Client Publication October 2004 Extensive Changes for Nonqualified Deferred Compensation Arrangements The American Jobs Creation Act of 2004 The American Jobs Creation Act of 2004 (the Act ) 1 overhauls the federal income tax rules applicable to nonqualified deferred compensation ( NQDC ) plans. Congress passed the Act on October 11, 2004, and the President is expected to sign it, possibly after the November election. The new rules generally apply to amounts deferred after December 31, 2004. Plan sponsors should begin to review their plans to identify provisions and operational practices impacted by the Act. However, we believe that plan sponsors should not amend their NQDC plans until expected Treasury guidance is issued. This publication summarizes the key provisions in the Act and its legislative history applicable to NQDC arrangements and provides an initial analysis of the issues that are likely to arise for NQDC plan sponsors. Highlights The Act places significant restrictions on elections and distributions under NQDC plans and imposes financial penalties for compliance failures, including interest on tax underpayments and an additional 20% penalty tax on compensation that is required to be included in income under the Act. Many deferred compensation arrangements and certain equity-based awards are covered by the Act. Certain amounts deferred prior to January 1, 2005 may become subject to the Act. The timing of distributions is limited to specified times and events. Deferral elections must be made in the year prior to the year in which the services are performed. Special rules govern deferral elections in performance-based plans. Subsequent deferral elections are permitted, but will be less attractive due to the Act s stringent requirements. Accelerated payments of amounts previously deferred, with or without haircuts, generally are prohibited. Affected participants will be subject to the Act s financial penalties if an NQDC plan fails to comply with the Act either in form or operation. The Act s financial penalties apply to deferred amounts held in offshore trusts or subject to plans that provide for a springing rabbi trust which is triggered upon the financial distress of the employer, and it is unclear if transition relief will be provided for amounts deferred prior to January 1, 2005. Treasury guidance is expected to establish a limited period during which plan sponsors may amend plans adopted before January 1, 2005 to comply with the Act. Arrangements Subject to the Act Covered Arrangements. The new rules apply to a broad spectrum of plans that provide for the deferral of compensation, including arrangements that only cover one individual. Presumably, the following types of plans are covered by the Act, although, in some cases, the extent and application of the coverage is unclear: Mandatory and elective plans providing for deferral of salary and/or bonus compensation. Individual employment agreements that provide for the deferral of compensation. Bonus plans with deferral features. Severance plans. Equity compensation plans with deferral features, including plans offering phantom equity, restricted stock units, stock appreciation rights ( SARs ) and certain stock options. Supplemental executive retirement plans ( SERPs ).
2 Plans Not Covered. The Act expressly excludes the following plans from its coverage: Stock Options. The report issued by the House-Senate Conference Committee (the Conference Committee Report ) states that the Act is not intended to apply to stock options with an exercise price that equals or exceeds the fair market value of the underlying stock at grant and that do not include a deferral feature with respect to shares received upon exercise. Additionally, incentive stock options and options granted under qualified employee stock purchase plans remain subject to current tax rules and are not covered by the Act. Bonus Plans. The payment of annual bonuses or other types of annual compensation within a twoand-a-half-month period following the close of the taxable year in which services are performed does not cause such compensation to be deferred. Governmental Plans. Qualified governmental excess benefit arrangements (415(m) plans) and eligible deferred compensation plans (457(b) plans) are not covered by the Act. Other Plans. Tax-qualified retirement plans and tax-deferred annuities, as well as bona fide vacation, sick leave, compensatory time, disability pay and death benefit plans, are excluded from coverage under the Act. Omnibus Equity Plans. The Act requires income inclusion of compensation deferred under a nonqualified deferred compensation plan unless the plan meets specified requirements. Omnibus equity plans may authorize various forms of compensation awards, including restricted stock units, that seem certain to be treated as forms of deferred compensation under the Act, and other forms of awards, such as SARs, that may be so treated (see discussion below). Deferral of income, however, has historically been incidental to the principal purpose of these plans in providing retention and performance incentives linked to a company s equity. Existing omnibus plans are unlikely to include the provisions relating, for example, to distributions, acceleration of benefits or elections required under the Act, although individual awards under the plan may well contain the required provisions or be capable of being amended relatively easily to add them. One issue that companies will need to address early on is whether their equity plans need to be amended to conform to the Act. (An ancillary issue is whether any such amendment would require shareholder approval.) Depending on the terms of a particular plan, it may be possible to take the position that the plan itself does not provide for the deferral of compensation and consequently is not an NQDC plan for purposes of the Act. Individual awards, on the other hand, that result in a deferral of income might be considered agreements or arrangements that are considered a plan for these purposes. The consequence should be that the individual awards would need to conform to the Act, but the plan itself would not require amendment. Stock Options. The Conference Committee Report s statement that the new rules do not apply to nondiscounted stock options raises several issues. Even companies that have a general policy against discounted stock options may grant options with an exercise price less than the fair market value of the underlying stock in limited circumstances. This may occur, for example, when an acquiring company assumes in-the-money options originally issued by