409A typically mention executives because it is rare for at least traditional deferred compensation plans to cover rank and file employees. Traditional deferred compensation plans are virtually all top-hat plans in order to escape ERISA. Section 409A is not a top-hat provision. It hits all arrangements that defer compensation and, therefore, will hit any rank and file employees who have deferred compensation as well as executives (hopefully the DOL will not use Section 409A s broad definition of deferred compensation to expand the scope of ERISA). C. What Is Not a Deferred Compensation Plan? The following arrangements are specifically excluded from the universe of plans subject to Section 409A: Plans that qualify under Section 401(a) of the Code ( tax-qualified plans), including 401(k) plans and traditional pension and profit sharing plans Section 403(b) plans (tax-deferred annuities) Section 415(m) plans (governmental excess plans) Section 457(b) plans for employees of state and local governments and tax-exempt entities SEPs, SIMPLEs and Code Section 501(c)(8) trusts Vacation leave, sick leave and compensatory time Disability and death benefit plans Archer Medical Savings Accounts (Code Section 220), Health Savings Accounts (Code Section 223) and other medical reimbursement plans that satisfy Sections 105 and 106 of the Code As discussed below, some types of plans may or may not be treated as deferred compensation plans depending on their structure. For example, stock issued with an exercise price equal to the underlying stock s fair market value on the date of grant are not subject to Section 409A, but discounted stock options are covered. -2-

3 D. Impact of Section 409A on a Salary-Deferral Plan An Illustration of the Basic Rules To illustrate the application of Section 409A, we ll run through the general rules that apply to all plans in the context of a plan that allows an executive to defer some or all of his regular salary during the year. Note: This discussion refers to elections because most plans allow some choice, and it is this choice that is the principal evil at which Section 409A is aimed. If a plan feature is hard-wired with a term or condition that satisfies Section 409A, then the plan qualifies as to that term or condition even if participants are not given a choice or required to fill out election forms. For example, a plan will satisfy Section 409A s payment trigger if it automatically cashes out all benefits on termination of employment. (1) Timing of the Election. The deferral election normally must be made in the year before the year in which the executive performs the services to which the compensation relates. Example: If an executive wishes to defer 2006 salary, he must make the deferral election no later than December 31, Once 2006 starts it is too late to make any elections with respect to any 2006 salary, even salary that would be earned after making an election. Newly Eligible Employee Exception: If an executive becomes newly eligible to participate in a plan, he may elect to defer compensation even if the election is made in the middle of the year, provided that (1) the election is made within thirty days of his becoming newly eligible and (2) the election applies only to compensation earned after the election is made. Example: An executive first becomes eligible to participate in the plan on May 1, He may elect to defer 2006 salary earned after he makes the election provided that he elects the deferral by May 30, If he wants to make an election after this date, he can t; he must wait and defer 2007 salary. (2) Payment Triggers. A salary deferral and the earnings associated with it may be paid only if triggered by one of the following events: A fixed date or after a fixed period of time Termination of employment Death Disability Change in control Unforeseeable emergency These triggers may be a combination of events elected and events hard-wired into the plan. For example, an executive might elect a fixed payment date in the future, but the plan may contain an override provision that requires payment if an event occurs prior to the employee s elected date (e.g., termination of employment). The following additional points about payment triggers should be kept in mind: A payment trigger must be elected, or hard-wired, at the time of the initial deferral. The plan may not permit the use of any triggers other than those specified in Section 409A. Most notably, a haircut provision that permits executives to take money earlier than the initial trigger date if they are willing to forfeit a portion of their accounts (typically, 10% of the amount withdrawn) is prohibited. A fixed date trigger means a date, not an event, e.g., dates when my child begins college or when my parent enters a nursing home are not acceptable. It is also noteworthy that an unforeseeable emergency is very narrowly defined. It does not mean simply that you need money but that you need money because you ve been blindsided by some unforeseeable outside force. In other words, while you might not foresee a natural disaster, you can probably foresee