The New World of Executive Compensation After The American Jobs Creation Act - Part I

The American Jobs Creation Act of 2004 (the "Jobs Act") has radically changed the world of nonqualified deferred compensation in particular and executive compensation in general. The Jobs Act has created a new starting place for structuring nonqualified deferral and retirement plans, but has not necessarily reduced their use or flexibility. In fact, as we begin to understand the new rules more fully, we discover new opportunities for providing executives and employers with desired objectives.

The Jobs Act also impacts many other types of executive compensation, such as equity plans and employment, severance and change in control agreements. Part I of this article discusses the application of Section 409A to traditional types of nonqualified deferred compensation arrangements and Part II, which will appear in the next issue, discusses the new funding, reporting and withholding rules as well as their application to other types of executive compensation arrangements and tax exempt organizations.

Application Of New Legislation

The American Jobs Creation Act of 2004 creates a new section in the Internal Revenue Code that specifically deals with deferred compensation plans. This Section, 409A, applies to any "plan," "agreement," or "arrangement" that provides for deferral of compensation, other than tax-qualified plans and tax-deferred annuities, IRAs, SEPs, SIMPLEs, 457(b) plans and Section 501(c)(18) trusts, and plans providing for vacation, sick leave, disability, compensatory time, and death payments. Thus, application is not limited to elective arrangements but also applies to non-elective supplemental executive retirement plans (SERPs).

The new rules establish three new sets of constructive receipt rules. These rules are in addition to all existing rules. In other words, all of the existing rules regarding constructive receipt, economic benefit and assignment of income continue to apply.

Deferral Elections

The new rules address the timing of elections to defer income. These rules are similar to the rules that have historically been used by the IRS as safe harbors for constructive receipt except that they focus on when "services are performed" rather than on when amounts are "earned." Amounts that are deferred will not be taxed until received if the election to defer is made no later than the end of the calendar year preceding the year in which services are performed. The IRS safe harbor rule allowing elections within 30 days of the participant first becoming eligible to participate in the deferred compensation plan has been retained in the new provisions, but under proposed regulations, only applies if the participant is not already a participant in another employer sponsored plan of the same kind.

There is also an exception for the deferral of amounts meeting the future regulatory definition of "performance bonus." A performance bonus must be payable over at least 12 months and based on parameters established within the first 90 days of the performance period. Under such circumstances, the election to defer the bonus may be made as late as 6 months before the end of the performance period. Notice 2005-1 and proposed regulations include a temporary definition of "performance based compensation" which requires that the bonus be "contingent on the satisfaction of organizational or individual performance criteria" which are not "substantially certain to be met at the time of the election." Bonuses may include subjective criteria relating to the performance of the participant or a group of participants but the determination of such subjective criteria must not be made by the participant or a family member. The performance compensation does not include any amount that would be paid regardless of performance or based on a level of performance substantially certain to be achieved at the time the criteria is established.

Thus, the new rules follow prior timing of election principles fairly closely but clarify the required timing for bonus deferral elections, which has historically been a very fuzzy area of the law. The new rules codify what was previously the conservative interpretation of the law, but implement a new compromise allowing midyear deferrals for performance based bonuses.

Distribution Elections

The new distribution rules say that compensation or benefits that have been deferred may not be distributed any earlier than the occurrence of any of the following events:

1. Separation from service ( except that top employees of public companies must wait 6 months after separation from service );

2. Disability of the participant: a statutory definition is provided;

3. Death;

4. A specified time (or fixed schedule, but not at an event);

5. A change in control. Proposed regulations include a majority (50%) change in control definition.

Acceleration may be automatic or elected before deferral or may be at the discretion of the employer but apparently employees may not be given discretion to elect to accelerate distribution at or around the time of the change in control without compliance with the normal change rules discussed below; or

6. The occurrence of an unforeseeable emergency. A statutory definition is provided.

Changes In Distribution Elections

Distribution elections may not be accelerated under any circumstances except as discussed in the next paragraph. A plan may permit participants to change distribution elections to further delay a payment or change the form of a payment, as long as (1) the election does not take effect until at least 12 months after the date on which the election is made, (2) if the election relates to a distribution to be made on separation from service, a specified time or a change of control, then the payment with respect to which the election is made must be deferred for a period of at least 5 years from the date the payment would have otherwise been made, and (3) if the election relates to a specified time, then it must be made at least 12 months before the date of the first scheduled payment.

