On December 20, 2004, the Treasury Department and the Internal Revenue Service issued Notice 2005-1 providing the first installment of guidance for the deferred compensation provisions of the American Jobs Creation Act of 2004, which are contained in new Section 409A of the Internal Revenue Code.
Notice 2005-1 addresses the most immediate issues raised by the Act, including flexible transition provisions giving until March 15, 2005 to make deferral elections for certain 2005 compensation and 2004 bonuses, and until December 31, 2005 for making certain payment elections. Although deferred compensation plans generally must be operationally compliant with Section 409A by January 1, 2005, companies generally have until December 31, 2005 to adopt plan amendments implementing Section 409A.
In addition to transition rules, Notice 2005-1 continues the expansive reading of what constitutes nonqualified deferred compensation under Section 409A, but salvages stock-settled stock appreciation rights granted at fair market value by public companies. The guidance also provides definitions of certain key terms, including substantial risk of forfeiture and change in control, and addresses a number of other interpretive issues, but leaves many interpretive issues unaddressed—for example, the treatment of dividend equivalents paid currently in cash with respect to restricted stock units.
Treasury and the IRS plan to issue additional guidance in 2005. The timing may depend in part on reaction to Notice 2005-1 and responses to specific requests for comments in the notice. This Update summarizes certain key issues addressed by Notice 2005-1 and offers practical advice.
Background on Section 409A
Section 409A generally provides that amounts deferred under a nonqualified deferred compensation plan are currently includible in income if not previously included and not subject to a substantial risk of forfeiture, unless the plan meets specified design and administration requirements. Section 409A generally applies to deferred compensation that is earned or becomes vested after December 31, 2004. It does not apply to deferrals earned and vested before 2005 unless the plan under which the deferral is made is materially modified after October 3, 2004. Failure to comply with Section 409A can result in significant tax consequences, including interest and a 20% penalty. For more information about the deferred compensation provisions of the Act, see our October 20, 2004 Update.
Flexible Transition Relief
Notice 2005-1 provides flexible transition relief for implementing the requirements of Section 409A through December 31, 2005.
Plan Amendments May Be Made as Late as December 31, 2005 If Plan Is Operationally Compliant Throughout 2005. Generally, a plan adopted before December 31, 2005 will not be treated as violating the requirements of Section 409A if the company:
- operates the plan throughout 2005 in good faith compliance; and
- amends the plan on or before December 31, 2005 to conform its terms to the requirements of Section 409A and any related guidance.
However, it appears that to the extent existing plans must be amended to comply with the rules relating to funding deferred compensation, companies must amend the plans on or before December 31, 2004.
Deferral Elections for 2005 Compensation and 2004 Bonuses May Be Made as Late as March 15, 2005. Companies may postpone or allow new deferral elections for compensation earned before December 31, 2005 so long as final deferral elections are made on or before March 15, 2005. To take advantage of this relief:
- the compensation must not be paid or payable at the time of election;
- the election must be in accordance with the terms of the plan as of December 31, 2005;
- the plan must have existed on or before December 31, 2004; and
- the plan must comply with the good faith compliance and amendment requirements described above.
Payment Elections May Be Made as Late as December 31, 2005. A plan may allow for new payment elections in 2005 with respect to amounts deferred before the election if the plan is amended to so provide and the participant makes the election on or before December 31, 2005. This transition relief may extend to participants who have already made payment elections with respect to 2005 and prior compensation subject to Section 409A.
Termination of Participation or Cancellation of Deferral Elections May Be Made as Late as December 31, 2005. A plan may be amended before December 31, 2005 to allow a participant during all or part of 2005 to terminate participation in the plan or cancel a deferral election with respect to deferrals of 2005 compensation. The affected compensation must then be included in the participant’s income in the taxable year in which the amounts are earned and vested. Companies are not required to extend the termination or cancellation right to all participants.
Elections Linked to Qualified Plan Distribution Elections Permissible Until December 31, 2005; Plans Linked to Qualified Plans Need Review. Some nonqualified deferred compensation plans provide that the time and form of payment are determined in accordance with the distribution elections made by the participant under a designated qualified plan. This type of tandem arrangement may lead to Section 409A violations if changes to a distribution election under the qualified plan do not comply with the distribution requirements of Section 409A. Notice 2005-1 provides transition relief through December 31, 2005 if the determination of the timing and form of payment under the tandem arrangement is made in accordance with the terms of the nonqualified deferred compensation plan in place as of October 3, 2004. In addition, Treasury officials have stated that 401(k) excess plans (also known as 401(k) wraparound plans) may require a change in structure in response to Section 409A.
