It seems that from the moment President Bush signed the American Jobs Creation Act of 2004 into law last October and added new Section 409A to the Internal Revenue Code of 1986, as amended ("Code"), a Pandora's box of questions, applications and interpretations of what is and is not subject to the new deferred compensation rules has opened. While the issuance of Internal Revenue Service Notice 2005-1 ("Notice") has started to fill in the holes on the scope and breadth of the new statute, more interpretative guidance is necessary. Understandably then, the Notice provides that until additional guidance is issued, with respect to issues not addressed within, employers and employees should base their positions upon a good faith, reasonable interpretation of the statue and its purpose, which includes consideration of the legislative history of the new law.
Complementing the two other recent pieces published on Section 409A in The Metropolitan Corporate Counsel , "New Law Makes Dramatic Changes to Deferred Compensation Rules" by Andrew L. Gaines of Weil, Gotshal & Manges (January) and "Treasury Issues Initial Guidance on New Deferred Compensation Rules" by Stephen T. Lindo and Frank A. Daniele of Willkie Farr & Gallagher LLP in this issue, this article is intended to provide a potpourri of issues addressed and those left unaddressed by the Notice. Unlike the pieces referenced above, this article will not focus on permissible modifications for so-called "grandfathered" plans, i.e., plans in existence on or before October 3, 2004. Rather, this article will recap what employers should be thinking about in relation to their nonqualified deferred compensation plans pending further guidance.
What We Know
Future Guidance
In early January, the Treasury Department announced informally that it anticipates the next set of guidance on Section 409A to be issued no later than June, 2005.
Forthcoming guidance will likely cover the following areas:
- Application of Section 409A to severance plans, including whether to exclude any specific types of severance plans and arrangements.
- Funding arrangements for deferred compensation that involve foreign trusts or similar offshore arrangements.
- Application of Section 409A to arrangements involving partners and partnerships.
- Where acceleration of benefits should be permitted when circumstances of the acceleration are beyond the control of the plan participant.
- 401(k) Wrap Plans - A frequently used vehicle where compensation amounts deferred in excess of the 401(k) plan limits ($14,000 for 2005) are deferred into a nonqualified plan not subject to ERISA. A strict reading of Section 409A would suggest that this arrangement would violate Section 409A; however, on a recent American Bar Association Teleconference (January 6, 2005), representatives of both the Treasury Department and the Internal Revenue Service indicated that the agencies may be sympathetic to an exemption for 401(k) wrap plans where the participant is irrevocably committed to deferring an entire amount and only the ERISA qualified versus nonqualified amount is to be determined by the employer.
- Continued Indemnification or Insurance Coverage - In certain circumstances, indemnification or insurance coverage can extend beyond the term of an employee's service. The question is whether this coverage is deferred compensation and may be subject to Section 409A. Remember, Section 409A applies to both employees and non-employees so insurance for directors may be at issue.
Filling In The Blanks
Equity Compensation
Section 409A itself is silent as to whether equity-based arrangements are deferred compensation. Until the Notice, the legislative history stated:
"É[i]t is not intended that the term 'nonqualified deferred compensation plan' include an arrangement taxable under Section 83 providing for the grant of an option on employer stock with an exercise price that is not less than the fair market value of the underlying stock on the date of grant if such arrangement does not include a deferral feature other than the feature that the option holder has the right to exercise the option in the future."
The Notice did clarify the application of Section 409A to equity compensation. It exempted the following:
- Incentive stock options (ISOs) granted in accordance with Section 422 of the Code.
- Options to purchase employer stock granted in accordance with a Section 423 "employee stock purchase plan (ESPPs)." Remember that nonqualified ESPPS, e.g., an ESPP that generally follows the statutory rules, but not the requirement to cover all employees of the corporation, are not exempt under the notice and all options awarded thereunder would be considered deferred compensation.
- Nonqualified stock options, but only if:
- the exercise price may not be less than the fair market value of the underlying stock on the date the option is granted.
- the receipt, transfer or exercise of the option is subject to taxation under the general rules of taxation of property under Section 83 of the Code.
- there is no feature whereby the gain on the option exercise may be deferred to a future date.
- Stock Appreciation Rights (SARs) for Publicly Traded Companies if the SAR is non-discounted, settled in company stock and does not include any feature for the deferral of compensation other than the participant's right to exercise it.
