New Tax Rules Require Changes In All Compensation Arrangements That Allow For Payment In A Later Year

Client Advisory

November 4, 2004

American Jobs Creation Act of 2004
As Passed by Congress on October 11, 2004
and signed by the President on October 22, 2004
adds new Section 409A to the Internal Revenue Code

Until now, employers were generally free to promise payment of amounts to management employees in the future, or allow those employees to have a certain part of their salary deferred until a later year, and the employees could then defer paying taxes on the promised amounts until the amounts were actually paid.  Now, to accomplish that tax result, your arrangement must meet very specific design requirements.

Virtually every one of these arrangements will need to be amended in the next few months, or huge additional taxes will be due.

Types of Arrangements Affected:  Any arrangement for employees or independent contractors (including corporate directors), that provides for the payment for services to be made later than 2½ months after the end of a calendar year to which the payments relate, is covered by this new law.

–  Excludes vacation, bonus, holidays, sick or disability pay, comp time arrangements, death benefit plans, eligible 457 plans and qualified retirement plans (401(a), 401(k), SEP, SIMPLE, 403(b)) plans), and stock option programs if the exercise price equals fair value at date of grant.
–  Includes elective and non-elective nonqualified deferred compensation, bonus deferral programs, SERPs or supplemental retirement plans, and excess benefit plans.
–  Even includes a single-person arrangement (for example, an employment contract that provides for some payments at a later time).
–  Guidance needed to see how the rules affect restricted stock, phantom stock and stock appreciation rights plans, stock options where the exercise price was below market value at grant, and severance plans.

Effective Date:  Applies to old and new plans in some respects

–  Deferrals made or amounts credited by an employer or vested  under an arrangement after December 31, 2004, and earnings on the new amounts (but generally not on old deferrals).
–  Amounts owed and vested under any current plan that relate to a prior period, if that plan is materially modified after October 3. 2004.
–  IRS is directed to come up with guidance within 60 days to provide a limited period during which current participants can cancel participation or change arrangements, and some transition period for detailed language for compliance related to post-2004 earned amounts.
–  Not intended to change the rules prior to passage with respect to timing of income inclusion on pre-12/31/04 earned amounts; IRS is expected to be more aggressive in its assertions as to when taxation occurs under old plans.

Basic Concept:  Plans must now meet certain design criteria,
OR the amounts must be subject to a substantial risk of forfeiture,
OR the earned contributions/deferrals and earnings accumulated on them are income-taxed immediately

–  Applies to all participants, not just public company executives.
–  Different rules for public company "key" employees  (officers who make over $130,000; most 1% shareholders, etc.).
–  Substantial risk of forfeiture is defined as receipt being conditioned on future performance of substantial services by the individual. Legislative history implies that a covenant not to compete is not likely to be considered a risk of forfeiture under these rules.

What is at Risk:   The executives who have arrangements like this are the ones who lose if the arrangement does meet the rules.

–  If a plan's written terms do not meet the rules, or in operation violates them, then the amounts owed under the plan become taxable to all executives (in the case of a plan design problem) or the affected executives (in the case of an operational error).
–  A non-complying program will require payment of interest on amounts earned in prior years, and a 20% penalty on top of ordinary income and employment taxes.
–  Employers have additional reporting and withholding obligations.

Elections to Defer:  Many plans give executives the right to elect to have some salary or bonus paid in a later year in order to defer the taxes on that amount.  Those elections are now subject to tight timing constraints or the hoped-for tax deferral will not occur

–  Election to defer must be made before start of calendar year or, for a newly eligible executive, within 30 days after eligibility.
–  If a bonus is being deferred, and it qualifies as "performance based compensation" the executive can defer up to 6 months before the end of the period with respect to which the bonus relates, but only if it is otherwise not readily determinable at that date.  For example, if executives get a bonus in early 2006, based on how the company performs in 2005, they must elect before June 30, 2005 if they want to delay payment (and taxes) on that bonus into another year.
–  Election to defer must include an election as to timing and form of distributions, unless plan dictates those things automatically.

Triggers for Distributions:   This portion of the law affects plans that are solely employer-funded, as well as plans that allow executives to elect an amount to be deferred.

–  Distributions must be made no earlier than

(i)   death,
(ii)  disability (using Code-based definition, so plans will need to be amended to  
      conform),
(iii)  separation from service (+ 6 months for public company "key employees"),
(iv)  change in control (IRS to define this concept)
(v)   unforeseeable emergency (defined by the new law, and still nothing like qualified
      plan hardship withdrawals), or
(vi)  at a fixed time (or over schedule) specified in plan or when  deferral is made.

Can no longer have plans that:

–  allow the employer discretion to change form or time of payment, even on plan termination (unless IRS guidance helps here);
–  allow payment earlier with a "haircut" or reduction in amount paid;
–  allow payment upon other types of events—like a child entering college; or
–  allow an employment transfer between companies in the controlled group to trigger plan payouts.

Change in election to delay distribution can be made if permitted by plan, and:

(i)   election cannot take effect for 12 months after made (or, in the case of a series of payments, must be made at least 12 months before the first payment), and
(ii)  first payment must be deferred for at least 5 additional years from date initially scheduled to be paid (unless distribution is earlier made due to death, disability or unforeseeable emergency). 

May never accelerate payment except for one of the distribution-triggering events above, and then only if the plan provides for acceleration in those events when deferral is made. Guidance may allow de minimis payouts outside these rules.

–  Regulations are expected to make exceptions where payments are needed to solve a Federal conflict of interest issue, or based on a divorce court order, and may make some concessions about the timing and form of payments elected under plans that are designed to coordinate with a qualified defined benefit plan.

Form of distribution:            

–  Must be specified in plan or, if participant elects, at time of deferral
–  Can be changed by participant under same timing guidelines as for time of payment elections above, but cannot have effect of accelerating payments.
–  This may mean that no change from installments to a lump sum will ever be allowed. 

  Funding:                     

–  As under prior law, cannot earmark assets to the sole benefit of executives or secure the promises so that company's general creditors cannot get access.
–  No offshore trusts allowed.
–  Rabbi trust (one that allows company's creditors access in the event of insolvency) still okay but taxation occurs if there is a shift in funding or in rights to certain assets based on an employer's financial health.  

Investments Options:  Unlike earlier proposals, this law does not restrict investment options that can be used to impute earnings on amounts until they are paid .

Tax Reporting Issues:                        

–  W-2 (for employees) or 1099 (for non-employee service providers) reporting is required as the money is deferred, even if not then income taxable.
–  Rules about including deferred or credited amounts in wages for FICA/Medicare tax (generally earlier than for income taxes) are not changed.
–  Non-account balance plans may get relief from annual reporting requirement, if amounts owed are not reasonably ascertainable.

Action Items:           

Additional Documents:

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