that your children will one day enter college or your parents a nursing home. Notice contains a definition of a change in control that is substantially the same as the definition used in Code Section 280G for golden parachute payments. Any plan definition that does not currently conform to the new definition must be replaced by the new definition. (3) The No Acceleration Requirement. Inherent in the fixed trigger requirement is a rule that prohibits benefits from being paid earlier than the initial trigger date. In addition to the no haircut prohibition, for example, plans will henceforth be prohibited from giving employers discretion to accelerate payment in their sole discretion. More disturbing, after 2005 benefits may not be distributed on account of a plan termination. (As discussed in the Action Items section below, the Service will permit existing plans to be terminated in 2005 along with the payment of accrued benefits without triggering the Section 409A penalties.) Plans may be frozen with respect to new accruals but benefits simply must be held by the employer until a participant s initially elected trigger date. However, Notice does contain the following modest exceptions to the no acceleration rule: Acceleration of Vesting. Although not actually an acceleration of payment, IRS Notice states that an employer may retain the right to accelerate the vesting of deferred compensation so long as the other requirements of Section 409A, including the fixed payment date, are not changed. Domestic Relations Orders. A plan may permit payment of benefits to a person other than the employee pursuant to the terms of a domestic relations -3-

4 order (typically, payment to a former spouse incident to a divorce). Conflict of Interest. A plan may permit early payment to comply with a certificate of divestiture. Acceleration for Tax Withholding Under Section 457(f) Plan. A Code Section 457(f) plan may accelerate payment to coincide with the vesting of the plan benefit but only in the amount needed to pay withholding taxes on the vested benefit. Thus, the employee does not end up with any net cash until the fixed payment date. Acceleration for Employment Taxes. A plan may permit payment from the account for the FICA taxes due on deferred compensation (due typically when deferred compensation vests) plus any income taxes due on the FICA tax payment. Cash Out of Small Benefits. If a plan participant terminates participation when the value of his benefit is less than $10,000, the entire benefit may be cashed out immediately in a lump sum payment provided payment is made by the later of 2½ months following termination or December 31 of the year participation terminates. (4) Subsequent Elections to Postpone Payment or the Form of Benefit. Although any change in the initially selected payment date is generally prohibited, Section 409A contains a modest exception that allows a postponement of the payment date or a change in the form of payment. The exception permits such a change only if (a) the new election is made at least twelve months prior to the initial payment date and (b) the new payment commencement date is at least five years after the subsequent election is made. Example: An executive initially elects a lump sum payment of his deferred salary to be made on January 1, If the plan permits benefits to be paid in five annual installments, the exception would permit this executive to change the method of payment to the five year installment method but only if (1) he makes the election no later than December 31, 2008 and (2) the first installment under the new election is made no earlier than January 1, (5) Funding. Section 409A permits the continued use of rabbi trusts for the purpose of maintaining a fund for the payment of deferred compensation. However, two specific uses of rabbi trusts are forbidden and if attempted will trigger immediate taxation of the deferred compensation along with the 20% penalty and the enhanced interest penalty: (1) use of an offshore rabbi trust and (2) use of a springing rabbi trust where funding is contingent on an insolvency trigger, i.e., funding that is triggered when it appears that the employer faces an increased risk of insolvency. (6) Effective Date/Grandfathered Accounts. The new rules apply to the following amounts: Compensation deferred on or after January 1, 2005 Compensation deferred prior to January 1, 2005 but vested on or after this date Compensation deferred under a pre-2005 plan but the plan is materially modified after October 3, A plan is materially modified after October 3, 2004 if it adds a new benefit even if that new benefit is one that is permitted by Section 409A (e.g., adding a hardship distribution). A plan is not materially amended if it is modified to conform to Section 409A without adding new benefits or if it eliminates future deferrals. Grandfathered accounts are generally accounts deferred and vested prior to January 1, 2005 and the earnings thereon. If an existing plan is not materially modified, it can continue to be operated in accordance with its pre-2005 terms and deferral