Employee Benefits Advisory Bulletin

Reminder: March 15, 2005 is the Extended Deadline for Deferred Compensation Elections

By Jeff Belfiglio and Stuart Harris
[March 2005]

Under the normal application of new Code Section 409A, an election to defer compensation for services performed in 2005 should have been made prior to Jan. 1, 2005 . However, under a special transition rule, plan participants have an extended deadline of March 15, 2005 to make deferral elections for any amounts of compensation earned in 2005, provided the amounts have not been paid or become payable as of that date.

For a summary of the new rules governing non-qualified deferred compensation, read on.

IRS Provides Guidance on New Deferred Compensation Rules

As previously described in prior Advisory Bulletins, on Oct. 11, 2004, The American Jobs Creation Act added new Section 409A to the Internal Revenue Code to set new limits on non-qualified deferred compensation. Then the IRS issued Notice 2005‑1 on Dec. 20, 2004, providing promised guidance on the implementation of new Section 409A. Beginning in 2005, Section 409A effectively overhauls the tax treatment of non-qualified deferred compensation plans, including stock option and stock appreciation rights plans.

Highlights and Action Steps

Notice 2005-1 is not a comprehensive regulation under Section 409A. Rather, it provides preliminary guidance, in a “question and answer” format, prior to the issuance of more complete regulations. Notice 2005-1 provides important guidance on the following topics:

• Which plans are “non-qualified deferred compensation plans” subject to Section 409A
• How to treat deferrals of bonus payments
• What constitutes a “change in control” (one of the events that permits payment of deferred compensation)
• When payments can be accelerated
• How Section 409A applies to existing plans
• How existing plans can be modified or terminated
• What reporting and withholding requirements apply to employees and non-employees

In general, Notice 2005-1 gives employers until the end of 2005 to modify their plans to comply with Section 409A. The Notice also alleviates concerns about current deferral elections (i.e., elections being made now for compensation earned in 2005) by allowing elections to defer 2005 compensation to be made as late as March 15, 2005, provided that these “grace period” elections only apply to compensation to be paid after the election is made. The Notice effectively permits most post-2004 bonuses to be treated as performance-based compensation, for which a deferral election can be made as late as six months prior to the end of the 12-month (or longer) measurement period. This liberal definition of a "performance-based compensation" will apply until further guidance is issued. These and other transition issues are discussed below.

In short, plan sponsors should take the following steps:

• Review Notice 2005-1 and begin assessing how the guidance affects plan design and operation, with an eye toward a Dec. 31, 2005 deadline for amending plans to comply with Section 409A or terminating them. However, since the IRS has promised more guidance in 2005, plan amendments should be delayed, pending the future guidance.
• If deferral elections have been made with respect to 2005 compensation, determine whether changes are warranted in light of the guidance in Notice 2005‑1. If so, corrected elections should be made by March 15, 2005.
• If plan participants have not yet made deferral elections for 2005 compensation, those elections should be made by March 15, 2005, in a manner consistent with the guidance found in Notice 2005‑1.
• Confirm that any elections related to bonus compensation earned in 2005 satisfy the liberal standard described in the Notice, and arrange for bonus deferral elections to be made no later than six months prior to the end of the corresponding bonus measurement period.

Scope of Section 409A and Exemptions

Section 409A applies to any "non-qualified deferred compensation plan." The law does not define what constitutes a non-qualified deferred compensation plan, other than to say it is "any plan that provides for the deferral of compensation," excluding qualified plans and certain welfare benefits. Framed in a question/answer format, the Notice clarifies what constitutes a “deferral of compensation” and excludes some additional plans.

Deferral of Compensation. A plan provides for the deferral of compensation if an employee (or independent contractor) has a legally binding right to compensation payable in a later year. An individual does not have a legally binding right to compensation if that compensation may be unilaterally reduced or eliminated by the employer (or other person) after the services creating the right have been performed. Similarly, if the facts and circumstances of a situation indicate that the discretion to reduce or eliminate compensation is available only in connection with a condition that is unlikely to occur, or the actual reduction or elimination of compensation is unlikely to be exercised, then a worker will be considered to have a legally binding right to the compensation. Notice 2005-1, Q&A 4. (Further references to a “Q&A” will refer to Notice 2005-1.)

Short-Term Deferrals. The Notice states that "short-term deferrals" are not treated as deferred compensation under Section 409A. Short-term deferrals are defined as amounts of compensation that will be paid, absent any deferral election, by the later of:

• 2-1/2 months after the end of the workers' taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or
• 2-1/2 months from the employer's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture.

