IRS Issues Initial Guidance on New Nonqualified Deferred Compensation Plan Rules

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1 JANUARY 10, 2005 IRS Issues Initial Guidance on New Nonqualified Deferred Compensation Plan Rules By Thomas McCord The IRS has issued its first round of guidance to implement the most comprehensive regulation ever enacted of nonqualified deferred compensation plans. In October 2004 Congress enacted new Internal Revenue Code Section 409A as part of the American Jobs Creation Act. This tax code section creates a brave new world for nonqualified deferred compensation arrangements. In brief, new Section 409A: limits flexibility in the timing of elections to defer compensation restricts distributions while employed to fixed dates, certain changes of control, or extreme financial hardship precludes acceleration of distribution dates prevents deferrals of distribution dates unless made at least one year in advance and the new distribution date is at least five years after the prior distribution date imposes immediate taxation plus a 20% penalty on deferred compensation arrangements that do not qualify under the new rules IRS Notice provides much-needed initial guidance in a number of crucial areas. Below is a summary of that guidance. What arrangements are subject to the new law? In General. An arrangement is a plan of deferred compensation subject to the new rules if the employee or other recipient has a legally binding right during a year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to the employee in a later year.

2 This definition covers a broad range of deferred compensation arrangements, but will exempt certain bonus programs. For example, if an arrangement provides for a cash bonus to be paid promptly upon meeting a performance goal, then the arrangement is not subject to Section 409A. Also, a short-term deferral is not subject to the new rules if it is paid by the later of two and one-half months after the tax year in which the deferral is no longer subject to forfeiture. Thus, a bonus program of a calendar year employer under which all amounts are paid to employees by March 15 (with no option for additional deferral) is not subject to the new rules. Equity Compensation. Grants of equity compensation are generally subject to Section 409A. There are, however, certain significant exceptions. Incentive Stock Options and Employee Stock Purchase Plans. The grant of an incentive stock option as described in Code Section 422, or the grant of an option under an employee stock purchase plan described in Section 423 (including the grant of an option under a Section 423 plan with an exercise price discounted up to 15%) does not constitute a deferral of compensation. Nonstatutory Stock Options. A non-incentive option (also known as a nonqualified or nonstatutory option) to purchase stock of the employer is not subject to the new law if: (1) the exercise price is not less than the fair market value of the underlying stock on the date the option is granted, and (2) the option does not include any feature for the deferral of compensation other than the regular deferral of recognition of income until the exercise of the option. Because discounted options will now be subject to Section 409A deferred compensation rules, this provision increases the importance of determining the fair market value of the stock at the time an option is granted. Certain Stock Appreciation Rights. A stock appreciation right (SAR) is generally subject to new Section 409A. However, an SAR is not subject to Section 409A if: (1) the SAR exercise price is not less than the fair market value of the underlying stock on the date the right is granted, (2) the employer s stock is traded on an established securities market, (3) the SAR payment upon exercise may be settled only in stock, and (4) the right does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the exercise of the right). This may make SARs a more attractive planning opportunity for public companies. In addition, there is a special transition rule for SARs granted pursuant to a program in effect on or before October 3, Until further guidance is issued, a payment of stock or cash pursuant to the exercise of a stock appreciation right (or economically equivalent right), or the cancellation of such right for consideration, will not be treated as subject to the requirements of Section 409A if (1) the SAR exercise price may never be less than the fair market value of the underlying stock on the date the right is granted, and (2) the right does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the exercise of the right). Restricted Stock. Transfers of actual shares subject to restrictions that defer tax under Code Section 83 are not subject to the new rules. 2 of 7