- SARs with Date Certain in which the payout of the SAR is made at the expiration of its term.
- Restricted Stock. The receipt of restricted stock or other restricted property is not, in itself, a deferral of compensation, even though the value of the property is not includible in income by reason of the property being nontransferable and subject to a substantial risk of forfeiture. However, where a service provider (employee) obtains a legally binding right to receive property (whether or not that property is restricted property) in a future year, that right may be subject to Section 409A.
Change In Control ("CIC")
Section 409A(a)(2) provides six distribution events, including "to the extent provided by the Secretary [of the Treasury], a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation."
A plan may permit a payment upon a change in control event ("CIC Event") provided that the occurrence of such event must be objectively determinable. Further, any requirement to certify the event (by the plan administrator or board of director's compensation committee) must be strictly ministerial and not involve any discretionary authority. Acceleration of payment is also permitted where the right to the payment arises due to the corporation's exercise of discretion under the terms of the plan to terminate the plan upon the occurrence of the change in control event and the distribution is made within 12 months following the change in control event.
The basic outline of what is a CIC Event for purposes of accelerating payment under Section 409A is similar in structure to the golden parachute definitions of a change in control under Section 280G, but more restrictive:
In general, a CIC Event is one of the following:
- Acquisition by a person or group of more than 50% of voting stock
- Acquisition by a person or group of 35% or more of voting stock within a 12-month period
- The replacement of a majority of directors during a 12-month period.
- Acquisition by a person or group of 40% or more of assets of a corporation prior to the acquisition (measured as total gross fair market value of such assets).
During 2005, a company should take time to review the CIC definitions in current plans, contracts, board resolutions, etc. and compare them with the Section 409A/Notice CIC Event definitions. Bear in mind that a CIC Event under Section 409A is not triggered by the shareholder approval of a transaction. Finally, the employer need to decide if some, but not all, CIC definitions should be changed to confirm with a Section 409A/CIC Event definition or only those plans, arrangements and contracts which would affect the timing of distribution of what is deferred compensation. Given the special post-termination distribution rules applicable to "key employees" under Section 409A, (see section of Andrew Gaines' article headed "Distribution Requirements"), the employer should take time to separate plans that have CIC definitions which cover key employees and those which cover non-key employees.
What We Don't Know - Miscellaneous Potential Applications Of Section 409A
Until future guidance is issued, advisors and employers will continue to speculate on the types of benefits, plans and arrangements that are caught in Section 409A's regulatory cross-hairs. The following is a short list of examples of the types of benefits, perquisites, that may be subject to Section 409A. Bear in mind that the list of potential applications is more extensive than those found below; therefore, it is critical for employers to inventory not only their plans, but individual contacts, agreements and arrangements to see if Section 409A applies.
- Whether post-termination perquisites (e.g., continued use of company facilities or office and secretary) fall outside Section 409A, particularly where the perquisites extend beyond 21/2 months after year end (the exception under Section 409A for "short term deferrals"). If those perquisites are provided to key employees (and most likely, they would be the persons for whom this benefit would be given) and if perquisites are, in fact, subject to Section 409A, does an employer need to impose a 6 month delay on the receipt of these benefits?
- Distribution of payments out of retention plans the triggering event of which does not fall within any of the Section 409A/CIC Event definitions.
- Reimbursement of COBRA premium payments for a period of time.
- Whether severance paid in an immediate lump (or even within 21/2 months of end of year) is completely outside of 409A (including the 6 month delay for key employees)?
Things Employers Can Do While Waiting For More Guidance
First, any employer contemplating establishing a new nonqualified deferred compensation arrangement must ensure that the document is specifically and explicitly in compliance with Section 409A. Employers may need to implement a higher degree of plan administration for existing plans and programs. Employers must make sure the election forms and all other communication pieces fully inform participants of all deferral and distribution date restrictions under Section 409A. It is a good idea to have participants acknowledge in writing that they have received and understand all the rules. All pre-October 3, 2004 arrangements which are grandfathered for application under Section 409A should be secured for grandfathered treatment by documentation and operation. Finally, for those nonqualified deferred compensation arrangements which cover a select group of management or highly compensated employees, make sure that an appropriate filing as a "top-hat" plan has been made with the Department of Labor.
Published February 1, 2005.