elections made pursuant to it. However, the IRS still has the right to challenge the effectiveness of the deferrals under prior law, i.e., under the rules governing the constructive receipt of income, they may nevertheless be subject to current taxation. E. Impact of Section 409A on a Bonus Deferral Plan Bonuses come in a variety of packages sometimes they are unexpected, sometimes they are regular annual bonuses and sometimes they are paid at the end of a multi-year incentive cycle. In general, deferred bonuses are subject to the same rules as deferred salary discussed in the preceding section. Here are the significant differences: Some Bonuses Are Not Deferred Compensation. Any compensation paid within 2½ months following the end of a calendar year in which it is earned is not deferred compensation under Section 409A. Hence, if you wish to stay completely clear of Section 409A, you can do so if you pay bonuses and other compensation for services rendered in one year by March 15 of the following year. If the bonus plan is a multiyear incentive plan, the bonus must be paid by the later of 2½ months following the end of the cycle or December 31 of the year in which the cycle ends. Timing of the Initial Election. If a bonus is paid with respect to services performed for a period of at least twelve months, the initial deferral election need not be made in the calendar year before the services commence but may be made at any time up to six months prior to end of the performance period. Example: If a bonus is paid with respect to calendar year 2005 performance, an election to defer this bonus can be made up to June 30, 2005 instead of by December 31, Example: An employer that never previously had a deferred compensation arrangement decides after 2005 has started that it will offer year end bonuses based on 2005 performance. It appears that under Section 409A these bonuses could be deferred if the employer establishes the plan -4-

5 and gets the deferral elections completed by June 30, 2005 even though the deferrals relate back to some compensation earned prior to June 30, If the employer had instead established a new deferred salary plan, deferrals would be permitted within thirty days of an executive s becoming eligible but only with respect to compensation earned after the election is made. F. Impact of Section 409A on Severance Plans The IRS has long had its sights on severance plan abuses because severance plans can be used to disguise a retirement or deferred compensation benefit by those who wish to avoid a variety of special rules applicable to retirement-type plans. Think of an executive severance plan that effectively says to executives: If you elect to sever employment at or after age 65, we will pay you a severance benefit of fifty percent of your final pay for the rest of your life. Sure, it is labeled severance, and it is paid on account of a severance from employment, but otherwise it definitely quacks like a retirement or deferred compensation benefit. On the other hand, a traditional severance benefit of, say, one or two weeks pay for any employee of the company who is involuntarily terminated is also severance but one that the IRS has no interest in discouraging by imposing on it stringent regulations meant to curb executive-level finagling. So far, neither Section 409A nor IRC Notice has provided definitive guidance on what types of severance plans will ultimately be subject to the deferred compensation rules of Section 409A. Notice excepts from Section 409A only a plan that meets all of the following requirements and only for 2005: The plan is either a collectively bargained plan or it covers only non-key employees (Code Section 416(i) definition); Benefits are paid only for involuntary terminations; and Benefits meet the ERISA definition of severance pay (in general, benefits cannot exceed two years of compensation, must be paid within two years of termination, and cannot be paid on account of retirement). The Service has asked for comments on what types of severance plans should be subject to Section 409A. In the meantime, based on the foregoing, it appears that while plans for the rank and file should be fine, you should take a close look at all executive severance arrangements, including severance provisions in employment contracts that cover any key employee (in general, an officer with annual pay greater than $130,000, a 5% owner, or a 1% owner with annual pay greater than $150,000). If the arrangements fail to comply with Section 409A (lack a permitted payment trigger, permit the acceleration or deferral of payments, or violate the rabbi trust funding rules), it seems prudent to make them comply. The most likely problem you will find are provisions that permit flexibility in exactly when payments will be made (for example, a choice of payment options or a provision that benefits will be paid over, say, a two- or three-year period, but the employer has the discretion to accelerate them or to pay the benefit in a lump sum). G. Impact of Section 409A on Equity (Company Stock) Plans Like severance plans, the IRS treats