Proposed Regulations Issued Interpreting 2004 Deferred Compensation Rules Changes
November 2005
As you may be aware, the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code of 1986, effective January 1, 2005. Code Section 409A imposes strict requirements on executive nonqualified deferred compensation plans, and has far-reaching implications for other employment agreements. Failing to comply subjects the executive to income taxes, interest and a 20% penalty on the deferred compensation benefits.
On December 20, 2004, the IRS issued Notice 2005-1, which sets forth initial guidance for complying with Code Section 409A and provides for certain transition rules. On September 29, 2005, the IRS issued proposed regulations, which are effective January 1, 2007. Until the final regulations are effective, employers and individuals can rely on the proposed regulations and Notice 2005-1, and must operate their nonqualified deferred compensation arrangements in good faith compliance with Code Section 409A.
The regulations provide considerable flexibility for designing and administering nonqualified deferred compensation plans under Code Section 409A. In addition, the regulations provide transition relief, some of which expires at the end of 2005, and some of which has been extended to the end of 2006, as follows:
- Employers may permit participants to terminate their participation in a nonqualified deferred compensation plan or cancel an outstanding deferral election. That election must be made, and any plan amendments must be adopted by December 31, 2005.
- Employers may terminate an existing nonqualified deferred compensation plan. To do so, any plan amendments must be adopted and all distributions must be made by December 31, 2005.
- Deferral elections with respect to compensation earned in 2006 generally must be made by December 31, 2005, unless the compensation is performance-based or tied to a fiscal year other than the calendar year.
- Plans must be amended to comply with the requirements of Code Section 409A by December 31, 2006.
- Employers may permit participants to make new elections with respect to the time and form of payment, so long as the new election is in place by December 31, 2006. The new election cannot, however, cause a payment to be made in 2006 or defer a payment that otherwise would have been paid in 2006.
- Some nonqualified deferred compensation plans “link” the time and form of payment to the time and form of payment elected by the service provider under a qualified plan. Linking payment in this manner will not violate Code Section 409A, so long as the time and form of payment is determined in accordance with the terms of the nonqualified deferred compensation plan that were in existence on October 3, 2004, and payments are made or commence on or before December 31, 2006. After 2006, the time and form of payment under the nonqualified deferred compensation plan cannot be linked to the qualified plan.
- A stock option or stock appreciation right that provides for a deferral of compensation, such as one granted at a discount, can be cancelled and reissued, so long as such action is taken by December 31, 2006. If the stock option does not otherwise contain any deferral features, it will not be subject to Code Section 409A.
If employers have not already done so, they should carefully identify potential deferred compensation arrangements, and review them with their benefits consultants. In addition to the more traditional types of deferred compensation plans, Code Section 409A could apply to:
- Salary continuation payments;
- Severance plans;
- Performance bonus programs;
- Expense reimbursement programs; and
- Change of control agreements.
Once the various plans have been identified, employers should work closely with their benefit consultants to determine what, if any, action may need to be taken. If you would like assistance with reviewing your plans and bringing them into compliance with Code Section 409A, please contact a member of our Compensation Planning & Employee Benefits Group.