EMPLOYEE BENEFITS

New Deferred Compensation Rules Require Immediate Action

January 2005

By Donald R. Saxon*

Legislation imposing new restrictions on a wide range of compensation arrangements was signed into law on 22 October 2004. The American Jobs Creation Act (AJCA) adds a new Section 409A to the Internal Revenue Code which applies to compensation deferred under a nonqualified deferred compensation plan after 31 December 2004. The new law imposes restrictions on funding, distributions, and elections to participate in the plan. While recent IRS guidance (IRS Notice 2005-1, as revised on 6 January 2005) provides some transitional relief, immediate changes to many compensation arrangements are necessary.

Who is affected?

The new Section 409A potentially applies to any arrangement which postpones payment of compensation to another year. Notice 2005-1 confirmed that this includes arrangements covering only one person, severance agreements, Supplemental Executive Retirement Plans (SERPs), “defined benefit” nonqualified plans, and arrangements with non-employees (e.g., directors and trustees). The statute identifies very few exceptions, the most significant of which are qualified plans and time-off plans.

For example, an agreement with a departing executive to pro-rate payment of her severance package over the next 24 months will fall within the scope of the new Section 409A.

What must be done now?

A prerequisite for the transitional relief included in Notice 2005-1 is that the plan be operated in good faith compliance with existing guidance and the current terms of the plan itself — to the extent not in conflict with the guidance — until the plan document is formally amended (see below). This means that the plan must immediately begin to operate in accordance with Section 409A, even if this conflicts with the written terms of the plan.

For example, a nonqualified plan which is funded via a “Rabbi Trust” held outside the United States will need to act immediately to move the ownership of that trust to a domestic “location” before 2005 deferrals are contributed.

For most plans, because pre-2005 deferrals will not be subject to the new rules unless the plan is materially modified (other than to comply with the new law), the only immediate impact will be on the solicitation of participant elections. Section 409A requires that an election to defer compensation, other than upon initial eligibility for the plan, be made prior to the taxable year in which the services subject to such election are performed. Of course, this means that the elections to defer 2005 compensation must have been made during 2004. Because the IRS did not publish Notice 2005-1 (the first, and to date only, guidance on the new law) until 20 December 2004, and then amended it 6 January 2005, the Notice includes a grace period for implementation of these election rules. Plans already in existence in 2004 may permit — if not inconsistent with the plans’ current provisions — participants to make elections relative to their 2005 compensation as late as 15 March 2005, provided the election is made before the amounts are earned.

For example, a plan may permit participants to make an election on 15 February 2005 to defer compensation earned on or after 16 February 2005. But a plan may not permit participants to make a 15 March 2005 election to defer compensation earned on or after 16 February 2005.

Certain performance-based compensation is subject to a less restrictive rule than that described above. Elections to defer performance-based (i.e., bonus) compensation may be made no later than six months prior to the end of the performance period. However, this will still require elections concerning 2005-based annual bonuses to be made by 30 June 2005.

What must be done by the end of 2005?

Section 409A requires both documentary and operational compliance. Further, the law requires that a plan contain specific provisions dictating compliance. For example, the XYZ Co. Executive Deferred Compensation Plan is a nonqualified plan operated in a manner consistent with Section 409A, and containing no written provisions in conflict with Section 409A, but which contains no explicit language concerning the timing of contribution elections. This plan will not satisfy Section 409A.

Fortunately, the IRS has acknowledged that more specific guidance and more time are required before sponsors of nonqualified deferred compensation plans can reasonably be expected to fully comply with Section 409A. Therefore, formal amendment of nonconforming deferred compensation plans may be postponed until the end of 2005, as long as the plan is operated in the interim in “good faith” compliance with the provisions of Section 409A and this IRS Notice.

By the end of 2005, every deferred compensation plan subject to Section 409A will most likely require amendment , even if only to codify existing procedure, or conform terminology to the language of the new law. Also, by this same date, administrators of these plans must be prepared to implement the new distribution rules for amounts deferred in 2005 or later. In some cases, this may require that different portions of a participant’s accumulated deferred compensation be handled in distinctly different manners. An administrator will want to ensure that the plan’s recordkeeping and documentation process is prepared for this possibility.

What restrictions does section 409A impose?

Section 409A provides that compensation deferred into a nonqualified deferred compensation plan will be subject to current taxation plus a 20% penalty unless the requirements identified below are both included in the written plan document and enforced.

Distributions. Section 409A permits deferred compensation to be distributed only upon the earliest of: (1) separation from service (but note that key employees of publicly traded companies must wait an additional six months), (2) disability, (3) death, (4) unforeseeable emergency (as defined in the statute); and (5) a date irrevocably designated at the time of the deferral elections. These “irrevocable” dates may be postponed, but not accelerated, if certain criteria are met.

Deferral Elections. As discussed above, compensation may be deferred only if the election to defer such compensation is made prior to the taxable year in which the compensation is earned. A newly eligible employee, however, may elect to defer compensation which would have been paid in that same year, as long as such election is made within 30 days of the date the employee was first eligible to participate and before the performance of the services subject to such election.

Funding. Section 409A prohibits the use of offshore Rabbi Trusts. In addition, domestic Rabbi Trusts are precluded from containing any provisions which purport to place the rights of participants ahead of the rights of general creditors.

*Donald R. Saxon is admitted in New Hampshire, California and Nevada.

Return to top of page

Return to Employee Benefits Articles
Return to Firm Publications