Deferred Compensation Loses Flexibility; IRS Requires Action by March 15
Corporate & Finance Alert
February 10, 2005
The American Jobs Creation Act of 2004 contains important provisions dealing with nonqualified deferred compensation. The act’s provisions, which are contained in a new Section 409A of the Internal Revenue Code, apply to amounts deferred in taxable years beginning after Dec. 31, 2004, and earnings thereon. For amounts deferred in taxable years beginning prior to Jan. 1, 2005, the act’s provisions apply to arrangements that are materially modified after Oct. 3, 2004. An amount is treated as deferred prior to Jan. 1, 2005, if it is earned and vested prior to that date. The taxable year is that of the recipient of the deferred compensation, rather than that of the employer. This will usually be the calendar year. The act’s requirements cover distributions, acceleration of benefits, and deferral elections. The act applies to arrangements that cover directors, employees, and independent contractors, plans that cover a broad group of employees, and arrangements, such as those contained in individual employment and severance agreements, which cover only one person. On Dec. 20, 2004, the IRS issued Notice 2005-1, the first in a series of guidance, which requires that certain actions be taken by March 15, 2005.
The act provides that all amounts deferred for a taxable year and all preceding taxable years, together with the earnings thereon, are includible in a person’s gross income to the extent that they are  not subject to a substantial risk of forfeiture;  not previously included in gross income; and  if at any time during the taxable year the governing document for the arrangement does not contain the act’s requirements, or the arrangement in operation does not satisfy the act’s requirements.
Substantial risk of forfeiture means that entitlement to the compensation is conditioned on the performance of substantial future services, or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. Examples of a compensation’s purpose are reaching financial targets, such as level of earnings or equity value, amounts payable on a sale of a division, or an initial public offering. A noncompete condition does not create a substantial risk of forfeiture.
Income inclusion means not only that the deferred compensation and earnings thereon are subject to income tax, but also two other charges. First, interest is charged on the underpayment of tax that would have occurred had the deferred compensation been included in income for the taxable year in which it was first deferred, or, if later, the first taxable year in which it was not subject to a substantial risk of forfeiture. The interest rate is the underpayment rate plus one percentage point. The underpayment rate is the federal short term rate plus three percentage points. Thus, the additional interest charge is the federal short term rate plus four percentage points. Second, the act imposes a penalty of 20 percent of the amount included in gross income.
Under the act’s distribution requirements, the arrangement must provide that amounts deferred cannot be distributed earlier than:
- A participant’s separation from service, with a special rule for “specified employees”;
- The date of a participant’s disability;
- The date of a participant’s death;
- A specified time, or pursuant to a fixed schedule specified under the arrangement at the date of the deferral;
- To the extent provided by IRS regulations, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation’s assets; or
- The occurrence of an unforeseeable emergency.
If an arrangement permits distribution for an event other than the foregoing events, income inclusion occurs. Thus, if the arrangement allows a participant to elect distribution at any time subject to a 10 percent forfeiture of the amount distributed, income inclusion occurs. A distribution in the discretion of the plan administrator also results in income inclusion. Furthermore, a provision that defers payment until it is deductible by the employer under Code Section 162[m] is probably impermissible. Finally, for “specified employees,” distribution cannot be made before the earlier of six months after the employee’s separation from service, and the employee’s death. A specified employee is a key employee of a publicly traded corporation under the top-heavy rules for qualified retirement plans. For larger public companies, the key employees will be the top 50 officers having annual compensation greater than $135,000.
Acceleration and Deferral
The act generally prohibits the acceleration of benefits. A plan cannot permit acceleration of the time or schedule of any payment, except as provided by IRS regulations. Thus, changes in the form of distribution that accelerate payments, such as a change from installment payments to a lump sum, result in income inclusion. Plans that allow participants to choose between a lump sum and installment payments must make the lump sum the default option. If installment payments were the default option, an election of the lump sum would cause an impermissible acceleration.
For an initial deferral election, the plan must provide that a participant can elect to defer compensation for services performed during a taxable year either not later than the close of the preceding taxable year, or at any other time provided by IRS regulations. In addition, the time and form of distribution must be specified in the initial deferral election. For performance-based bonuses for services performed over at least 12 months, the participant must make the initial deferral election no later than six months before the end of the service period.
