Deferred Compensation Deadlines

Set Tight Deadlines and Possible Tax Penalties for Employees and Plan Participants

Deadlines are rapidly approaching for employers and employees in connection with nonqualified deferred compensation. Code Sec. 409A was enacted in the American Jobs Creation of 2004 to tighten the limits on nonqualified deferred compensation plans. The regulations address key provisions of Code Sec. 409A: the scope of Code Sec. 409A, possible accelerated taxable income, the timing of initial deferral elections, the timing of benefits, and subsequent elections to defer benefits.

The IRS provided interim guidance in Notice 2005-1. The notice set an effective date of January 1, 2006 for many provisions. The proposed regulations, which incorporate the notice, pushed back the effective date for some rules to January 1, 2007. But many other important provisions still take effect January 1, 2006, requiring employers and plan participants to act by December 31, 2005.

Failure to comply with these rules has significant consequences: taxation of deferred amounts, plus interest and a 20% penalty on the taxable amount. Employers who fail to act risk being saddled with complex plans that are costly to administer.

Scope of New Rules

The new Code Sec. 409A rules are sweeping in their coverage. Under Code Sec. 409A, amounts earned in one year and payable in a later year are deferred compensation. Bonuses, stock appreciation rights (SARs), stock options, excess benefit plans, and severance pay can all be subject to Code Sec. 409A, depending on their terms. The regulations exclude amounts paid within 2 1/2 months after the year the amounts are earned. These are called “short-term benefits.” Multi-year bonus arrangements that pay out benefits shortly after they vest can also be excluded as short term deferrals.

Elections

Deferral elections generally must be made no later than the close of the year before the amounts will be earned. An employee who wants to defer salary earned in 2006 must make a deferral election by December 31, 2005. There is no 2 1/2 month rule here. Elections made in the same year as amounts are earned will not be respected.

A bonus based on measures of the company’s or the individual’s performance is treated as deferred compensation. If the bonus is based on services performed over a 12 month period or longer, the employee must make the election to defer income at least six months before the end of the bonus period.

Payments must be made on a fixed date or schedule or upon one of the following events: separation from service, death, disability, change in control of the employer and hardship or an unforeseeable emergency. If payments are scheduled for a particular starting date, and the employee wants to push back the date, the employee must make the election at least 12 months before the starting date and must push back payments at least five years.

The regulations forbid an employer from re-establishing a plan within five years after it is terminated.

Effective Dates

Code Sec. 409A applies to amounts earned and deferred starting in 2005. Vested amounts earned and deferred before January 1, 2005 are not subject to Code Sec. 409A. Stock options that were immediately exercisable for vested stock by December 31, 2004 are excluded from 409A. Earnings on excluded amounts also are excluded. However, if a plan is materially modified after October 3, 2004, amounts deferred under the plan become subject to Code Sec. 409A.

Key Dates

Many provisions take effect January 1, 2006. Employers therefore must act promptly to decide whether to take advantage of transition relief that expires December 31, 2005. Employers must also revise deferral election procedures in existing plans to ensure that deferrals of 2006 compensation are timely.

Cancellation of deferrals and termination of plan participation. For plans adopted before December 31, 2005, a participant may be granted the right to cancel an outstanding election or terminate participation. If a plan amendment is needed, the amendment must be enacted and effective by December 31, 2005. The regulations did not extend this relief. Termination or cancellation of participation is treated as taking effect January 1, 2005. The exercise of an SAR or stock option by December 31, 2005 will be treated as a cancellation.

Termination of grandfathered plans. Plans may be amended and deferred compensation may be distributed by December 31, 2005, provided all amounts are included in income in the year of termination. This relief was not extended.

Severance Pay. Short term severance pay for involuntary termination is not subject to Code Sec. 409A. This rule applies to all employees, not just rank and file. The severance payments must not exceed twice the employee’s salary and must be paid within two years of termination of employment. Furthermore, the regulations treat severance payments as a separate benefit that will not taint other deferred compensation benefits if the severance pay violates Code Sec. 409A.

Extended Deadlines

Good faith compliance. Under Notice 2005-1, plan documents had to be amended by December 31, 2005 to comply with Code Sec. 409A. The Treasury and the IRS decided to give employers more time to comply with the final regulations, extending the deadline to December 31, 2006 for the plan to comply with the election, distribution and acceleration provisions of Code Sec. 409A.

Amounts deferred for 2005. These amounts are subject to 409A. The regulations allow existing plans to be amended to provide for new payout elections (the time and form of deferred payments), provided the amendment and participant elections are made by December 31, 2006. This was extended from the 2005 date in the notice. However, participants cannot change a payout election for payments that would otherwise have been received in 2006, and cannot choose to receive the amounts in 2006.

Options and stock appreciation rights. Stock options issues at fair market value and stock appreciation rights pegged to fair market value are not subject to Code Sec 409A. Notice 2005-1 said that employers can substitute non discounted rights for the original date of grant, if the options and SARs are cancelled and reissued by December 31, 2005. This relief is being extended until December 31, 2006. This relief can be used for rights that were not earned and vested before January 1, 2005.

Excess benefit plans. Elections that will mirror qualified plan elections (which can be made at the time of payout) would violate 409A because, in part, the time and form of the payment would not be established at the time of the deferral. For periods ending on or before December 31, 2006, payments under a nonqualified deferred compensation (NQDC) plan may be tied to a qualified 401(a) plan if the deferred compensation plan had this provision on October 3, 2004. This applies to NQDC that begins or is paid from January 1, 2005 to December 31, 2006. Participants can begin receiving benefits at the same time as benefits are paid under the qualified plan. The notices had provided relief through 2005.

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