3 Partnership Profits Interests. Until additional guidance is issued, for purposes of Section 409A, taxpayers may treat an issuance of a profits interest in connection with the performance of services as not resulting in the deferral of compensation, if under existing IRS guidance the recipient would not recognize taxable income at the time of issuance. In general, this requires that the partnership interest be limited to income or gain earned by the partnership after the date of issuance. Severance Plans. Severance plans that provide for a deferral of any payments beyond the normal payroll period in which severance occurs may be considered deferred compensation plans. It is not yet clear whether the new rules will apply to lump sum severance payments of key employees in public companies; if so, such severance payments must be deferred until six months after the termination of employment. The IRS has indicated it intends to issue more detailed guidance on severance plans later in the year. However, in a limited transition relief exception, a severance plan is not required to meet Section 409A rules during calendar year 2005 if the plan is either (i) a collectively bargained plan; or (ii) covers no employees who are key employees (generally officers earning more than $130,000 or 1% stockholders earning more than $150,000). What are the special rules for acceleration events, changes in control, and performance-based compensation? Acceleration Events. Except under circumstances specified by the IRS, a nonqualified deferred compensation plan may not permit the acceleration of payments under the plan. This Notice provides limited circumstances under which payments under the plan may be accelerated, such as to meet the requirements of a domestic relations order or conflict of interest divestiture requirements. Also, a plan that does not otherwise provide for de minimis (up to $10,000) cashout payments may be amended to permit such accelerated cashouts, provided that (i) the payment accompanies the termination of the entirety of the participant s interest in the plan; and (ii) the payment is made on or before the later of (A) December 31 of the calendar year in which occurs the participant s separation from service, or (B) the date 2-1/2 months after the participant s separation from service. Change in Control. The Notice also allows a plan sponsored by a corporation to grant the corporation discretion to terminate the plan and distribute the deferred compensation within twelve months of a Change in Control. The guidance provides a detailed definition of Change in Control, under which most sales but not most initial public offerings will qualify. Performance-Based Compensation Rules. Section 409A provides that an election to defer performance based compensation may be made as late as six months prior to the end of the performance period. Until additional guidance is issued, the term performance or bonus compensation refers to compensation where (i) the payment of the compensation is contingent on the satisfaction of organizational or individual performance criteria, and (ii) the performance criteria are not substantially certain to be met at the time a deferral election is permitted. But bonus compensation does not include any amount that will be paid regardless of performance, based upon a level of performance that is substantially certain to be met at the time the criteria is established, or that is based solely on the value of, or appreciation in value of, employer stock. 3 of 7

4 What does it take to be grandfathered from the new law? Pre-2005 Vested Benefits are Grandfathered. Section 409A is effective with respect to amounts deferred after December 31, For purposes of Section 409A, an amount is grandfathered, i.e., considered deferred before January 1, 2005, if (i) the employee has a legally binding right to be paid the amount and (ii) the right to the amount was earned and vested as of December 31, The IRS Notice provides that a right to 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 future services. The Notice provides that earnings on amounts deferred before January 1, 2005, are grandfathered if the underlying amounts are grandfathered. Material Modifications. Even if an amount is earned and vested, Section 409A also applies to amounts deferred before 2005 if the plan under which the deferral is made is materially modified after October 3, In general, a modification is material if a benefit or right is enhanced or a new benefit or right is added. A plan amendment that enhances an existing benefit or right or adds a new benefit or right will be considered a material modification even if the enhanced or added benefit would be permitted under Section 409A. For example, the addition of a right to a payment upon an unforeseeable emergency would be considered a material modification. The reduction of an existing benefit is not a material modification. For example, the removal of a haircut provision generally would not constitute a material modification. Also, it is not a material modification to change or add an investment measure. It is presumed that the adoption of a new arrangement or the grant of an additional benefit under an existing arrangement after October 3, 2004 will constitute a material modification of a plan. This presumption may be rebutted by demonstrating that the adoption of the arrangement or grant of the additional benefit is consistent with the service recipient s historical compensation practices. For example, the presumption that the grant of a stock appreciation right on November 1, 2004, is a material modification of a plan may be rebutted by demonstrating that the grant was consistent with the historic practice of granting substantially similar stock appreciation rights (both as to terms and amounts) each November for a significant number of years. Amending an arrangement to stop future deferrals thereunder is not a material modification of the arrangement or the plan. Amending an arrangement on or before December 31, 2005, to terminate the arrangement and distribute the amounts of deferred compensation thereunder will not be treated as a material modification, provided that all amounts deferred under the plan are included in income in the year in which the plan terminates. What transition relief is available for prior deferral elections and for future needed plan amendments? IRS Notice provides transitional relief in several areas. Current compensation deferral elections under preexisting plans. With respect to deferrals subject to Section 409A that relate all or in part to services performed on or before December 31, 2005, the requirements of the new law relating to the timing of elections will not be applicable to any elections made on or before March 15, 2005, if certain requirements 4 of 7

