Client Alert. New Tax Law Will Require Substantial Changes to Many Non-Qualified Deferred Compensation Arrangements.

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1 October 19, 2004 Client Alert An informational newsletter from Goodwin Procter LLP New Tax Law Will Require Substantial Changes to Many Non-Qualified Deferred Compensation Arrangements Employers must take immediate action to review closely and in many cases revise substantially their non-qualified deferred compensation arrangements that cover employees or directors (or other independent contractors such as consultants), in light of new legislation (known as the American Jobs Creation Act) that has been approved by Congress. It is expected that the President will sign this legislation, although at this time it is unclear when that will occur. The new non-qualified deferred compensation rules established by this legislation generally will become effective January 1, 2005, and in some circumstances will apply to deferred compensation earned before that date. This Client Alert is intended to assist employers in responding to this new legislation. First, the Client Alert provides a brief overview of the major features of the new rules. Second, steps for assessing the impact of the new requirements and developing an effective response are outlined. Lastly, the Client Alert includes a series of Questions and Answers that provide more detailed information regarding the types of arrangements subject to the new rules, the scope of the new requirements, the effective date, and expected IRS guidance. Brief Overview Types of Arrangements Affected. This legislation will have a broad impact, as it generally will affect all types of deferred compensation arrangements other than specific types of plans (such as 401(k) and other tax-qualified retirement plans and 403(b) arrangements) that currently are entitled to special tax treatment. For example, the legislation will cover: arrangements that permit individuals to elect to defer compensation (including socalled 401(k) wraparounds); non-elective retirement arrangements with formula benefits (including so-called SERPs and excess plans ); certain stock-related compensation arrangements, such as stock appreciation rights ( SARs ), phantom stock, discounted stock options, and restricted stock units; and one-person arrangements, including employment agreements, that provide for any type of special retirement benefits or other deferral of compensation. In this Client Alert all of these arrangements are referred to as NQDC Arrangements and employees and directors (and other independent contractors) covered by a NQDC Arrangement are referred to as NQDC Participants.

2 New Requirements. The changes imposed on NQDC Arrangements by the new legislation will be substantial. Among other things, the new law will establish significant restrictions on distributions and elections to defer restrictions that many NQDC Arrangements currently do not contain. For example, distributions generally will be permitted only: following the NQDC Participant s separation from service, disability, or death; at a time specified under the plan; in connection with an unforeseeable emergency; or (to the extent permitted by the IRS) following a change in control. In addition, the new law will require any election to defer compensation generally to be made before the beginning of the year in which that compensation is earned, and to specify the time and form of payment. Although in some cases a NQDC Participant will have a limited ability to defer payment further, past the scheduled distribution date, any acceleration of payment (e.g., under a so-called haircut provision) will be prohibited. The legislation will also impose new requirements relating to the funding of NQDC Arrangements, which restrict the use of offshore rabbi trusts and transfers to rabbi trusts based on triggers relating to the financial health of the employer. Importantly, these new requirements will have to be incorporated into the documents governing the NQDC Arrangement, and the NQDC Arrangement will also have to comply with the rules in operation. A NQDC Arrangement that satisfies the requirements that will be imposed by the new legislation is referred to in this Client Alert as a Section 409A Plan, after the section of the Internal Revenue Code ( IRC ) added by the new law. This legislation will also impose certain wage withholding and reporting requirements relating to non-qualified deferred compensation. Consequences of Non-Compliance. The consequences of failing to comply with the new requirements will be significant: a NQDC Participant covered by a NQDC Arrangement that does not constitute a Section 409A Plan will be subject to tax on the deferred compensation as soon as he vests in his rights to receive the deferred compensation, which often is years before the NQDC Participant would actually receive a benefit under the NQDC Arrangement. In addition, the amount that is taxable under a NQDC Arrangement that does not constitute a Section 409A Plan will be subject to an additional 20% penalty tax, as well as interest. In light of these consequences, employers will as a practical matter need to structure their NQDC Arrangements to comply with the Section 409A Plan requirements. Effective Date and Expected IRS Guidance. The new rules generally will apply to all amounts that are deferred or that become vested on or after January 1, Rules in effect before the new legislation will continue to apply to deferred amounts that are earned and vested before January 1, 2005, unless the NQDC Arrangement is materially modified after October 3, A number of the new statutory rules are vague, and will require IRS guidance to explain them. The IRS has indicated that it intends to issue guidance in the near future, after the law is signed by the President. Nevertheless, given the impending effective date of the changes, it is essential that employers begin to take steps immediately to assess the impact these new rules will have on the NQDC Arrangements they maintain and to begin to develop an effective response to these changes. Goodwin Procter LLP Page 2

