Congressional Overreaction at its Finest: An Attack on Perceived Abuses in Executive Compensation
Kegler Brown Business Tax Alert January 18, 2005
The American Jobs Creation Act of 2004 (the "Act"), signed into law by the President on October 22, 2004, substantially changes the tax rules governing non-qualified deferred compensation arrangements. Benefit arrangements that may be affected include salary and bonus deferral plans, supplemental executive retirement plans ("SERP") or other nonqualified defined benefit plans, certain severance or change in control agreements, certain Section 457 plans, discounted stock options and stock appreciation rights ("SAR").
The Act provides that both existing and new plans must contain specific provisions relating to distribution of benefits, acceleration of benefits and elections for deferral. Failure to meet these requirements could result in deferred amounts being included in a participant's current gross income along with penalties and interest.
Benefits that were earned and vested prior to January 1, 2005 will be "grandfathered" and thus not subject to the new rules so long as the underlying plan has not been materially modified since October 3, 2004. Benefits that were not earned and vested by the end of 2004 will not be grandfathered.
The Treasury Department issued a Notice ("Notice 2005-1") on December 20, 2004 providing preliminary guidance with respect to these new tax rules codified at Code Section 409A of the Internal Revenue Code ("§409A"). The following questions and answers provide important information you need to know about complying with the new tax rules:
1. How do I know if I have a nonqualified deferred compensation plan and what should I do if I have one?
We encourage employers to compile an inventory of all arrangements they currently sponsor that may constitute nonqualified deferred compensation plans and thus be impacted by the new tax rules. You may then want to contact one of our attorneys who can assist you in developing a strategy to comply with the new rules, the preliminary guidance and any other guidance issued by the IRS.
2. What happens if I ignore §409A?
If your plan does not meet the requirements of §409A (which no pre-§409A plan does) or is not operated in accordance with §409A, all amounts deferred under the plan for 2005, and all prior taxable years, are included in gross income for the tax year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. In addition, you will be subject to substantial interest and underpayment penalties.
3. Does §409A apply only to employees and directors?
No. It also applies in certain circumstances to independent contractors and partners.
4. I heard that I have until December 31, 2005 to amend my plan. Does that mean I can continue to operate my plan as written until then?
Yes and no. You do have until December 31, 2005 to amend your nonqualified deferred compensation plans; however, your plans must be operated in good faith based on a reasonable interpretation of §409A and Notice 2005-1 until they are amended. This means, in effect, that you have to comply with §409A and Notice 2005-1 prior to amending your plans.
5. When do I need to make my deferral elections relating all or in part to services performed prior to December 31, 2005?
You have until March 15, 2005 to make such elections as long as you meet the following requirements: (1) the amounts to which the deferral election relate have not been paid or become payable at the time of election, (2) the plan under which the deferral election is or was made was in existence on or before December 31, 2004, (3) the elections to defer compensation are made in accordance with the terms of the plan in effect on or before December 31, 2005, (4) the plan is otherwise operated in accordance with §409A with respect to deferrals subject to §409A and (5) the plan is amended to comply with the requirements of §409A .
6. I have a SAR plan in place. What do I need to know?
Pending further guidance, SARs granted pursuant to plans in effect on or before October 3, 2004 do not represent deferred compensation if (1) the exercise price of the SAR can never be less than the Fair Market Value of the underlying stock on the date the right is granted, and (2) the SAR does not include any feature for deferred compensation other than deferral of recognition of income until the exercise of the right.
7. Can I establish new SARs?
Yes. The terms of a SAR with a fixed payment date generally will comply with the provisions of §409A.
A public company can structure SAR plans to avoid being considered nonqualified deferred compensation plans and thus avoid §409A completely.