For amounts that are never subject to a substantial risk of forfeiture (as that phrase is defined in Notice 2005-1), the operative date is 2-1/2 months after the taxable year in which the worker has a legally binding right to the amount of compensation. Q&A 4(c).

Stock Options. Incentive stock options under Code Section 422 and options under an employee stock purchase plan under Code Section 423 do not constitute a deferral of compensation. Q&A 4(d)(iii). A non-statutory stock option is similarly exempt, but only if the option exercise price may never be less than fair market value of the underlying stock on the option grant date and the option does not include any feature for the deferral of compensation, other than the deferral of income pursuant to a deferred exercise or distribution of the option.

The Notice also provides that a non-statutory stock option will not fail the exception merely because it is substituted for another option in connection with a corporate transaction, provided that the ratio between the option price and fair market value in the new option remains the same as it was in the old option. This rule will be useful in corporate mergers where the surviving corporation wishes to replace existing stock options, but allow the optionees to retain the benefit of any built-up appreciation.

Stock Appreciation Rights. Unlike stock options, stock appreciation rights (SARs) have no liberal exemption under Section 409A. The IRS rejected pleas to exempt SAR altogether because they function the same as stock options. The Notice confirms that a SAR can be structured to meet Section 409A, primarily by including a fixed payment date (rather than payment when the holder exercises the SAR). This will be a drastic change for future SARs.

The Notice provides two limited exemptions for SARs. First, there is an exemption for SARs based on publicly traded stock, provided the SAR is paid in the form of stock. Second, pending further IRS guidance, SARs granted under a SAR plan that was in effect on or before October 3, 2004 are exempt from Section 409A, provided the SAR exercise price is not discounted and the SAR does not include any feature for additional deferral. Thus existing SAR plans without a fixed exercise date can continue to operate for now, if there is no additional deferral of income after the SAR is exercised. Q&A 4(d).

457 Plans and Substantial Risk of Forfeiture. The notice confirms that deferred compensation plans under Code Section 457(b), which are plans for tax-exempt and governmental employers, are free from the requirements of Section 409A. On the other hand, "ineligible" plans relying on Code Section 457(f) are subject to Section 409A. If 457(f) plans are structured so that the deferred compensation is paid upon vesting, they will meet Section 409A. Q&A 6.

The Notice comments on the definition of a “substantial risk of forfeiture,” which is relevant to many non-qualified deferred compensation plans and particularly key to Section 457(f) plans. A substantial risk of forfeiture requires that compensation be conditioned on performance of “substantial” future services or the occurrence of a condition related to the purpose of the compensation (such as attaining a prescribed level of earnings). In Notice 2005-1 the IRS said that merely refraining from performing services (a covenant not to compete) is not enough to constitute a substantial risk of forfeiture, at least for purposes of Section 409A. This raises the question of whether a similar interpretation applies for purposes of Section 457(f). Many tax-exempt employers have used a covenant not to compete as a substantial risk of forfeiture under their Section 457(f) plans, largely in reliance on IRS regulations under Section 83, which provide that a covenant not to compete may be a substantial risk of forfeiture in some circumstances. This is an area that needs further clarification.

The guidance also prohibits any extension of the period of a substantial risk of forfeiture, such as a “rolling risk of forfeiture” used by some plans. It also takes the position that a salary deferral cannot be made subject to a substantial risk of forfeiture, except to forego a current bonus for a later, materially greater bonus. In other words, the IRS thinks an employee would never put his own salary at risk. Q&A 6, 10. These positions will require major changes to many 457(f) plans in 2005.

SERPs. The Notice provides a couple of pointers to help supplemental executive retirement plans (SERPs), which are nonqualified plans that replace benefits that executives lose due to limits on qualified pension plans. Many SERPs pay supplemental benefits at the same time and in the same form as the employee elects under the qualified plan. The notice permits the non-qualified SERP to be controlled by an election under the qualified plan, but only for 2005. Q&A 23. Presumably, the IRS will issue permanent rules later. Also, the Notice gives guidance on how to calculate the portion of a defined-benefit type SERP that accrues before Jan. 1 2005 and is therefore exempt from the new law. It is the present value of the vested amount the employee would receive from the SERP if he voluntarily terminated on Dec. 31, 2004 and was paid at the earliest possible date allowed by the plan. Q&A 17.

Severance Plans. The Notice asks for further comment from the public on how Section 409A should apply to severance plans. The notice then exempts collectively bargained severance plans and those that cover no key employees during 2005, if they are amended to comply by the end of 2005.