3 Steps Employers Should Take In responding to this new legislation, employers should take the following steps: 1. Identify all of the employer s NQDC Arrangements that will be subject to the new rules. 2. Determine whether any of the identified NQDC Arrangements fail to comply with the Section 409A Plan requirements. 3. In the case of any NQDC Arrangement that does not satisfy the Section 409A Plan requirements, take prompt action to address issues regarding 2005 deferrals (see below). 4. Take steps to draft and adopt the appropriate documents. 5. Implement the changes to (or termination of) the affected NQDC Arrangements. Depending on the circumstances, it may be appropriate to communicate with, and obtain the approval of, NQDC Participants, at various stages in this process. In particular, if a decision is made to continue to offer a NQDC Arrangement, employee communications distributed in connection with 2005 deferrals must be reviewed and revised as soon as possible to reflect the new law. In this regard, the legislation authorizes the IRS to issue guidelines that would allow NQDC Participants, during a limited period, to terminate participation or cancel outstanding elections under NQDC Arrangements for deferrals after Further, it is possible that IRS guidance will permit employers to delay the documentation of amendments to NQDC Arrangements until later in 2005, and implement appropriate modifications operationally before such formal amendments are made. However, at this time it is not clear how much flexibility the IRS will permit. A number of other practical issues may be encountered in implementing changes in response to the new requirements. For example, in certain cases it may be necessary to obtain the approval of the employer s board of directors or board of trustees. In addition, some NQDC Arrangements may by their terms be amended or terminated only with the consent of the relevant NQDC Participants. In certain situations, securities law considerations may also be implicated in implementing a response to the new law. For example, material amendments to a NQDC Arrangement or the adoption of a new NQDC Arrangement may need to be reported to the SEC on a Form 8-K within four business days of the adoption of the amendment or new plan. In addition, newly adopted NQDC Arrangements and any material amendments should be filed as exhibits to the company s next Form 10-Q or 10-K. For any NQDC Arrangements that have been registered with the SEC on Form S-8, the prospectus for the registered plan will need to be amended to reflect the changes to the applicable tax law as well as any amendments made to the NQDC Arrangement. The amended prospectus should be delivered to plan participants in a timely manner. Goodwin Procter LLP Page 3

4 Questions and Answers ARRANGEMENTS COVERED BY THE NEW REQUIREMENTS In general, what types of arrangements will be subject to the new requirements? The new rules generally will apply to any arrangement that provides for the deferral of compensation, other than certain specified arrangements that qualify for favorable tax treatment under other IRC provisions, such as: plans qualified under IRC Section 401(a) (including 401(k) plans, ESOPs, and other qualified profit-sharing, stock bonus, and pension plans); IRC Section 403(b) tax-deferred annuities and custodial accounts; and eligible IRC Section 457(b) plans sponsored by tax-exempt and governmental employers. 1 Notably, non-qualified IRC Section 457(f) arrangements are not excepted from the new rules. Will stock options be subject to the new requirements? The legislative history discussing the new rules indicates that the new requirements do not apply to incentive stock options that satisfy IRC Section 422 or options granted under an IRC Section 423 employee stock purchase plan. The legislative history also indicates that the new requirements are not intended to apply to an employer s grant of a non-qualified stock option, where the exercise price is not less than the fair market value of the underlying stock on the date of the grant and the arrangement does not include any deferral feature (other than the right to exercise the option in the future). This would appear to mean that discounted stock options, or stock option arrangements that permit the deferral of compensation after exercise are subject to the new requirements. For example, the practice of deferring receipt of stock (and associated gains) from an exercised stock option should be subject to the new rules and so, for example, any such deferral election will need to be made in accordance with the applicable Section 409A Plan requirements. Will other stock-related arrangements be covered by the new rules? Yes, if they provide for the deferral of compensation and do not fall within any exception. For example, there is no exception for (and it is expected the new legislation will apply to) grants of stock appreciation rights ( SARs ), phantom stock, or restricted stock units. Will the new requirements apply to non-elective deferred compensation arrangements, such as so-called excess plans and supplemental retirement plans ( SERPs )? Yes. The new requirements will be applicable to both elective and non-elective NQDC Arrangements. Note, in this regard, that excess plans often provide for the distribution of 1 Also excepted from the new law requirements are IRC Section 408(k) simplified employee pensions, IRC Section 408(p) SIMPLE plans, and IRC Section 415(m) excess arrangements sponsored by governmental employers. Goodwin Procter LLP Page 4