5 are met. The requirements are that (a) the amounts to which the deferral election relate have not been paid or become payable at the time of election, (b) the plan under which the deferral election is or was made was in existence on or before December 31, 2004, (c) the elections to defer compensation are made in accordance with the terms of the plan in effect on or before December 31, 2005 (other than a requirement to make a deferral election after March 15, 2005), (d) the plan is otherwise operated in accordance with Section 409A with respect to deferrals subject to Section 409A, and (e) the plan is amended to comply with the requirements of Section 409A. Solely for purposes of this transitional relief, this election opportunity will not be treated as causing amounts the participant defers to be includible in income under the doctrine of constructive receipt or other preexisting tax rules. Plan Amendments and Operational Compliance. Any plan adopted before December 31, 2005, will not be treated as violating Section 409A if (i) the plan is operated in accordance with a good faith, reasonable interpretation of Section 409A and IRS Notice , and (ii) the plan is amended on or before December 31, 2005, to conform to the provisions of Section 409A with respect to non-grandfathered amounts (e.g. non-vested prior deferrals) subject to the new rules. This transition relief is available both to old plans that contain nongrandfathered benefits and to new plans adopted during To operate in good faith compliance, neither the plan sponsor nor a participant may exercise discretion under the terms of the plan in a manner that causes the plan to fail to meet the requirements of Section 409A. Some plan sponsors may wish for the sake of uniformity of administration to amend even grandfathered plans to comply with new Section 409A. If, however, the plan is not operated in compliance with the new rules after January 1, 2005, the sponsor will be unable subsequently to amend the plan document into compliance For example, if an employer retains the discretion under the terms of the plan to delay or extend payments under the plan and exercises such discretion, the plan will not be considered to be operated in good faith compliance with Section 409A with regard to any plan participant, and the plan amendment transition relief is not available. Termination of Participation/Cancellation of Deferral Election. In addition, either an old plan or a new plan may be amended to allow a participant during all or part of the calendar year 2005 to terminate participation in the plan or cancel a deferral election of amounts deferred subject to Section 409A, with respect to amounts deferred after December 31, 2004, provided that (i) the amendment is enacted and effective on or before December 31, 2005, and (ii) the amounts subject to the termination or cancellation are includible in income of the participant in the taxable year in which the amounts are earned and vested. Solely for purposes of this transition relief, this election opportunity will not be treated as resulting in a violation of the requirements of Section 409A or causing amounts the participant continues to defer to be includible in income under the doctrine of constructive receipt (although these provisions may still apply for other reasons). There is no requirement that the opportunity to terminate participation in a plan or to cancel a deferral election be granted, or that if granted, be granted to all plan participants. A termination or cancellation may be made with respect to elective or non-elective deferred compensation and may be undertaken by the plan sponsor or at the election of the participant. 5 of 7

6 The IRS has promised additional guidance in the upcoming months. But in light of the current guidance, companies should now consider transition actions to comply with the new law. These actions include: identifying deferral arrangements subject to the new law determining whether to amend an existing arrangement, or instead to freeze and adopt a new arrangement qualifying under Section 409A monitoring compliance of plans with the new rules prior to plan amendment determining whether any deferral arrangements should simply be terminated in 2005 developing communications materials to explain to participants the changes and any elections they may be given. The new rules are complicated and evolving as the IRS issues additional guidance. If you have any questions about the new rules, please do not hesitate to contact a member of our Benefits Team. 6 of 7

7 Employee Benefits Team Please feel free to call or your usual contact or any of the attorneys on our Employee Benefits Team listed below. ATTORNEY NAME PHONE BOSTON Thomas McCord tmccord (617) Laura Sanborn lsanborn (617) ROCHESTER Christian Hancey chancey (585) Brian Kopp bkopp (585) Lori Stone lstone (585) Bob Wild rwild (585) Albany, NY Omni Plaza 30 South Pearl Street Albany, NY Boston, MA 100 Summer Street Boston, MA Buffalo, NY 1600 Main Place Tower Buffalo, NY Garden City, NY 990 Stewart Avenue Garden City, NY Hartford, CT CityPlace 185 Asylum Street Hartford, CT Manchester, NH 889 Elm Street Manchester, NH McLean, VA 2010 Corporate Ridge, Suite 700 McLean, VA New York, NY 437 Madison Avenue New York, NY Orange County, CA 2040 Main Street, Suite 850 Irvine, CA Philadelphia, PA 1818 Market Street Philadelphia, PA Providence, RI One Citizens Plaza Providence, RI Rochester, NY Clinton Square Post Office Box Rochester, NY San Francisco, CA Two Embarcadero Center San Francisco, CA Washington, DC 401 9th Street, N.W., Suite 900 Washington, DC