Permitted Acceleration of Payments

Section 409A generally penalizes acceleration of payment from a non-qualified plan, but the law allows the IRS to make exceptions. The Notice provides some exceptions, perhaps the most important of which allows existing plans to continue to allow the employer to exercise discretion over the time and manner of payment of benefits. Q&A 18(a). Therefore, prior plans that allowed the employer to decide whether to pay benefits in a lump sum or in installments should be protected. The Notice also allows acceleration of payment to satisfy a domestic relations order, to accomplish a divestiture, or to pay employment taxes. It allows a 457(f) plan to accelerate payment to cover the income tax that comes due when the benefit vests (some 457(f) plans make such a partial payment upon vesting, then stretch out the remaining benefit plus earnings). Q&A 15.

The Notice also permits a “cash out” of small benefits. This allows plans to add a feature that accelerates payments of existing or future benefits worth less than under $10,000, in order to completely pay off a terminated participant in the year of termination. For future deferrals, a plan can add such a lump sum cash-out payment at any level. Q&A 15(e).

The employer can also accelerate vesting if that by itself does not trigger payment. For example, if a plan says that deferred compensation is forfeitable until the later of termination of employment or five years of service, the employer can waive the five-year vesting period so that the deferred compensation will be payable upon termination of employment. Q&A 15(a). This flexibility could be useful if the employer wanted to provide an early retirement incentive.

Deferral Bonus Payments

Section 409A raised several questions about how an employee should defer bonus payments. The new law requires that deferral elections be made prior to the calendar year in which services are rendered that give rise to the compensation. Strictly applied, this rule requires employees to make deferral decisions long before they know whether a bonus will be paid. For example, an employer with an annual bonus program for 2005 would typically not pay the bonus until after year-end, some time in 2006, but given the requirement to make deferral elections before the year in which the services are rendered, the employee would need to make a 2005 bonus deferral election by Dec. 31, 2004.

Section 409A softened this rule by providing that with respect to "performance-based compensation." Under this exception, an employee could make a deferral election as late as six months before the end of the period over which the performance pay was measured (which measurement period needs to be at least 12 months). Unfortunately, the Notice does not provide further guidance as to what constitutes "performance-based compensation." However, as a transition rule, and until additional guidance is issued, a deferral election with respect to "bonus compensation," which is based on services performed over a period of 12 months, will be treated as meeting the requirements of Section 409A, provided the deferral election is made at least six months before the end of the applicable measurement period. Q&A 22. The Notice defines "bonus compensation" to mean compensation that satisfies the following requirements:

• The payment or amount of the compensation is contingent on the satisfaction of organizational or individual performance criteria;
• The performance criteria are not substantially certain to be met at the time the deferral is made, or at the time the criteria are established; and
• If the performance criteria includes subject performance measurements the satisfaction of the criteria is gauged by someone other than the participating individual (or his or her family member); and
• The amount paid is not based solely on the value of, or appreciation associated with, the employer's business or equity units, such as stock.

Change in Control Events

Section 409A limits the distribution of deferred compensation to specific dates and events, including changes in the ownership or control of an employer or a substantial portion of its assets, but only to the extent the IRS permitted such triggering events. The Notice specifies that deferred compensation may be paid in connection with a Change in Control Event, which includes a change in the ownership of the corporation, a change in the effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation. Q&A 11. For these purposes, the “corporation” is (a) the corporation for whom the plan participant is performing services at the time of the Change in Control Event, (b) the corporation that is liable for the payment of the deferred compensation (or all corporations liable for the payment, if more than one is liable), or (c) a corporation that is a majority shareholder of a corporation identified in (a) or (b), or any corporation or chain of corporations in which each corporation is a majority shareholder of another in the chain, ending in a corporation identified in (a) or (b). In determining ownership, the stock attribution rules of Code Section 318(a) will apply, and the stock underlying the vested option is considered as owned by the individual who holds the vested option. Q&A 11.

Change in Ownership of a Corporation. A change in the ownership of a corporation occurs on the date that any single person, or more than one person acting as a group, acquires ownership of the stock of the corporation, such that when the acquired stock is added to the stock held by such person or group, the aggregate stock constitutes more than 50 percent of the total fair market value or total voting power of the stock of the corporation. In a situation where one person (or multiple individuals acting as a group) are already considered to own more than 50 percent of the total fair market value or total voting power of the stock of a corporation, then the acquisition of additional stock by that person (or group) is not considered to cause a change in the ownership of the corporation.