the target corporation in a merger. Similarly, an adjustment to outstanding stock options to take account of a significant corporate event such as a stock split or recapitalization might technically take the form of an issuance of additional stock options, which, in order to preserve the inherent value that exists at the time of adjustment, may be in-the-money at the time of grant. It is hoped that Treasury will confirm that discount options awarded in these and similar circumstances fall outside the scope of the Act. Currently, the taxation of non-qualified stock options (including discounted options) is covered by Section 83 of the Code. 2 Any subsequent rulemaking regarding discounted options will need to reconcile any inconsistencies between the specific tax treatment of such options under Section 83 and the provisions of the Act. SARs. The Conference Committee Report does not provide a specific exemption for SARs, instead directing Treasury to address issues relating to SARs. Most commentators to date have assumed that SARs will be treated as a form of deferred compensation. In our view, the status and treatment of SARs require prompt attention from Treasury. Initially, we believe it will be difficult for Treasury to advance a convincing justification for treating SARs differently from cashless exercise or net share settlement of nonqualified stock options, which are economically and functionally equivalent to SARs. As the Conference Committee Report offers no indication that Congress intended to differentiate the treatment of stock options based on the form of exercise selected, we believe that non-discounted stock
3 options exercised using cashless exercise or net share settlement should not be subject to the rules on deferred compensation. This argues in favor of exempting SARs from such treatment as well. Moreover, if SARs are to be made subject to the new rules on deferred compensation, various issues will need to be sorted out. Presumably a holder of SARs would be required to recognize income when the SARs vest, but in what amount? Two possibilities would be (i) the intrinsic value of the SAR at the time of vesting (which, in the case of at-the-money SARs vested upon grant or out-of-the-money SARs, would be zero) and (ii) an amount based on the Black- Scholes value (or a value determined under another option pricing methodology) of the SAR at the time of vesting or possibly the time of grant. (Indeed, if SARs are considered to constitute a form of deferred compensation, the taxable year in which first deferred may most plausibly be the year of grant.) The amount taken into income, however determined, would presumably be augmented by interest at the underpayment rate plus one percent and a 20% surtax (see Penalties for Noncompliance below). Whatever income recognition method is countenanced by Treasury, an additional issue surrounds the tax treatment of SARs subsequent to vesting. One possibility would be a mark-to-market approach, under which employees would be taxed on the intrinsic value of their SARs at vesting and recognize subsequent amounts of income or loss thereafter depending on the change in the market value of the underlying stock. Marking-to-market, however, would represent a novelty in the context of individual income taxation, and it is not clear that it was contemplated or intended by Congress. Perhaps the more logical approach would be to treat vesting as the sole tax event, so that a SAR holder would recognize no additional compensation income at any time after vesting, including at exercise. This would effectively assimilate SARs to the current treatment under Section 83 for stock options that have a readily ascertainable market value. If Treasury were to adopt this approach, it is even possible that SARs might be more attractive than stock options in many circumstances, notwithstanding the interest charge and 20% surtax. Restricted Stock Units. Restricted Stock Units, or RSUs, had increased in prevalence as a compensatory tool in the past year, particularly for companies that expense options. Although the Act may restrict the flexibility previously afforded to RSUs, it appears that many plan sponsors will have to make only minimal changes to these arrangements in order to bring them into compliance with the Act. SERPs. SERPs that mirror the plan sponsor s qualified plans are likely to require significant amendments to comply with the Act. Such plans typically provide that distributions will be made at the time and in the form of participants distributions from the qualified plans, which permit participants to make such elections at the time of distribution. Pending further guidance from Treasury, it appears that provisions in SERPs that ultimately permit participants to elect the time and form of payment are not consistent with the Act and will require amendment. When Is Severance Earned? The broad language of the Act may include some types of severance arrangements, which raises the question of when severance is earned. There is a respectable argument that severance should be considered compensation, or damages, for a termination of employment and, therefore, is not earned until the separation from service occurs. Thus, there is no deferral. This issue has been litigated in the bankruptcy courts, and some courts have taken this view. 3 Other courts have held that severance is compensation earned over a career and paid at termination of employment. 4 This is another topic on which guidance from Treasury would be useful. Employment Agreements. For employment agreements currently under negotiation, employers should negotiate with an eye toward the Act and consider adding a savings clause that would afford them flexibility to amend any necessary provisions to the extent necessary to comply with the Act and the anticipated Treasury regulations. Covered Persons The Act applies to deferrals by non-employee directors, as well as employees, consultants and other independent contractors. Effective Date General Rule. As a general rule, amounts deferred after December 31, 2004 are covered by the Act, and current law will continue to apply to amounts deferred before January 1, 2005. There are, however, exceptions to this, as explained below. Material Modifications. If a plan is materially modified after October 3, 2004, the Act applies to amounts deferred prior to January 1, 2005, unless such modification is made pursuant to Treasury guidance. The addition of any benefit, right or feature or the acceleration of vesting is a material modification. The elimination or reduction of an existing benefit, right or feature is not.
