As we detailed in our December 2004 UPDATE (which is available on www.riker.com), the American Jobs Creation Act of 2004 significantly changed the rules governing the taxation of nonqualified deferred compensation arrangements. In late December 2004, the IRS issued Notice 2005-1 (the "Notice"), which provides additional guidance on the new deferred compensation rules under Section 409A of the Internal Revenue Code The most important announcement in the Notice is that employers have until December 31, 2005 to amend their agreements to bring them into compliance with Section 409A. However, there are still many questions that the Notice does not answer. Therefore, in many cases it may be better for an employer to hold off on making changes to a deferred compensation agreement until the IRS issues additional guidance, which is expected later this year. Until that guidance is issued, employers generally should take the following actions:
1. Identify Agreements Potentially Impacted by Section 409A. Employers should perform a complete and careful review of all agreements to determine which ones may be impacted by Section 409A so that they will be able to act quickly to bring the agreement into compliance with Section 409A once the IRS issues additional guidance. Because Section 409A can apply to a broad range of agreements, employers should review all agreements (including non-traditional deferral arrangements such as employment agreements, buy/sell agreements, severance arrangements, stock appreciation rights, phantom stock plans, certain stock option plans, etc.) that could possibly provide for the deferment of compensation more than 2 ½ months after the year in which the right to receive the compensation vests. Listed below are a few examples of provisions that could cause an agreement (by any name) to be considered a deferral arrangement subject to Section 409A.
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Provisions providing that severance will be paid over a period of years
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Provisions providing that bonuses will be paid in the tax year following the year that they are earned but are silent as to the specific date the bonus will be paid
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Provisions providing for reimbursement of expenses that are taxable compensation to the employee (e.g., financial planning fees) and are to be paid on a date more than 2 ½ months after the year in which the right to receive the reimbursement vests
It is critical that employers identify all agreements that may be subject to Section 409A because the Notice states that all agreements classified as providing the same types of benefits and that cover the same employee will be aggregated for that employee. The Notice provides for three possible types of plans: (1) account balance plans (i.e., defined contribution plans); (2) nonaccount balance plans (i.e., defined benefit plans); and (3) all other plans (e.g., discounted stock options, stock appreciation rights or other equity based plans).
Example: Prior to the enactment of Section 409A, Steve received stock appreciation rights under one agreement and discounted stock options under another agreement. Both agreements became subject to 409A, but only one of the agreements was modified to comply with Section 409A. Because both agreements are aggregated for purposes of Section 409A, the failure of one agreement to comply with Section 409A causes all of Steve's agreements to flunk Section 409A requirements and, as a result, all of Steve's deferred compensation will be included in his current income and he will be liable for a 20% penalty plus interest.
2. Good Faith Compliance. All agreements must be operated in good faith compliance with the existing guidance even if compliance conflicts with the terms of the existing agreement.
3. Make Necessary Elections. Under Section 409A, employees generally must (with limited exceptions) elect to defer compensation in the tax year prior to the year in which the compensation is earned. However, Notice 2005-1 permits participants to make elections for 2005 as late as March 15, 2005 for amounts that have not been paid or become payable at the time the election is made. Elections for performance based compensation must still be made at least 6 months before the end of the performance period.
Example: If an employee makes an election on March 1, 2005 to defer income earned in 2005, the election will only apply to income earned beginning on March 2, 2005, but will not apply to any compensation paid or that became payable between January 1, 2005 through March 1, 2005.
However, participants have until December 31, 2005 to revoke any previous elections to defer income under a plan subject to Section 409A without incurring any interest or penalties, but all of the previously deferred income would be taxable in 2005.
If you have any questions about Section 409A compliance during the transition period, need assistance in identifying agreements that may be subject to Section 409A, or have general questions regarding Section 409A, please contact your tax advisor at the firm or a member of the firm's tax and trusts & estates group.