Acceleration of the time or schedule of any payment of benefits is not permitted. This is primarily intended to prevent what have been called "call" or "haircut" provisions - the imposition of a penalty (often 10%) on acceleration of distributions which was previously thought to avoid constructive receipt rules. The new legislation limits not only the employee but also the employer from accelerating distributions under the plan. Thus, plans will no longer be able to allow employers the discretion to accelerate distributions even on termination or restructure of a plan. The legislative history suggests the following exceptions may be implemented through regulatory guidance:

Accelerated distributions beyond the participant's control (e.g., distributions to comply with federal conflict of interest or court orders pursuant to divorce);

Withholding of employment taxes;

Distributions necessary to pay income taxes due to vesting in a section 457(f) plan;

Distributions of minimal amounts for "administrative convenience," e.g., cash-out amounts; and

Small benefit lump sum distributions (subject to the 6-month delay rule for key employees).

Application Of New Distribution Rules To Deferred Compensation Plans

The new distribution and change in distribution rules have had the most dramatic effect on the design and structure of nonqualified deferred compensation and retirement plans. Under prior law, participants were generally allowed to change at least the form, and often the commencement date, of retirement benefits up to one year prior to termination of employment. Under the new rules, distributions conditioned on retirement or termination of employment must be elected at the time of the original deferral election and may generally not be changed (even well in advance of retirement) without delaying commencement of the benefits at least 5 years beyond the date of retirement or termination. Because retirees and employers will rarely want to delay commencement of benefits until 5 years after retirement, this limitation effectively prohibits changes to retirement distributions. However, the flexibility lost in retirement elections may be made up to a significant extent by creative use of scheduled date distributions.

Under prior law, scheduled date or in-service distributions were available but conservative advisors did not allow or severely limited the ability to change such distributions. Also, plans generally allowed only one or two scheduled distributions and generally required funds to be paid out in a lump sum or over a fairly short period of time. The new rules specifically allow the change of scheduled distributions (as long as such changes meet the specified change rules) and do not limit the number of scheduled date elections or changes to such elections which a participant may make either before or after retirement. Thus, a participant who does not know the form in which she would like to receive her retirement benefits need only select a scheduled distribution date at least five years in advance of the year in which she wants to begin receiving benefits. Then, one year before such scheduled distribution, the participant can make a change election and specify any time and form of payout allowed under the plan as long as commencement is delayed by at least 5 years. If an employer is willing to offer participants maximum flexibility, a participant might establish 5 scheduled distribution dates in consecutive plan years and then have the ability beginning one year before the first scheduled date to annually decide how much of the amount elected for distribution in the following year to receive and how much to roll over another five years or more.

The proposed regulations create additional flexibility by providing that plans may allow separate distribution elections for specified payments, accounts or categories of funds as specified in the plan document and change elections may apply separately to each category and even to individual installments if the plan so provides.

The new rules no longer allow unscheduled withdrawal ("call" or "haircut") provisions which previously allowed participants to take unscheduled distributions by payment of a penalty. However, the election of early scheduled distribution dates for multiple accounts which can be rolled forward in five year increments allows flexibility to take deferrals out early if it becomes desirable or advisable to do so without penalty.

Thus, while the new rules dramatically change the form which distribution elections may take going forward, they do not necessarily reduce the amount of flexibility which may be provided to participants in connection with the timing of distributions. However, the clear disadvantage of the new rules is the difficulty in communication and administration of such complex alternatives.


If a plan fails to meet all of the requirements of the rules or does not operate according to the rules in any given taxable year, all the compensation for that taxable year and all preceding years is includible in gross income for that taxable year if it is not subject to a substantial risk of forfeiture. Additionally, the taxable amount is increased by interest for the entire time the plan is not in compliance and an excise tax of 20% is then added . The IRS has indicated that these penalties will be imposed individual by individual, so every participant will not be affected by the violation of one participant. The most significant impact of these severe penalties is likely to be the chilling effect on creative plan design.

Effective Dates and Transition Rules

The new rules are effective and apply to amounts "deferred" after December 31, 2004. (Earnings on amounts that are grandfathered are also grandfathered and not treated as additional deferrals). However, if plans are "materially modified" after October 3, 2004, then the grandfather treatment is lost and the amounts are subject to the new rules of section 409A. Notice 2005-1 and proposed regulations provide transition rules which give employers until December 31, 2006 to bring plans into compliance with the new rules. There has also been some informal indication that the deadline to amend plans may slip further if final regulations do not come out until late summer as now expected.

With respect to amounts subject to Section 409A or prior deferrals being brought into compliance with the new Section 409A rules, plans may be amended to provide for new payment elections with respect to amounts deferred prior to the election and the election will not be treated as a change in the form and timing of a payment under Section 409A provided that the plan is amended and the participant makes the election on or before December 31, 2006, as long as the new election does not have the effect of deferring payments scheduled to be made in 2006 or accelerating payments into 2006. Thus, except with respect to 2006 payments, employers may restructure plans and give employees the right to make new payout elections with respect to existing account balances under the new structure at any time on or before December 31, 2006.

Published July 1, 2006.