Limited Relief for Severance Plans. A severance plan is generally not required to meet the requirements of Section 409A during 2005 if the plan is collectively bargained or does not cover any key employees and the plan is amended by December 31, 2005 to comply with Section 409A. Notice 2005-1 requests comments on how Section 409A should apply to severance plans.
Partnership Profits Interests Not Treated as Deferred Compensation. Until additional guidance is issued, the same principles that govern the issuance of stock by corporations can be used for the issuance of partnership interests and the nontaxable issuance of partnership profits interest will not be treated as deferred compensation. Notice 2005 1 specifically solicits comments on the application of Section 409A to partnership arrangements.
Impact of Section 409A on Equity-Based Compensation
Partial Relief for Stock Appreciation Rights. Notice 2005-1 confirms that SARs are generally subject to Section 409A, but makes exceptions for certain SARs and solicits comments on the extent to which SARs should be further excepted from coverage under Section 409A.
Certain Stock-Settled SARs at Publicly Traded Companies Exempt from Section 409A. SARs do not result in the deferral of compensation for purposes of Section 409A when:
- the exercise price may never be less than the fair market value of the underlying stock on the grant date;
- the stock is traded on an established securities market;
- only the stock may be delivered in settlement of the SAR upon exercise; and
- the SAR does not include any deferral feature other than that related to the exercise right.
- SARs with a Fixed Payment Date May Comply with Section 409A. SARs may comply with the requirements of Section 409A by providing for a fixed payment date. As long as the ultimate payment date is not changed, a fixed payment date is satisfied even if the participant is allowed to exercise the SAR at any time and redirect the stock appreciation into another phantom investment measure.
- Grandfathered Non-Discount SARs Exempt from Section 409A. Pending further guidance, payment of stock or cash pursuant to the exercise or cancellation of a SAR with an exercise price equal to the fair market value of the underlying stock on the grant date, which was granted pursuant to a program in effect on or before October 3, 2004, is not subject to the requirements of Section 409A if the SAR does not include any deferral feature.
Relief for Restricted Stock and Non-Discount Stock Options. Standard restricted stock and standard nonstatutory stock options with an exercise price that may never be less than the fair market value of the underlying stock on the grant date will not constitute a deferral of compensation. Any reasonable valuation methodology may be used to determine the fair market value of the stock, including the methodology that is permitted for statutory incentive stock options. Statutory incentive stock options and employee stock purchase plans qualified under IRC Section 423 also do not constitute a deferral of compensation for purposes of Section 409A. Notice 2005 1 does not exempt from Section 409A employee stock purchase plans that do not qualify under IRC Section 423, but does provide some transitional provisions for previously granted discount stock options that do not vest until after December 31, 2004.
Deferral Requirements for Bonus Compensation
Election to Defer Performance-Based Bonus Compensation May Be Made No Later Than Six Months Before Service Period-End. Under Section 409A, an election to defer performance-based compensation may be made no later than six months before the end of the service period. If the compensation is not performance-based, the election must be made before the service period begins.
Interim Guidance on Performance-Based Compensation. Until Treasury or the IRS issues additional guidance that specifies the requirements for compensation to qualify as performance-based, bonus compensation attributable to services performed over a period of at least 12 months will be treated as performance-based if:
- the payment or amount is contingent on the satisfaction of organizational or individual performance criteria;
- such criteria are not substantially certain to be met at the time a deferral election is permitted; and
- such criteria do not include an amount or portion of an amount that will be paid regardless of performance, is based on a level of performance substantially certain to be met at the time the criteria is established, or is based solely on the value of, or appreciation in the value of, the company or its stock.
Exceptions to Prohibition on Acceleration of Payments
Section 409A prohibits the acceleration of the time or schedule of any payment under a plan, except as provided in Treasury guidance. Notice 2005-1 contains several exceptions and solicits comments on other circumstances under which a plan should be allowed to accelerate payments.
Company May Accelerate Vesting. No prohibited acceleration occurs when the company waives or accelerates the satisfaction of a condition that constitutes a substantial risk of forfeiture if the requirements of Section 409A are otherwise satisfied. For example, if a plan provides for a lump-sum payment upon separation from service after the completion of ten years of credited service, Section 409A is not violated when the company reduces the vesting requirement to five years.