4 Earned and Vested Amounts. The Conference Committee Report states that an amount is considered deferred before January 1, 2005 if it is both earned and vested before that date. Accordingly, it appears that unvested amounts deferred prior to January 1, 2005 are covered under the Act. In addition, amounts earned after that date would be subject to the Act, even if part of a vested plan benefit. This could occur, for example, where an executive is fully vested in a SERP but the SERP benefit is based on a final pay formula or on accruals occurring after the Act s effective date. Earnings. Earnings (either actual or notional) on deferred amounts are subject to the Act only to the extent that the Act applies to the corresponding deferred amount. Therefore, it appears that earnings on vested amounts deferred prior to January 1, 2005 under plans that were not materially modified after October 3, 2004 are not covered under the Act, but earnings on unvested deferred amounts are. It is unclear what will constitute earnings in defined benefit arrangements. Subsequent Deferrals. Subsequent deferrals of earned and vested amounts originally deferred before January 1, 2005 that were permitted under the terms of an NQDC plan as in effect prior to October 3, 2004 (if not materially modified thereafter) are excluded from coverage under the Act. However, it should be noted that the Conference Committee Report states that plan sponsors should not infer from this provision that all such subsequent deferral elections under plans that are not materially modified are permissible under current law. 5 Status of Outstanding Deferrals. The statutory provision concerning material modifications to existing plans made after October 3, 2004 raises significant issues. The statute indicates that such a material modification will result in amounts deferred in taxable years beginning before January 1, 2005 being treated as amounts deferred in a taxable year beginning on or after such date, but the scope of this provision is not clear. Any retroactive application of the new rules could have dramatic consequences for many plans. A more sensible interpretation is that Congress, in subjecting deferred amounts under plans modified after October 3, 2004 to the new rules, was targeting deferrals pursuant to elections made after October 3, 2004 and before January 1, 2005. The statutory language leaves room for doubt, however, and one can only hope that Treasury adopts a reasonable approach. The risks presented by this issue underscore the need for caution in amending existing plans until guidance from Treasury becomes available. Review Plans. Once Treasury issues additional guidance, plan sponsors will need to review all NQDC plans to determine whether amendments are necessary to bring the plans into compliance. Earned and Vested Amounts. Although not supported by the language of the Act, the Conference Committee Report indicates that deferred amounts must be earned and vested before January 1, 2005 in order not to be covered under the Act. The Conference Committee Report does not elaborate on the meaning of earned. It is not clear how the Act applies to defined benefit SERPs that pay benefits in the form of an annuity and how to compute the earned amount. Unvested Amounts. It appears that any deferred amount subject to a vesting schedule (and not yet vested) or other risk of forfeiture is unvested under the Act. Plan sponsors should note that they cannot avoid compliance with the Act by amending the plan now to fully vest unvested amounts because such an amendment would be considered a material modification made after October 3. Similarly, until Treasury guidance is issued, it would appear that awards such as restricted stock units granted before January 1 under a five-year vesting schedule would be covered by the Act to the extent not vested on January 1. We note the possibility of contractual disputes between NQDC plan sponsors and participants, due to the Act s coverage of unvested amounts as of December 31, 2004. If a plan sponsor attempts to amend its plans and individual award agreements to state that such unvested amounts are covered by the Act, certain participants may object, preferring to pay the penalties imposed by the Act in order for such amounts to remain subject to current law. For example, in cases where the plan sponsor is on the verge of insolvency, participants may be willing to pay the penalties to retain the less restrictive distribution options available under current law. Deferral Elections Timing of Elections. With few exceptions, the Act requires that the election to defer compensation be made in the year preceding the year in which the services to which the compensation relates are performed. Limited exceptions to this rule apply to: Initial Deferral Elections. In the first year that a participant becomes eligible to participate in an NQDC plan, the deferral election may be made
5 within 30 days of the date on which the participant first becomes eligible. Performance-Based Compensation. In the case of performance-based compensation for services performed over a period of at least 12 months, the deferral election may be made up to six months before the end of the service period. Performance-based compensation refers to amounts that are (i) variable and contingent on the satisfaction of pre-established organization or individual performance criteria and (ii) not readily ascertainable at the time of the election. The reference to performance-based compensation is evocative of Section 162(m) of the Internal Revenue Code (the Code ), and the Conference Committee Report indicates that Treasury is expected to define performance-based compensation using at least some requirements similar to those that apply under Section 162(m) of the Code. Certification by the compensation committee of the board of directors, however, is not likely to be required. 