equity compensation plans as the equivalent of deferred compensation, essentially because a company grants stock or an option to purchase stock as part of a compensation package in one year, but the compensation is not recognized as taxable income until a later year (typically upon exercise (at the time of an executive s choosing) or vesting). The unique application of Section 409A as applied to different types of equity compensation plans is as follows: (1) Stock Options. The following plans are exempt from Section 409A: Incentive Stock Option ( ISOs ) Plans (Code Section 422) Qualified Employee Stock Purchase Plans (Code Section 423) Non-Qualified Stock Option Plans if the exercise price of an option equals the fair market value of the underlying stock on the date of grant. Presumably, the Service decided to exempt ISOs and non-qualified options with an exercise price equal to the fair market value of the underlying stock because an exercise on the date of grant would not result in any gain and hence there is no immediate deferral of compensation on the grant date. There is value in the option, of course, but it only comes with the subsequent appreciation in value of the stock. Fortunately, the fair market value requirement will apparently not be a trap for the unwary since Notice permits value to be determined under any reasonable method for valuing company stock. In addition to discounted non-qualified stock options, Notice indicates that Section 409A will cover the following options: (1) an option granted with a put giving an optionee the right to require the company to buy back any stock acquired by the exercise of an option, and (2) an option granted in tandem with other rights such as stock appreciation rights. (2) Stock Appreciation Rights ( SARs ). Unlike the plans described above where an employee is given the right to receive certain shares of stock upon exercise, an SAR gives an employee the right to receive the increase in the value of the stock from the date of grant to the date of exercise. Traditionally, this value would be paid either in company stock or in cash. The Service is of two minds about SARs. On the one hand, discounts and the employee s right to select the date of exercise make them operate as deferred compensation. However, the Service also recognizes that certain SARs operate just like stock options, and are non-abusive. Consequently, it does not wish to subject them to Section 409A. Here s -5-

6 where the Service drew the line on what SAR practices will not violate Section 409A: Designed-Based SARs. An SAR with a fixed exercise date, i.e., the SAR is automatically paid out as of a date that is fixed at the time the right is granted. Of course, very few SAR plans have ever been designed in this way. A principal value of an SAR, as of an option, is in having the discretion to decide when to exercise. Exempt SARs. An SAR that satisfies all of the following: (1) the exercise price equals the fair market value of the company stock on the date of grant; (2) the company stock is traded on an established securities exchange; (3) upon exercise, payment will be made only in company stock, not cash; and (4) there is no feature in the SAR other than the right to determine the date of exercise that defers compensation. Note: One of the principal values of an SAR has been to have the benefit payable in cash. Cash avoids certain securities law issues for insiders and can be used, unlike stock, to pay one s taxes. Requiring settlement to be in company stock is a real takeaway unless one has the ability to sell the shares. Grandfathered SARs. Until further guidance is issued, an SAR granted before October 4, 2004 is not subject to Section 409A even if the company stock is not traded on an established exchange and even if payment may be made in cash as well as company stock provided that (1) the exercise price is not less than the fair market value on the date of grant and (2) the SAR does not have any feature that defers compensation other than the right to determine the date of exercise. Note: As discussed below under Action Items, if outstanding SARs would otherwise become subject to Section 409A (presumably because they were not vested by the end of 2004), new compliant SARs may be substituted for the outstanding ones. (3) Restricted Stock or Other Restricted Property. Unlike options, where an employee does not receive stock unless he exercises the option, restricted stock is given outright on the date of grant, but it does not vest until some substantial risk of forfeiture is lifted (e.g., the employee must be continuously employed until a specified future date or the company s revenues, earnings, stock value or some other performance target must be reached over a specified performance period). Once the restriction lifts, the employee is vested and subject to tax. Restricted stock (or other property) is not subject to Section 409A as long as the grant meets the requirements of Section 83 (the property can t be transferable and must be subject to a risk of forfeiture that is substantial). Notice warns that property