Small Account Cashouts Permitted. A plan may be amended to permit de minimis distributions of $10,000 or less when the payment results in a distribution of the participant’s entire interest in the plan and is made on or before the later of December 31 of the year of the participant’s separation from service or 2 1/2 months after the participant’s separation from service. Similarly, a plan may be amended to provide that for future deferrals a participant’s entire interest will be distributed in a lump-sum payment if the participant’s interest under the plan has a value below the amount specified by the plan at the time of a permissible distribution event.
Other Permissible Acceleration. A plan may permit acceleration of the time or schedule of a payment under certain specified situations such as to:
- a participant to the extent necessary to pay FICA taxes (and related income taxes) under IRC Section 3121(v);
- an individual other than the participant to comply with a domestic relations order; and
- a participant to the extent necessary to pay income taxes due at the time of a vesting event under a Section 457(f) plan.
Requirements for Payments upon a Change in Control
Notice 2005-1 discusses when nonqualified deferred compensation payments may be accelerated in connection with a change in control and specifies the change in control events that constitute a permissible distribution event under Section 409A as:
- a change in the ownership of the company, occurring when a person or group acquires more than 50% of the total fair market value or voting power of the company’s stock;
- a change in the company’s effective control, occurring (i) when a person or group acquires or has acquired during the preceding 12-month period 35% or more of the total voting power of the company’s stock or (ii) a majority of members of the company’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the preexisting board; or
- a change in ownership of a substantial portion of the company’s assets, occurring when a person or group acquires or has acquired during the preceding 12-month period assets totaling more than 40% of the gross fair market value of all the company’s assets.
The guidance provides that the occurrence of the change in control event must be objectively determinable and that any requirement that any person or committee certify the occurrence of a change in control event must be strictly ministerial and not involve any discretionary authority. A payment will also be treated as occurring upon a change in control, however, if the right to the payment arises because of a company’s exercise of its discretion to terminate a plan in accordance with its terms and distribute the compensation deferred under the plan within 12 months of a qualifying change in control event.
Compensation payable pursuant to customary payment timing arrangements may not result in a deferral of compensation. For short term deferrals such as bonuses earned during a performance period but not paid until after the end of the period, there is not a deferral of compensation if the terms of the plan require payment and payment is actually or constructively received by the participant within 2 1/2 months from the end of the first taxable year in which the amount is no longer subject to a substantial risk of forfeiture.
Narrowed Definition of Substantial Risk of Forfeiture
Notice 2005-1 significantly narrows the definition of a substantial risk of forfeiture for purposes of Section 409A from the definition currently applicable under IRC Section 83. For example, the guidance provides that amounts will not be treated as subject to a substantial risk of forfeiture for purposes of Section 409A merely because:
- the right to the amount is conditioned on refraining from services, such as in the case of a restriction related to a covenant not to compete;
- a substantial risk of forfeiture is added after the service period to which the compensation relates begins; or
- a service period is extended during which compensation is subject to a substantial risk of forfeiture.
In addition, the guidance provides that salary deferrals cannot be made subject to a substantial risk of forfeiture unless the amount to be paid (ignoring earnings) is materially greater than the salary deferral.
To constitute a substantial risk of forfeiture for purposes of Section 409A, the possibility of forfeiture must be substantial. To determine whether the possibility of forfeiture is substantial when the individual owns a significant amount of the total combined voting power or value of stock, various circumstances must be considered, including: the individual’s position, relationship to other stockholders and the extent of their control, and the company’s past action in enforcing the restrictions.
Material Modification to Grandfathered Plans
A modification of a plan is a material modification if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added, whether by plan amendment or by the company’s exercise of discretion, even if the enhanced or added benefit would be permitted under Section 409A. For example, adding the right to receive payment upon an unforeseeable emergency would be considered a material modification. Adopting a new arrangement or granting additional benefits under an existing arrangement after October 3, 2004 will not be a material modification if it is consistent with the company’s historical compensation practices.
Notice 2005-1 provides the following examples of modifications within a grandfathered plan that are not material:
- suspending future deferrals;
- terminating a plan and distributing all accounts in 2005;
- reducing an existing benefit (such as removing a haircut distribution provision); and
- changing an investment measurement fund.
This Update is intended only to summarize key provisions of Notice 2005-1. You can find a complete copy of Notice 2005-1 on the IRS website at http://www.irs.gov/pub/irs-drop/n-05-01.pdf.