6 Timing and Form of Distribution. The timing and form of distribution must be specified at the time of the initial deferral, either by the plan or a participant. An NQDC plan may, by its terms, specify the timing and form of payment at distribution. Alternatively, the plan may include the options permitted by the Act and allow participants to elect the timing and form of payment from such options at the time of the initial deferral election. Congress left room for participants to exercise a degree of flexibility in their election decisions. For example, multiple payout events, such as an election to receive 25% of the account balance at age 50 and the balance at age 60, are permissible. Plans may also permit participants to elect a different form for different distribution events, such as a lump sum distribution upon disability and an annuity at age 65. Subsequent Deferral Elections. An NQDC plan may allow a participant to make a subsequent deferral election that delays the timing or changes the form of distribution if: the plan requires that the commencement of payments in connection with a subsequent election cannot take effect for at least 12 months from the date of the subsequent election; in the case of an election not related to a participant s death, disability or unforeseeable emergency, the additional deferral must be for a period of at least five years from the scheduled payment date; and the plan requires that an election related to a distribution at a specified time be made at least 12 months prior to the scheduled payment date. Alternative Elections. It appears that the Act will permit alternative elections regarding the time of distribution, such as on the later of a separation from service and attainment of age 65. Note that without such an alternative election, a question exists whether the Act would permit a plan to distribute a participant s account upon a separation from service if such participant had elected to receive a distribution at a later, specified time and the plan did not provide for such earlier distribution. Distributions Permissible Distributions. The Act permits distributions upon the occurrence of the following events: Separation from Service. The Act permits all participants, except specified employees of a publicly traded company, to receive a distribution immediately upon a separation from service. Specified employees cannot receive a distribution until at least six months following their separation from service. For purposes of the Act, a specified employee is any employee who is (i) a five percent owner, (ii) a one percent owner with compensation over $150,000, or (iii) an officer (up to a maximum of 50) with annual compensation in excess of $135,000 (adjusted for inflation). These are the same criteria that plan sponsors of qualified retirement plans use to identify key employees for purposes of determining if a plan is top-heavy. 7 The Code s controlled group rules apply to distributions from NQDC plans. Therefore, a participant who transfers from a parent corporation to one of its wholly owned subsidiaries has not undergone a separation from service. Additionally, a change in control of one member of a controlled group is not a distributable event for employees of other members of the group. Death or Disability. Participants who die or become disabled and their beneficiaries, including beneficiaries of specified employees, may receive a distribution immediately following the participant s death or disability. Disabled participants are participants: with a physical or mental impairment that is expected to result in death, or last for at least
6 12 months, who receive income replacement benefits for at least three months under the plan sponsor s accident and health plan; or who are unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months. There does not appear to be any requirement that the disabled participant be terminated from service in order to be eligible for an early distribution. Specified Time or Schedule. Distributions at a designated time or pursuant to a fixed schedule are permitted if specified at the time of deferral, as discussed above. For example, amounts payable when participants attain age 65 are considered payable at a specified time, but amounts payable when participants children begin college are payable upon the occurrence of an event and are not permitted by the Act. Change in Control. Distributions will be permitted upon a change in control of the employer to the extent permitted by the forthcoming Treasury regulations. Unforeseeable Emergency. Under the Act, participants in NQDC plans may take a distribution due to an unforeseeable emergency. However, the amount of the distribution is limited to the amount necessary to satisfy the emergency, plus applicable taxes. For purposes of the Act, an unforeseeable emergency means a severe financial hardship to the participants resulting from: an illness or accident of the participant, the participant s spouse or dependent, 8 loss of the participant s property due to casualty; or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the participant s control. No Acceleration. The Act generally prohibits acceleration of the timing or schedule of distributions from an NQDC plan. Similarly, the Act prohibits any subsequent election from changing the form of distribution that results in an acceleration, such as a change from an annuity to a lump sum, or from a five-year payout to a three-year payout. The prohibition applies regardless of whether the amounts distributed are subject to a haircut, which is a common design feature of NQDC plans. In the absence of Treasury regulations, determining whether a particular plan provision will trigger acceleration is not always easy. For example, in a phantom share plan under which payment of dividend equivalents at the time dividends on the shares are paid is discretionary with the company, rather than a fixed term of the plan, it is not clear whether the discretionary payment of dividend equivalent rights would constitute an accelerated payout under the Act. If they may be paid, the plan sponsor might consider requiring dividend equivalents to be deferred and paid out at the same time as the underlying phantom shares. It appears that the deferral would be subject to the provisions of the Act even if the underlying phantom shares were not (because they were vested prior to December 31, 2004). Exceptions to the Prohibition on Acceleration. Congress contemplates that Treasury will permit limited exceptions to the prohibition on acceleration. 