which an employee has a binding right to receive (i.e., it is nonforfeitable) in a future year may be subject to Section 409A whether or not it is restricted property. H. Impact of Section 409A on Section 457 Plans Section 457 contains special rules for non-qualified deferred compensation plans of tax-exempt organizations and state and local governments. Section 457(b) plans ( eligible plans) are not subject to Section 409A. Section 457(f) plans ( ineligible plans) are subject to Section 409A. The principal impact of Section 409A on Section 457(f) plans appears to be the fixed payment date requirement. This requirement seems clearly to prohibit the use of rolling vesting plans. This prohibition may, in turn, result in Section 457(f) plans having only a very limited future utility because few executives are likely to want their deferred compensation to be at risk, over long time periods, on account of their leaving their jobs. Termination, voluntary or involuntary, has proved to be a rather common occurrence with tax-exempt employers as well as with others. I. Impact Of Section 409A On SERPS Supplemental executive retirement plans ( SERPs ) can be of either a defined contribution or a defined benefit variety. Defined contribution SERPs, typically a top-hat 401(k) arrangement, are subject to the same basic rules that apply to any salary deferral plan. There are no unique problems with the possible exception of the current practice in some tandem arrangements of transferring fund balances between a qualified and non-qualified plan depending on the outcome of antidiscrimination testing in the qualified plan. Defined benefit SERPs frequently supplement an underlying qualified defined benefit plan, i.e., they restore benefits otherwise curtailed under the qualified plan because of statutory limits on the benefits the qualified plan can provide. Because the two plans are meant to work in tandem, executives have often not been given an election on when they would receive their SERP benefits or the form those benefits would take. The election under the qualified plan would govern the timing or form of benefit or both under the SERP. This linkage violates the fixed payment rule. For 2005 only, IRS Notice permits any such linkage provision that was in effect on October 3, 2004 to continue in effect. Presumably, however, plans containing such linkage will need to be revised for post-2005 distributions and, instead, require the executive to make a separate, fixed date, election for the SERP. This will likely result in many SERP benefits being paid out at different times and in a different manner than the qualified plan benefits they were intended to supplement. What are the Tax Reporting and Withholding Requirements? All amounts deferred in 2005 and later years must be reported on Form W-2 for employees and on Form Misc for independent contractors even if the deferrals are not vested. Normally, benefits are subject to wage withholding -6-

7 for income tax purposes when paid, assuming the benefits accrue for employees rather than independent contractors. If an arrangement violates Section 409A, however, wage withholding is required at the time the deferrals vest. A special rule for 2005 permits employers to wait until December 31, 2005 to withhold on these deferrals. The current rules on the payment of FICA and Medicare taxes on deferred compensation are unchanged by the Section 409A rules (generally, these tax obligations arise when the deferred compensation vests). Action Items For 2005 What Are They? If you haven t done anything yet for 2005 or if you want to undo what you have done, the IRS has provided some very accommodating rules as follows: A. Plan Level Actions Plans in Existence on December 31, 2004 Grandfathered Deferrals: Follow old plan documents, pre-2005 compensation elections and old law. Post-2004 Deferrals Operate plan in accordance with Section 409A (subject to special rule on 2005 deferral elections noted below) Note: A plan s operation must be in good faith compliance with Section 409A and the guidance issued under IRS Notice Amend plan document to comply with Section 409A by December 31, 2005 If existing plan was or will be materially modified after October 3, 2004, treat as new plan as outlined below New Plans for 2005 Operate plan during 2005 in good faith compliance with Section 409A Adopt written plan document that conforms to Section 409A by December 31, 2005 Plan Terminations. As noted previously, after 2005, it will be virtually impossible to terminate plans until all benefits have been paid in accordance with the originally elected payment dates. However, IRS Notice permits plans to be terminated, and benefits distributed, by December 31, Termination is something to consider if you have frozen plans, plans with small accounts, or plans you have no interest in maintaining under the new rules. Plan Amendments to Permit Participant Changes. Transition rules allow an employer to amend an existing plan to permit participants to make changes in their prior elections during all of 2005 even though such changes would otherwise