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 impacts not only traditional deferred compensation arrangements but many other types of executive compensation arrangements, such as employment agreements and equity, incentive, severance and even some welfare benefit plans, in often counterintuitive ways that will continue to plague employers and executives for some time. The impact of the Jobs Act on traditional nonqualified deferred compensation arrangements was discussed in Part I of this Article in our prior edition. This Part II discusses the impact of the Jobs Act on other types of executive compensation arrangements and deferred compensation arrangement of tax-exempt employers.
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 plans providing for vacation, sick leave, disability, compensatory time, and death payments. Section 409A is not limited to elective non-qualified deferred compensation arrangements but also applies to non-elective plans and other arrangements which the regulations interpret as "providing for the deferral of compensation." Because most arrangements other than voluntary deferral arrangements do not have deferral elections, the most significant applicable requirements under Section 409A to be aware of in other types of arrangements are: (i) the requirement that the timing of payments be specified in writing, (ii) that payment on termination of employment to "key employees" of a public company be subject to a 6-month delay and (iii) that neither party, nor both parties acting together, have the ability to accelerate or change the timing of distributions, except as permitted under Section 409A.
Short Term Payment Exception
The proposed regulations issued last September provide that the new rules are not intended to apply to bonus plans or other compensation arrangements where compensation is paid within 21 /2 months after the close of the taxable year in which the right to the compensation is earned and vested (the "Short Payment Period"). However, to the extent that a compensation arrangement provides for payments beyond this period, it will be subject to the new rules. Proposed regulations provide that if the arrangement does not specify the timing of the payments and payments are in fact made within the Short Payment Period, the payments will not be treated as deferred compensation subject to Section 409A. However, if payments are not made within the Short Payment Period they will be subject to Section 409A and may, therefore, have failed to comply with the requirements and be subject to an excise tax. Thus, it is important that all compensation arrangements now specify the timing of all payments in order to avoid the inadvertent application of Section 409A.
Definition Of Substantial Risk Of Forfeiture
The Short Payment Period discussed above commences upon the "vesting" of the right to the payment. Vesting occurs when a payment is no longer subject to a "substantial risk of forfeiture." The proposed regulations include a new definition of "substantial risk of forfeiture" and provide that compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. Interestingly, the new rules provide that substantial risks of forfeiture added after the beginning of the service period to which the compensation relates are disregarded for purposes of determining whether the compensation is subject to a substantial risk of forfeiture (i.e. rolling risks of forfeiture will not work). In addition, unlike the substantial risk of forfeiture standard that applies under Section 83, an amount is not subject to a substantial risk of forfeiture under Section 409A merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services. Thus, non-competes will not constitute a substantial risk of forfeiture under the Section 409A definition. Proposed regulations also provide that an amount will not be considered subject to a substantial risk of forfeiture beyond the date or time at which the recipient otherwise could have elected to receive the amount of compensation, unless the amount subject to a substantial risk of forfeiture (ignoring earnings) is materially greater than the amount the recipient could have elected to receive. As a result, a salary deferral generally may not be made subject to a substantial risk of forfeiture. Proposed regulations also question whether amounts that may be paid on termination "for good reason" are subject to a substantial risk of forfeiture. As a result, many severance payments may be subject to Section 409A. Finally, Notice 2005-1 and proposed regulations include guidance regarding substantial risks of forfeiture when the service provider has a significant ownership interest in the service recipient.
Application To Bonus Plans
Section 409A should not apply to annual bonus plans to the extent that bonus payments are made within the Short Payment Period. However, it would be safest to specify this timing in bonus plan documents or an employment agreement in order to avoid the inadvertent application of Section 409A if bonus payments are not made by this date. To the extent that a multi-year bonus plan or other arrangement provides for the payment of compensation beyond the Short Payment Period, it will be subject to the new rules. Also, to the extent that voluntary deferral plans allow the deferral of bonus amounts, it may be necessary to make sure the bonus plans comply with the definition of "performance based compensation" under the new rules to enable the deferral of bonuses 6 months before completion of the performance period.