5 benefits under the excess plan to coincide with the timing and form of payment under the related tax-qualified plan. This would not be consistent with the Section 409A Plan requirements and therefore would have to be modified, unless IRS guidance provides relief. (See the Questions and Answers relating to elections, below.) Will the new rules be applicable to informal or unwritten arrangements, or deferral agreements covering only one individual? Yes. NQDC Arrangements will be subject to the new requirements even if they are informal or unwritten, and regardless of how many individuals are covered. For example, the new rules would apply to a clause in an employment agreement that provided an executive with a special retirement supplement, or an arrangement under which an employer informally allowed an employee to defer a bonus payment into the future. Will arrangements, such as vacation pay policies, that may indirectly result in the deferral of compensation be covered by the new requirements? The new rules include an exception for any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. Severance arrangements are not specifically excepted, but it is expected that IRS guidance will address the extent to which severance may be treated as non-qualified deferred compensation under the new requirements. Will the new rules be applicable to bonuses and other similar payments? The legislative history indicates that the Section 409A Plan requirements are not intended to apply to annual bonuses or other annual compensation amounts paid in the ordinary course within two and one-half months after the close of the taxable year in which the relevant services have been performed. Other bonus arrangements that result in the deferral of compensation would be subject to the new requirements; however (as explained below), there is a special rule for deferral elections applicable to performancebased compensation, which in some cases may include bonuses. (See the Questions and Answers relating to elections, below.) DISTRIBUTION RESTRICTIONS APPLICABLE TO SECTION 409A PLANS In general, what distribution requirements will a NQDC Arrangement have to satisfy to constitute a Section 409A Plan? Compensation deferred under a Section 409A Plan may not be distributed earlier than: the NQDC Participant s separation from service; the date the NQDC Participant becomes disabled; the NQDC Participant s death; a time specified under the plan or pursuant to a fixed schedule specified under the plan; a change in the control of the employer, to the extent permitted by the IRS; or the occurrence of an unforeseeable emergency. Goodwin Procter LLP Page 5

6 In addition, a Section 409A Plan may not permit the acceleration of the time or schedule of any payment under the plan, except as may be provided in future IRS guidance. Certain aspects of these distribution restrictions are discussed in the following Questions and Answers. Will any special rules apply in determining whether a distribution may be made upon separation from service? In the case of an employer that is a publicly-traded corporation, distribution may not be made to a key employee until six months after separation from service. For this purpose, key employees generally include (i) up to 50 officers having annual compensation greater than $130,000 (adjusted for inflation), (ii) five percent owners, and (iii) one percent owners having annual compensation greater than $150,000. Notably, the controlled group employer aggregation rules will apply to these new requirements (except to the extent IRS guidance provides otherwise). Consequently, a separation from service with one entity within the controlled group would not be a permissible distribution event if the NQDC Participant continued in employment with another member of that controlled group. What does it mean to be disabled for this purpose? A NQDC Participant is disabled if, by reason of any medically determinable physical or mental impairment which can be expected to result in death or to last for a continuous period of not less than twelve months, either: (i) he is unable to engage in any substantial gainful activity, or (ii) he is receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the NQDC Participant s employer. What does it mean for a distribution to be made at a specified time or pursuant to a fixed schedule? The time or fixed schedule must be specified under the plan. In this regard, the legislative history indicates that amounts payable upon the occurrence of an event are not treated as payable at a specified time. For example, amounts payable when the NQDC Participant attains age 65 are payable at a specified time, but amounts payable when the NQDC Participant s child begins college are payable upon the occurrence of an event. It is worth noting that while there must be a fixed schedule for payment, some level of flexibility can be achieved by providing NQDC Participants with choices as to what schedule should apply. In this type of scenario (as discussed below under the Questions and Answers dealing with elections) a NQDC Participant would need to make an appropriate distribution election prior to the commencement of the calendar year in which the services giving rise to the deferred compensation relates. When will distributions be permitted following a change in control? Distributions on account of a change in control will be permitted only to the extent authorized by guidance to be issued by the IRS. The legislative history indicates that the IRS is to apply a restrictive definition of change in control for this purpose. Goodwin Procter LLP Page 6