9 Such exceptions are likely to include: withholding of employment taxes from participants deferred amounts; accelerations due to reasons beyond the participants control, such as payment of courtapproved settlements; and automatic distributions of small amounts for purposes of administrative convenience, such as mandatory distributions of account balances under $10,000 upon separation from service (except for specified employees of public companies). Impact on Subsequent Elections. While the Act permits subsequent elections, the rule against accelerations limits the utility of this possibility. For example, a plan generally could not permit a subsequent election changing the timing of a distribution to a separation from service, because such a change could create an acceleration, depending on the timing of the separation. (But a subsequent election changing the distribution date from a fixed date to the date of separation from service, but in no event earlier than five years after the originally elected fixed date, would be permitted as long as it was made at least 12 months before the originally elected distribution date.) Specified Employees. The six-month delay on distributions to specified employees of public companies raises the following issues: Severance agreements and severance provisions in employment agreements and other plans that
7 require immediate distributions on termination may require amendment. It is not clear whether the required six-month delay in payment will apply to a participant in an NQDC plan who is not a specified employee when the participant makes an election but thereafter becomes a specified employee. Non-employee directors are not specified employees under the Act. Combining Payment Triggers. Although not specifically addressed in the statute or Conference Committee Report, we believe that it is reasonable to understand the statute to permit distribution schedules that combine two or more of the permitted distribution triggers, e.g., separation from service and a specified schedule. For example, a plan (or participant election) that provides for distribution in ten annual installments that will begin two years after separation from service should be permitted. Disability. If a plan provides for early distribution upon a separation from service due to disability, the plan s standard for disability should not have to conform to the statute. In this case, the trigger for acceleration is tied to separation from service, and nothing in the Act precludes a plan sponsor from adopting its own standards for which circumstances of separation from service will trigger an accelerated distribution. Moreover, the Act s definition of disability may allow sponsors of NQDC plans that permit distributions upon disability to lower the plan s disability threshold and, therefore, trigger an earlier distribution than the participant would have otherwise been eligible for. The Act requires that the expected duration of a disability be at least 12 months, but there is no requirement that the definition parallel the definition in the plan sponsor s long-term disability plan. Therefore, in an NQDC plan that currently uses a long-term disability threshold, adopting the Act s definition of disability may increase the number of participants who are eligible to receive distributions upon a disability. Until Treasury transition guidance is available, it is unclear if such an amendment would be considered an acceleration of distributions. We believe that it should not, since a plan amendment which conforms the plan definition of disability to that of the Act should not have a punitive effect on affected participants. Unforeseeable Emergency. The Act s unforeseeable emergency standard follows the standard used by the Internal Revenue Service (the IRS ) in its rulings. 10 Therefore, NQDC plans that currently use the IRS standard may only require minimal changes to conform to the Act s definition of an unforeseeable emergency. NQDC plans that use an unforeseeable emergency standard similar to the safe harbor standard established by Treasury for purposes of hardship withdrawals from Section 401(k) plans will require amendments, as the Act s standard is noticeably narrower. While the safe harbor standard for Section 401(k) plans is an immediate and heavy financial need, there is no requirement in a Section 401(k) plan that the need be unforeseeable. 11 Change in Control. The Treasury regulations on distributions following a change in control should provide black-letter rules addressing the circumstances under which such distributions may be made. We expect that plan sponsors will welcome these rules, as they should provide certainty as to the requirements for compliance with the Act and eliminate the need that exists under certain plans for plan sponsors to exercise discretion when making such distributions. For this reason, we further expect that plans that currently do not permit distributions upon a change in control, will be amended once the regulations are issued, to permit such distributions. Impact on Proposed M&A Transactions. For those companies that are contemplating acquisitions or dispositions of businesses, the treatment of NQDC plans in those transactions, particularly as regards acceleration and cash out provisions, must be closely scrutinized to ensure that it does not violate the Act. Plan Terminations. The Act s omission of plan termination as a distributable event suggests that, absent contrary guidance from Treasury, distribution of the assets of a terminated plan may not be permitted until several years after the amendment terminating the plan is adopted. This requirement would place additional administrative burdens on, and create expenses for, plan sponsors as plans would have to be maintained and accounted for until all assets are distributed in accordance with the Act. No Company-Initiated Acceleration. The general ban on accelerated payments appears to apply to accelerations initiated by the plan sponsor, as well as to those requested by a participant. Thus, plan provisions that give a plan sponsor a broad right to accelerate payments in its discretion will need to be eliminated. No Restrictions on Investment Control The Act places no restrictions on the investment options available to employees under NQDC plans, although restrictions had been proposed.