Application To Employment Agreement
Section 409A may apply to many types of payments under an employment or consulting agreement. It is, thus, important to specify the timing of each type of payment to either exclude it from application of Section 409A as within the Short Payment Period or comply with Section 409A specified payment date requirements. Application of the six-month delay requirement may be avoided by specifying payments to be made within the Short Payment Period. The timing of severance payments should no longer be at the discretion of the employer, and care should be taken to comply with Section 409A if severance is payable upon termination for good reason. While the continuation of some forms of benefits after termination of employment will not be considered deferred compensation, proposed regulations are less than perfectly clear about what type of benefits may be extended, and for how long, without becoming subject to application of Section 409A. If there is any possibility of payments being made or benefits provided outside the Short Payment Period, appropriate Section 409A language should be included in the employment agreement to provide for application of the six-month rule on termination of employment of a key employee, and to specify that the parties shall not have discretion to accelerate or change the timing of payments in violation of Section 409A.
Notice 2005-1 and proposed regulations make clear that the grant of a stock option, SAR, or other equity-based compensation may provide for deferral of compensation that is subject to the new rules subject to the following limitations:
(i) Stock Options: The grant of incentive stock options under Section 422 and the grant of an option under an employee stock purchase plan under Section 423 do not constitute deferrals of compensation under Section 409A. All other options to purchase stock of the service recipient will not constitute deferrals of compensation only if all of the following requirements are satisfied: (1) the exercise price is not less than the fair market value of the underlying stock on the grant date, (2) the receipt, transfer or exercise of the option is subject to taxation under Code Section 83, and (3) the option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option. For purposes of determining the fair market value of stock at the date of grant, the regulations include valuation rules for public companies and for not public entities, any reasonable valuation method may be used until further guidance is issued. Proposed regulations further specify that the stock must be common stock of the service recipient or its parent.
(ii) Stock Appreciation Rights: Proposed regulations provide that the grant of a SAR for the stock of the service recipient does not constitute a deferral of compensation if the SAR exercise price is not less than the fair market value of the underlying stock on the date the right is granted, and the right does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the right.
(iii) Restricted Property: Proposed regulations provide that there is no deferral of compensation if a service provider receives property merely because the value of the property is not includible in income (under Section 83) in the year of receipt by reason of the property being nontransferable and subject to a substantial risk of forfeiture, or is includible in income (under Section 83) solely due to a valid election under Section 83(b). However, the new rules do apply to the receipt of a legally binding right to receive property (whether or not the property is restricted property) in a future year. Thus, restricted stock units or phantom stock will generally be subject to the new rules, while restricted stock will not (assuming the requirements prescribed above are satisfied).
(iv) Partnership Interests: Notice 2005-1 and proposed regulations provide that while Section 409A will apply to compensation deferral arrangements between a partner and a partnership, until further guidance is issued, an issuance of or grant of an option to purchase a partnership interest in connection with the performance of services will be treated in the same manner as an issuance or option grant of stock.
Split Dollar Life Insurance
Proposed regulations indicate that collateral assignment split dollar life insurance arrangements and, under some circumstances, even endorsement structure split dollar arrangements may be subject to Section 409A. Special guidance is expected to be issued later this year to address the application of Section 409A in this context and the interaction between the transition rules under Section 409A and the grandfathering rules under the new split dollar regulations which were effective September 17, 2003.
Likely Application To Tax-Exempt Organizations
Tax-exempt organizations are subject to special deferred compensation rules under Section 457. Section 457(b) eligible plans are specifically exempted and only Section 457(f) plans are subject to the new rules. Because Section 457(f) plans generally do not involve voluntary deferrals of compensation, they will be subject to the new timing of deferral election rules. Also, Section 457(f) plans generally cliff vest benefits on retirement and do not offer any choices regarding the time and form of distribution nor any opportunity to accelerate distributions, except on death or disability. Thus the new rules limiting forms of distribution, acceleration and changes in distributions should not affect Section 457(f) plans significantly.
Benefits payable under Section 457(f) plans are often conditioned upon a "substantial risk of forfeiture." Thus, the new definition of "substantial risk of forfeiture" which excludes rolling risks of forfeiture and noncompete provisions, if applied to Section 457, may significantly impact Section 457(f) plans.
The new rules are likely to require certain definitional changes such as the definition of disability under the plan. They may also require amendment of termination provisions which allow employers to liquidate the plan. Also, the new reporting requirements will apply to Section 457(f) plans. The new rules may also have adverse tax consequences for other plans that are not covered by Section 457(f), such as severance plans, split dollar, SAR and discounted option plans that may be sponsored by tax-exempt organizations.
Published August 1, 2006.