7 What is an unforeseeable emergency for this purpose? Under the new rules, an unforeseeable emergency is a severe financial hardship to the NQDC Participant resulting from (i) an illness or accident of the participant, or the participant s spouse or dependent, (ii) loss of the participant s property due to casualty, or (iii) other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant. Notably, this is not the same standard applicable to hardship distributions under a 401(k) plan. In the case of an unforeseeable emergency, the plan may distribute no more than the amount necessary to satisfy the emergency (plus amounts necessary to pay taxes reasonably anticipated on the distribution), after taking into account reimbursement from insurance and liquidation of the participant s available assets. What types of issues may be raised by the prohibition on acceleration of distributions? A Section 409A Plan may not permit a NQDC Participant or an employer maintaining a NQDC Arrangement to accelerate payment of a distribution. This will prohibit, among other things, so-called haircuts in which a NQDC Participant forfeits a portion (e.g., ten percent) of the benefit he has earned under the NQDC Arrangement in return for receiving payment (as a lump sum) earlier than otherwise provided under the NQDC Arrangement. It would appear that the prohibition on acceleration would also preclude an employer from forcing out payment of benefits upon the termination of a NQDC Arrangement. However, the IRS is authorized to issue guidance that could provide limited exceptions to the prohibition on acceleration. ELECTION REQUIREMENTS APPLICABLE TO SECTION 409A PLANS Under a Section 409A Plan, when must a NQDC Participant elect to defer compensation earned during a year? In general, an election to defer compensation for services performed during a calendar year must be made before the beginning of that year. However, with regard to the first year in which a NQDC Participant becomes eligible to participate, the Section 409A Plan may permit him to make an election within 30 days after the date he first becomes eligible, so long as the election applies only to compensation for services to be performed after the election. Are there any special rules for performance-based compensation? Yes, in the case of performance-based compensation based on services over a period of at least twelve months, a Section 409A Plan may permit a participant to make an election no later than six months before the end of the period. For example, if an employer had an arrangement under which performance-based compensation was payable in January 2006, based on services for 2005, the employer s Section 409A Plan could permit a participant to file a deferral election with regard to that performancebased compensation no later than June 30, Goodwin Procter LLP Page 7

8 What is performance-based compensation for this purpose? It is expected that the IRS will issue guidance defining performance-based compensation. The legislative history indicates that it is intended compensation will be considered performance-based to the extent that it is variable and contingent on the satisfaction of pre-established organizational or individual performance criteria, it is not readily ascertainable at the time of the election, and it meets the IRS requirements. Will the new legislation impose restrictions on the ability of NQDC Participants to elect the timing and form of distribution? Yes. Under a Section 409A Plan, the timing and form of distribution will have to be specified at the time of initial deferral. In this regard, the legislative history indicates that a Section 409A Plan could specify the time and form of payments that are to be made as a result of a distribution event, or could allow participants to elect the time and form of payment at the time of the initial deferral election. Will a Section 409A Plan be able to permit changes in the time and form of distributions after the time of the initial deferral? Yes, subject to certain requirements. A Section 409A Plan may allow a subsequent election to delay the timing and form of distributions only if three requirements are satisfied. First, the plan must require that the election cannot be effective for at least twelve months after the date the election is made. Second, the plan generally must require that the additional deferral be for a period of at least five years from the date the payment would otherwise be made; however, this rule does not apply to elections relating to distributions on account of death, disability, or unforeseeable emergency. Third, the plan must require that an election related to a distribution to be made upon a specified time (or fixed schedule) may not be made less than twelve months prior to the date of the first scheduled payment. The IRS will have authority to issue guidance in this area. RESTRICTIONS ON FUNDING APPLICABLE TO SECTION 409A PLANS Will the new law have any impact on rabbi trusts? Yes. The new law will prescribe specific standards that must be met by rabbi trusts and other arrangements used to pay deferred compensation benefits. In this regard, a rabbi trust is a trust that holds assets contributed to it by the employer which are intended to be used to pay deferred compensation benefits, but which remain subject to the claims of the employer's creditors in the event of insolvency or bankruptcy. In recent years some employers have established rabbi trusts and similar arrangements outside of the United States in an effort to keep the assets out of the hands of the employer s general creditors if the employer were to become bankrupt. In order to address this practice, the new rules will provide that assets that are set aside in a rabbi trust or in some other arrangement outside the United States are treated as having been transferred to the NQDC Participant (and therefore, includible in his income). That is, for example, assets held in an offshore rabbi trust would be treated as transferred to the participants benefiting under such trust at the time the assets are first held (directly or indirectly) outside the United States and therefore would be includible in the participants income at that time (or, if later, when vested) regardless of whether the participants have any access to those assets. This rule Goodwin Procter LLP Page 8