8 Effect on Offshore Trusts The Act does not generally prohibit the funding of NQDC plans through rabbi trusts, and rabbi trusts should remain a viable strategy for setting aside assets to meet obligations under NQDC plans. The Act, however, explicitly limits the use of offshore trusts. Assets set aside in offshore trusts (including rabbi trusts) for purposes of paying NQDC obligations will be treated as property transferred to participants under Section 83 of the Code (whether or not available to satisfy the claims of general creditors) at the time assets are set aside, unless the assets are located in a jurisdiction where substantially all of the services related to the NQDC are performed. Any increases in the value of, or any earnings with respect to, such transferred assets will be treated as additional transfers of property. These rules may create significant challenges for non-u.s. domiciled companies whose personnel in the United States participate in equity based compensation programs of the foreign parent. Often, due to limitations on the ability to hold treasury shares and other legal restrictions, non-u.s. companies fund their obligations to provide shares pursuant to employee compensation programs at the time of vesting through the use of employee share trusts. Because these are non-u.s. companies, the trusts are necessarily offshore from the U.S., and frequently due to applicable local tax regimes they are not domiciled in the country of the parent company that sponsors the underlying plan. Unless Treasury provides some relief for non-u.s. companies, the tax consequences for U.S. employees of non-u.s. companies could be severe. Treatment of Financial Distress Triggers If an NQDC plan provides that assets will be restricted to the provision of benefits upon a change in the plan sponsor s financial health or if the assets are so restricted, assets deferred under the plan are considered transferred to participants as of the earlier of the date assets are restricted or when the plan provides that the assets will be restricted. Any subsequent increases in the value of, or any earnings with respect to, restricted assets are treated as additional transfers of property. For example, all amounts deferred under plans would be treated as property transferred to participants (and subject to the interest and tax penalties) if, upon a change in the plan sponsor's financial health, assets are transferred to a rabbi trust, or if a trust holding assets in connection with deferrals becomes funded on a change in the employer s financial health. Prohibition of springing rabbi trusts is a curious provision, given the Act s general approach of allowing rabbi trusts as funding vehicles, and will likely have the effect of encouraging plan sponsors to establish rabbi trusts sooner rather than later. Penalties for Noncompliance NQDC Plans. The Act imposts penalties on amounts deferred under NQDC plans that fail in form or operation to comply with the Act, as explained below: May Reach All Participants. All participants in an NQDC plan that fails to comply with the Act may be subject to its penalties. The Act requires that the applicable penalties be imposed on participants in an NQDC plan to whom the failure relates. If the form of an NQDC plan fails to comply with the Act, such failure may relate to all participants. If a plan fails to comply in operation, the failure may relate to only one participant or to a small group of participants. For example, a non-complying plan provision, such as a provision permitting all participants to accelerate distributions, relates to all participants, even if none actually receive an accelerated distribution. If a plan conforms to the Act in form, but in operation permits certain participants to accelerate their distributions, the operational failure should relate only to those participants who received an accelerated distribution. Amounts. If a failure occurs in an NQDC plan, the participants to whom the failure relates are subject to income inclusion, plus interest on the tax underpayments and a 20% tax penalty on the compensation included in income. Compensation deferred during the current year and all preceding years is includible in income, if not subject to a substantial risk of forfeiture or not previously included in income. This may mean that amounts otherwise grandfathered under the Act could be subject to the tax and penalty if there is a posteffective date failure in the plan under which the amounts were deferred. Participants must pay interest at the statutory underpayment rate 12 plus one percentage point on the underpayment resulting from the deferral, determined as of the date on which the compensation was first deferred or no longer subject to a substantial risk of forfeiture. Offshore Trusts and Springing Rabbi Trusts. The same penalties apply to transfers of property in offshore trusts and springing rabbi trusts. Amounts held in offshore trusts treated as transferred are included in income at the time of the transfer or, if later, upon vesting. Amounts deferred under an
9 NQDC plan with a springing rabbi trust are includible income at the time the transfer is considered to have occurred. In both cases, earnings on, or increases in the value of, transferred amounts are includible in income when earned or when the value increases. Tax underpayments due to the failure to include such transferred amounts in income are subject to tax at the statutory underpayment rate plus one percentage point, determined in the manner described above. All amounts includible in income are subject to the 20% penalty tax. Wage Withholding. The Act amends the definition of wages for purposes of the withholding rules to cover amounts that are includible in gross income by virtue of the new rules. Withholding on such income must be made in the taxable year in which the amount was includible in income. Consequently, an employer may become subject to the penalties attendant to failures to withhold in the event of a plan defect or a mischaracterization of amounts deferred. Plan Sponsor Liabilities. If an NQDC plan failure causes participants to become subject to the penalties imposed by the Act, the plan sponsor will face additional tax reporting and withholding obligations, and possibly additional penalties. Additionally, senior executives who are parties to individual agreements (including employment, severance, change of control or non-compete