For purposes of determining whether multiple individuals are acting a group, they will not be considered to be acting as a group solely because they purchase or own stock of the same corporation at the same time, or as the result of the same public offering. However, they will be considered as acting as a group if they are owners of the corporation that enters into a merger, consolidation, purchase or acquisition of stock, or similar business transaction with the corporation.

Change in the Effective Control of the Corporation. Even in a situation where a corporation has not undergone a change in ownership, as described above, the corporation will be considered to have experienced a change in the effective control of the corporation on the date that either of the following occurs:

• Any one person, or multiple persons acting as a group, acquires (or has acquired during the preceding 12-month period ownership of stock of the corporation possessing 35 percent or more of the total voting power of the stock of such corporation; or
• A majority of members of the corporation’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 corporation’s board of directors prior to the date of the appointment or election.

For these purposes, if any one person, or more than one person acting as a group, is considered to effectively control a corporation, then the acquisition of additional control is not considered to cause a change in the effective control of the corporation.

Change in the Ownership of a Substantial Portion of the Corporation’s Assets. A change in the ownership of a substantial portion of the corporation’s assets occurs on the date that any person, or multiple individuals acting as a group, acquires (or has acquired during the preceding 12-month period) assets from the corporation that have a total gross fair market value equal to 40 percent or more of the total gross fair market value of all the assets of the corporation immediately prior to such acquisition or acquisitions. Q&A 14. For this purpose, gross fair market value means the value of the assets of the corporation, or the value of the assets being disposed of, determined without regard to any liabilities associated with such assets.

A change in the ownership of a substantial portion of a corporation’s assets is not triggered where the transfer is to an entity that is controlled by the shareholders of the transferring corporation immediately after the transfer. Specifically, a transfer of assets by a corporation is not treated as a change in the ownership of such assets if the assets are transferred to:

• A shareholder of the corporation (immediately before the asset transfer) in exchange for or with respect to its stock;
• An entity, 50 percent or more of the total value or voting power of which is owned, directly or indirectly, by the corporation;
• A person, or multiple persons acting as a group, that owns, directly or indirectly, 50 percent or more of the total value or voting power of all the outstanding stock of the corporation;
• An entity, at least 50 percent of the total value or voting power of which is owned, directly or indirectly, by a person described in the preceding item.

Transition Rules for 2005

The Notice provides many useful transition rules that generally give plans all of 2005 to determine how to come into compliance. (Even elections made by March 15, 2005 can be revoked by the end of the year.) There are also some options for plans to avoid the new rules entirely. These options should all be kept in mind while reviewing non-qualified plans this year.

New Elections for Prior Deferrals. Many existing plans contemplate that participants may select how deferred compensation should be paid by making an election well after the initial deferral election date. If these prior deferrals are not grandfathered (for example because they are not yet vested), the plan can be amended to allow participants to make elections during 2005 with respect to desired payout strategy of the prior deferrals. Q&A 19(c).

Fixing SAR Plans. An existing SAR plan that does not meet the exemption for existing plans described above (for example because SARs were issued at a discount) can issue substitute SARs during 2005 that bring it within the exemption. Or, during 2005 a SAR plan can substitute SARs that comply with Section 409A (for example that pay at a fixed date) for SARs that do not comply.

Suspend or Terminate Plan. An existing plan can be suspended or frozen without triggering payment, and this is not a “material modification” that triggers the application of Section 409A. Therefore if done before any further deferrals are made for 2005 (or if those deferrals are revoked during 2005), the plan should be entirely grandfathered. An employer can also terminate a plan entirely and pay out all deferred compensation in 2005. The compensation will of course all be taxable, but the plan will not have to worry about complying with 409A. Q&A 18.

Individual Opt-out. An existing plan can offer some or all participants the option to terminate participation in the plan during 2005. If the participant takes this option, amounts deferred are includable in income in 2005, or if later, in the year in which the amounts are “earned and vested.”

Amend to comply with 409A. The Notice also makes clear that a plan operated in good faith compliance with Section 409A has until Dec. 31, 2005 to be amended to bring it into compliance. Again, we expect more comprehensive regulations to be issued by that time.

For more information on this Advisory Bulletin, please contact:

Jeff Belfiglio Bellevue, Washington (425) 646-6128 JeffBelfiglio@dwt.com

Stuart Harris Portland, Oregon (503) 778-5428 StuartHarris@dwt.com

This Employee Benefits Advisory is a publication of the Employer Services Department of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in employment law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

Copyright © 2004, Davis Wright Tremaine LLP.

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