A performance-based bonus means that payment of the bonus, or the amount thereof, is contingent on satisfying organizational or individual performance criteria, and the criteria are not substantially certain to be met at the time of the deferral election. A performance-based bonus does not include any amount that is based “solely” on the value of, or appreciation in the value of, employer stock. Thus, these criteria can be one of multiple performance criteria. Finally, a performance-based bonus may be based on subjective performance criteria that relate to the performance of the participant, a group of service providers that includes the participant, or a unit or organization for which the participant provides services.
A plan can permit a subsequent election to change the time or form of distribution only if the plan contains the following requirements:
- The election cannot take effect until at least 12 months after it is made;
- For an election for a payment made other than by reason of disability, unforeseeable emergency or death, such as on separation from service, change in control, or at a specified time, the first payment for which the subsequent election applies must be deferred for at least five years from the date on which the payment would otherwise have been made. For example, if an executive changes the form of distribution from a lump sum to installment payments, the executive cannot receive the first installment until five years after the lump sum would have been paid; and
- Any election for a payment to be made at a specified time or under a fixed schedule cannot be made less than 12 months before the date of the first scheduled payment.
Under the act’s effective date rules, subsequent deferral elections for amounts deferred for taxable years beginning before Jan. 1, 2005, under a plan that is not materially modified after Oct. 3, 2004, are not subject to the act.
Since the act does not apply to and grandfathers amounts deferred for taxable years beginning prior to Jan. 1, 2005, a critical issue is determination of these amounts. Under the Notice, an amount is deferred prior to Jan. 1, 2005, if on Dec. 31, 2004 a person has a legally binding right to be paid the amount, and the right to the amount is earned and vested. These requirements mean that the amount is not subject to a substantial risk of forfeiture, which is defined by reference to the Section 83 regulations.
This definition of substantial risk of forfeiture is different from the definition for purposes of the income inclusion trigger, which is not defined by reference to the Section 83 regulations. The Section 83 regulations contain a presumption that the risk of forfeiture under a noncompete agreement is not substantial. Thus, amounts forfeitable on breach of noncompete agreement are not grandfathered if the risks of breach and forfeiture are substantial.
Furthermore, amounts accrued and vested under supplemental executive retirement plans as of Dec. 31, 2004 should be grandfathered if the amounts are forfeitable because of misconduct or violation of a noncompete agreement, as long as the presumption of nonsubstantiality is not rebutted. If the employer withheld FICA taxes on the deferred compensation under Code Section 3121[v] because the amounts were no longer subject to a substantial risk of forfeiture under Section 83, the executive can reasonably take the position that grandfathered treatment applies.
In addition, any negative discretion in the employer to reduce amounts earned as of Dec. 31, 2004, regardless of how unlikely it is that the employer will exercise this discretion, defeats eligibility for grandfathered treatment. Thus, Section 162[m] bonus arrangements that grant the compensation committee discretion to reduce the bonus are ineligible for grandfathered treatment.
Many bonuses for services performed in 2004 and payable in 2005 will be ineligible for grandfathered treatment, and will not otherwise comply with the act’s requirements for deferral elections. Fortunately, the IRS has provided transition relief for these bonuses, and also for the deferral of salary earned in 2005, and nonperformance based bonuses earned in 2005. The Notice states that these amounts do not have to satisfy the act’s requirements for deferral elections as long as an election is made on or before March 15, 2005, and the following requirements are met.
First, the amounts to which the deferral election relate have not been paid or become payable at the time of the election. Second, the plan under which the deferral election is made existed on or before Dec. 31, 2004. Third, the deferral elections are made in accordance with the terms of the plan in effect on or before Dec. 31, 2005. Fourth, the plan is otherwise operated in accordance with the act. Finally, the plan must be amended to comply with the act’s requirements by Dec. 31, 2005. The transition relief applies not only to bonuses, but to other forms of deferred compensation.
When a bonus is payable only after action authorizing the bonus is taken, such as compensation committee approval of payment of a Section 162[m] bonus, the prudent course is for the executive to make the deferral election before both the action is taken and March 15, 2005.
This article was first published in the January 31, 2005, issue of the New Jersey Law Journal. c. 2005 ALM Properties, Inc. All rights reserved.