agreements) may demand that such agreements include an indemnification from the plan sponsor holding the executive harmless from any penalties incurred due to the plan s failure to comply under the Act. Not One-Time. It is important to note that the penalties imposed by the Act are not necessarily onetime penalties applicable to a single tax year. To the extent that an amount that is subject to the penalties remains deferred in subsequent taxable years, subsequent earnings on, or increases in the value of, such amounts are subject to income inclusion, the underpayment tax and the 20% penalty tax. Transition Relief for Trusts Uncertain. The Conference Committee Report does not address transition relief for offshore trusts and NQDC plans with springing rabbi trusts. Therefore, in the absence of further guidance, it appears that all amounts held in an offshore trust or deferred under an NQDC plan with a springing rabbi trust as of December 31, 2004 will be covered by the Act. Reporting Requirements The Act requires that amounts includible in income and amounts deferred (even if not currently includible in income for that taxable year) be reported on Form W-2 or 1099, as applicable. Treasury may establish a minimum amount below which reporting is not required. Treasury Guidance Expected Congress has conferred on Treasury broad regulatory authority to interpret the NQDC provisions in the Act. Accordingly, it is expected that Treasury will issue regulations on many of the issues raised in this publication, including the determination of deferrals in defined benefit plans and the definition of financial health. In the near term, Treasury has been directed to issue, within 90 days of the enactment of the Act, regulations defining change in control and, within 60 days of the Act s enactment, regulations to address certain of the transition issues raised by the Act, including: a limited period during which NQDC plans adopted before January 1, 2005 may be amended to comply with the Act; and plan amendments permitting participants to terminate their participation in such plans or cancel an election to defer amounts after December 31, 2004. Additionally, the Conference Committee Report states that Treasury may provide exceptions to certain requirements of the Act during the transition period for NQDC plans coming into compliance with the Act. Transition Relief. It is expected that the transition issues addressed by the regulations will include: 2004 Deferral Elections of Amounts Payable in 2005. Treasury recognizes that the Act has created a quandry for plan sponsors that permitted or intend to permit employees to make elections in the third or fourth quarter of this year to defer bonuses payable in 2005. For this reason, it is expected that the regulations will provide some relief for such deferrals, but the nature of that relief is not certain at this time. While bonuses that are not earned and vested as of December 31, 2004 will be covered by the Act, it is hoped that the regulations will waive application of the Act s requirements for the timing of elections for purposes of pre-2005 deferral elections. 2004 Deferral Cancellations. Congress direction to Treasury to permit participants to cancel 2004
10 deferral elections should further mitigate concerns about proceeding with deferral elections for bonuses payable in 2005. It appears that plan sponsors need not be overly concerned that NQDC plan participants will be stuck with deferral elections made without a complete understanding of the Act and its impact on such deferrals. Pre-2005 Distribution Elections. Distribution elections currently in place with respect to pre-2005 deferrals subject to the Act (for example, distribution elections with respect to deferred amounts that are unvested as of December 31, 2004) may not be consistent with the distribution requirements of the Act. We hope that the transition relief will address a process for revising these elections in a manner that does not trigger the penalties imposed by the Act. Amended Plan vs. New Plan. Once Treasury issues transition guidance, plan sponsors will have to decide whether current plans will be amended or frozen and replaced with new plans. A primary consideration in this decision is whether the amendment approach would jeopardize the grandfathered status of earned and vested pre-2005 deferrals should the plan fail to comply with the Act either in form or operation. It is hoped that Treasury will address this issue in the transition regulations. Plan sponsors should also consider administrative and employee communication issues before reaching a final decision on the amended vs. new plan issue. For example, they should consider whether a new plan would make it easier for the plan record keeper and trustee to segregate pre-2005 deferrals from post-2005 deferrals and whether employees will be able to better understand the impact of the Act on their deferrals if the changes are presented via a new plan. Additional Considerations Implementation of the Act presents significant design and administrative challenges, particularly in light of the fact that so many of the open questions regarding the Act s application will only be clarified through the forthcoming Treasury regulations. As a first step, plan sponsors should: Take inventory of existing NQDC plans and arrangements to identify whether they are covered under the Act and all deferrals that do not appear to be earned and vested as of December 31, 2004, which may be covered by the Act and subject to its penalties. Not let the Act deter them from obtaining deferral elections for bonuses payable in 2005. Direct record keepers and trustees to develop systems to segregate pre-2005 deferrals from deferrals subject to the Act. Examine the form of future long-term incentive compensation awards in light of the Act and other recent developments in compensation practice and accounting. Review tax disclosures in employee plan prospectuses to ensure they comply with the Act. Develop a strategy for responding to employee inquiries. Evaluate provisions in transaction agreements under negotiation and the target s NQDC plans that may trigger distributions of deferred amounts for specified employees immediately following a separation from service. Begin to consider whether current NQDC plans should be amended or frozen and new plans adopted. Refrain from adopting or amending NQDC plans until Treasury issues transition rule guidance.