9 does not apply, however, if substantially all the services to which the deferred compensation relates are performed in the foreign jurisdiction where the assets are held. May a Section 409A Plan link funding or payment to an employer s financial health? No. Some nonqualified deferred compensation plans include triggers which provide that plan benefits will become transferred to a rabbi trust, or otherwise become funded or actually paid upon the occurrence of certain events. The new law will provide that in circumstances where such a trigger is based on the financial health of the employer, vested deferred compensation amounts will become includible in the income of the affected NQDC Participants at the time the trigger is included in the plan or, if earlier, when the assets become restricted to the provision of benefits on account of the employer s financial health. CONSEQUENCES OF NON-COMPLIANCE What are the consequences of failing to comply with the new requirements? If a NQDC Arrangement fails to satisfy the requirements of Section 409A, all vested nonqualified deferred compensation would become immediately includible in the affected NQDC participant s income, regardless of when the amounts become payable, and any unvested amounts would become includible in income if and when they do vest. In addition, earnings credited on any deferred compensation amounts which become includible in a NQDC Participant s income as a result of a failure to comply with Section 409A will be includible in the NQDC Participant s income when credited. At the time any amount is includible in income as a result of a failure to comply with Section 409A, the affected NQDC Participant will also be required to pay an additional penalty tax equal to 20% of the amount included in his income. Further, the NQDC Participant will be required to pay interest on the amount included in income determined as if the amount should have been included in income when it first vested. So, for example, if an NQDC Participant enters into a NQDC Arrangement in 2005 that provides for a vested benefit and that complies with Section 409A, and then that arrangement is amended in 2007 in a way that violates Section 409A, he will be required to pay interest as if he should have been taxed on his benefit in WITHHOLDING AND REPORTING REQUIREMENTS What will the withholding and reporting requirements be under the new law? Amounts includible in income under the new law will be subject to wage withholding and must be reported on an individual s Form W-2 (or Form 1099) for the year in which they are includible in income, regardless of when payable. In addition, an employer must report on an individual s Form W-2 (or Form 1099) amounts deferred for the taxable year, even if not includible in income for such year. The IRS is expected to issue guidance on a minimum threshold amount for reporting amounts deferred but not taxable, as well as rules for the time of reporting amounts that are not readily ascertainable for non-account balance plans. These reporting rules apply for taxable years beginning on or after January 1, Goodwin Procter LLP Page 9

10 EFFECTIVE DATE When will this new law become effective? The new law will apply to all amounts that are deferred or become vested on or after January 1, Deferred amounts that are earned and vested before January 1, 2005 will be grandfathered against the new requirements, and will therefore continue to be subject to present law (including current constructive receipt rules) so long as there is no material modification to the relevant NQDC Arrangement after October 3, Earnings on grandfathered deferrals are also grandfathered. However, the IRS has reserved its right to challenge grandfathered arrangements that do not comply with present law. What is a material modification for purposes of the grandfather rule? A material modification is the addition of any benefit, right, or feature to a NQDC Arrangement. The exercise or reduction of any existing benefit, right or feature is not a material modification. Examples of changes to NQDC Arrangements that would be considered material modifications if made after October 3, 2004 include revising the arrangement to accelerate vesting, or amending the arrangement to permit an early distribution if a participant forfeits 10% of the distribution (i.e., a haircut provision). Examples of changes that would not be considered a material modification include changing the plan administrator, or removing a distribution provision (e.g., amending the arrangement to remove a haircut provision). With regard to modifications, note that under many NQDC Arrangements amendments may not be made without the consent of the affected NQDC participants. How can a plan comply for new deferrals by January 1, 2005? The IRS is authorized to issue transition guidance within 60 days of enactment that will provide a limited time for NQDC Arrangements to be amended to comply with Section 409A. In addition, the IRS has authority to permit NQDC Participants to terminate participation in a plan or cancel deferral elections with regard to amounts deferred (or vested) after December 31, 2004, but only if amounts subject to the termination or cancellation would be included in compensation under the new rules when earned or vested. However, even before this IRS guidance is issued, it would be prudent for employers to move forward to communicate with NQDC Participants and to prepare relevant election materials. If you would like additional information about the issues addressed in this update or have other questions regarding benefit plans or executive compensation, please contact: Marian Tse mtse@goodwinprocter.com Matt Giuliani mgiuliani@goodwinprocter.com Dan Condon dcondon@goodwinprocter.com Scott Webster swebster@goodwinprocter.com Kris Wardwell kwardwell@goodwinprocter.com or any of the other members of the ERISA/Employee Benefits Practice of Goodwin Procter LLP. This brochure, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys Goodwin Procter LLP. All rights reserved. Goodwin Procter LLP Page 10