violate Section 409A. Amending existing plans to permit the following changes will not be considered to be a material modification: A change in the form or timing of a benefit payment A termination of participation in the plan, i.e., a participant s opting out and taking the entire value of his benefit into income A termination of an existing deferral election Replace Certain Equity Compensation Subject to Section 409A with Compensation Not Subject to Section 409A. Discounted non-qualified stock options issued under pre-2005 plans that are not grandfathered (because they did not vest prior to 2005) may be replaced with non-discounted stock options prior to the end of 2005 without such substitution constituting a material modification. Similarly, SARs that are now subject to Section 409A may be replaced during 2005 with SARs that are not subject to Section 409A. Negotiate Changes with Participants. Unilateral revision of plans and current elections may breach contractual rights that plan participants currently enjoy. Employers will need to identify those rights (e.g., a plan provision that prohibits plan amendment or termination without obtaining participant consent) and obtain the necessary consent. B. Participant Level Actions 2005 Deferral Elections Under Plans in Existence on December 31, 2004 Elections for deferring 2005 compensation may be made any time prior to March 15, 2005 (as opposed to the normal rule of December 31, 2004). Elections can be effective, however, only for compensation payable after the election is made. If a plan is amended to so permit (see plan level actions under heading A above), a participant can, during 2005, change a current election regarding the form and timing of his benefit payment, terminate participation in the plan and take out his deferrals or terminate his existing deferral election, all actions that would otherwise be prohibited by Section 409A Deferral Elections Under All Plans Deferral elections and benefit payment elections already made with respect to 2005 compensation and subject to Section 409A may be changed or revoked by December 31, For the typical, ongoing deferred compensation plan, these rules effectively permit executives to modify elections made prior to 2005 up to and including a complete bailout. If they choose to opt out of a plan, they must take a distribution of their entire account balances. In addition, those who plan on continuing participation and who made salary deferral elections at the end of 2004 for 2005 income may undo these elections by year-end However, if they wish to have different elections for 2005 salary, they need to act by March 15, 2005 to get these elections in place. Obviously, those procrastinators who simply never got around to making year-end 2004 elections also have a second chance, assuming they can get their acts together by March 15 and make an election for the rest of their 2005 income. -7-

8 Does Deferred Compensation Still Make Sense? Although tax deferral remains a potent reason for deferring income, Section 409A certainly makes nonqualified deferred compensation a good deal less attractive to both companies and their executives in the future. An employer should consider the following disadvantages: The added burden and costs of complying with the document and operational requirements of the new law. In a real sense, deferred compensation plans have become qualified plans which imposes a burden of compliance with the law s qualification requirements as well as compliance with the contractual rights created under the plan itself. The inability to terminate an arrangement once established regardless of otherwise compelling business reasons for terminating the arrangement. An executive should consider the following disadvantages: Because the new law closes all but a few escape hatches, potentially needed assets will be inaccessible until the specified payment date regardless of individual circumstances that may change greatly after an initial election is made. Because of the lack of escape hatches, the risk of losing the deferrals is substantially increased in the event of employer insolvency or, in the case of Section 457(f) plans, in the event of any termination of employment. Apart from new Section 409A, the lower tax rates that currently apply to capital gains and dividend income compared to deferred compensation all of which is taxed at ordinary income rates plus the prospect of higher tax rates in the future that will apparently be required to deal with Social Security, Medicare and budget shortfalls generally all reduce the relative attractiveness of deferred compensation. If you have any questions, contact one of the following benefit attorneys. Benefits Attorneys Christian Hancey chancey@nixonpeabody.com Brian Kopp bkopp@nixonpeabody.com Tom McCord tmccord@nixonpeabody.com Laura Sanborn lsanborn@nixonpeabody.com Bob Wild rwild@nixonpeabody.com New York, NY Rochester, NY Boston, MA San Francisco, CA Washington, DC Albany, NY Buffalo, NY Hartford, CT Long Island, NY Manchester, NH McLean, VA Orange County, CA Philadelphia, PA Providence, RI