11 ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 For the text of the Act, H.R. 4520, 108th Cong. (2004), as approved by Congress and submitted to the President, see http://frwebgate.access.gpo.gov/cgi-bin/getpage.cgi?dbname=2004_record&page=h8411&position=all. See I.R.C. 83 (generally providing that transferred assets are included in income at the time of transfer or, if later, when vested). See, e.g., Straus-Duparquet, Inc. v. Local Union No. 3 Int l Brotherhood of Elec. Workers, 386 F.2d 649, 651 (2d Cir. 1967) ( [s]everance pay is not earned from day to day and does not accrue [but rather] is compensation for termination of employment ); Trustees of Amalgamated Ins. Fund v. McFarlin s, Inc., 789 F.2d 98, 104 (2d Cir. 1986) ( severance pay is compensation for the hardship which all employees suffer when they are terminated and is therefore earned when the employees are dismissed ). See, e.g., Mason v. Official Comm. of Unsecured Creditors (In re FBI Distrib. Corp.), 330 F.3d 36 (1st Cir. 2003) ( severance pay was a component of compensation for services rendered that is, the employees wages included severance pay ) (citing In re Mammoth Mart, Inc. v. Mammoth Mart, Inc., 536 F.2d 950) (1st Cir. 1976). See H.R. Rep. No. 108-755 at 527 (2004). See H.R. Rep. No. 108-755, at 522 (2004). See I.R.C. 416(i)(1)(A). For purposes of the Act, the term dependent has the same meaning as that ascribed to it in Section 152(a) of the Code. See H.R. Rep. No. 108-755, at 521 (2004). See Rev. Proc. 92-65, I.R.B. 1992-33, Aug. 17, 1992 (stating that an unforeseeable emergency is an unanticipated emergency that is caused by an event beyond the control of the participant or beneficiary and that would result in severe financial hardship to the individual if early withdrawal were not permitted). See Treas. Reg. 1.401(k)-1(d)(2)(iv)(A) (stating that financial hardship withdrawals are permitted for such foreseeable needs as (i) costs related to the purchase of the participant s principal place of residence and (ii) payment of tuition and related expenses for post-secondary education for the participant and the participant s spouse, children or dependents). The underpayment rate, determined under Section 6621 of the Code, is currently five percent. See I.R.B. 2004-37. This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. We would be pleased to provide additional details or advice about specific situations if desired. For more information on the topics covered in this issue, please contact: Henry C. Blackiston III New York (+1 212) 848-7001 hblackiston@shearman.com Kenneth J. Laverriere New York (+1 212) 848-8172 klaverriere@shearman.com John J. Cannon III New York (+1 212) 848-8159 jcannon@shearman.com Doreen E. Lilienfeld London (+44 (0) 20) 7655-5942 dlilienfeld@shearman.com Jeffrey P. Crandall New York (+1 212) 848-7540 jcrandall@shearman.com Linda E. Rappaport New York (+1 212) 848-7004 lrappaport@shearman.com www.shearman.com 2004 SHEARMAN & STERLING LLP 599 Lexington Avenue, New York, NY 10022 Under the regulations of some jurisdictions, this material may constitute advertising. As used herein, Shearman & Sterling refers to Shearman & Sterling LLP, a limited liability partnership organized under the laws of the State of Delaware.