| EXECUTIVE
SUMMARY |
 THE AMERICAN JOBS CREATION
ACT ADDED IRC section 409A and
significantly changed the rules for
nonqualified deferred compensation plans.
For a deferral to escape current
taxation, it must be subject to a
substantial risk of forfeiture and must
follow limited deferral and distribution
rules. ALL NQDC ARRANGEMENTS MUST
FOLLOW section 409A unless
specifically exempted. Among the
arrangements that must comply are IRC
section 401(k) mirror, shadow and tandem
plans; IRC section 457(f) plans; certain
stock option and stock appreciation
rights; and phantom restricted and
deferred stock plans.
THE NEW RULES DON’T
COVER CERTAIN SEVERANCE plans,
SARs that meet certain rules, short-term
deferrals paid by the later of 21/2
months from the end of the
employer’s tax year or 21/2
months from the end of the
participant’s tax year, nonstatutory
stock options, tax-qualified employer
plans and certain welfare benefit plans.
UNDER SECTION 409A, NQDC PLAN
DISTRIBUTIONS are permitted only
in the event of separation from service,
disability, death, a change in employer
control or an unforeseeable emergency.
Distributions also can be made at a
specified time or under a fixed schedule,
as stated in the plan at the time of
deferral. The law also permits plans to
make accelerated distributions under
certain circumstances.
IN CALENDAR YEARS BEGINNING
AFTER DECEMBER 31, 2004, new
reporting rules apply to
non-account-balance NQDC plans. All
amounts deferred must be reported to the
IRS on form W-2 or form 1099.
SIGNIFICANT PENALTIES APPLY
FOR NONCOMPLAINCE with section
409A. In addition to having compensation
included in income, tax penalties equal
to the IRS underpayment rate plus 1% from
the time the compensation should have
been included in income plus 20% of the
compensation amount apply.
|
| BARTON J. BRADSHAW, JD, is an
advanced marketing attorney with Genworth
Financial Inc. in Richmond, Va. MARK
PAPALIA, CLU, ChFC, CFP, is founder and
president of Papalia Financial in
Danville, Pa. His e-mail address is mpapalia@papaliafinancial.com. Neither Genworth Financial nor
Papalia Financial engage in the practice
of law or provide legal advice. |
here’s a new set of rules for players in the
high-stakes nonqualified deferred compensation
(NQDC) game. The American Jobs Creation Act of
2004 established IRC section 409A, which affects
existing NQDC plans for companies and executives
alike. The section broadly defines a
“deferral of compensation” to include
all amounts employees defer under such plans.
These amounts are included in gross income unless
they are subject to a substantial risk of
forfeiture or were previously included in income.
To avoid this draconian tax
treatment, section 409A significantly restricts
when plan participants may make deferral and
distribution elections, and narrowly defines when
they can take distributions. Section 409A also
includes rules for certain trusts located outside
the United States or that provide benefits only
when the plan sponsor’s financial health
declines. In December 2004 the IRS issued notice
2005-1, which provided interim guidance on the
new rules; the IRS says it will issue additional
guidance later in 2005.
CPAs need to help clients and
employers review existing NQDC plans to determine
whether the new rules affect them, and if so,
what actions to take to bring the plans into
compliance. Managing partners at CPA firms also
need to make sure any NQDC plans they maintain
comply. This article summarizes the main points
of section 409A, including a review of new
reporting rules, and offers some planning tips
for 2005.
WHEN
AND WHAT
The new rules
apply to amounts deferred after December 31,
2004. Amounts deferred before that date, as well
as future earnings, are not subject to section
409A unless the plan was “materially
modified” after October 3, 2004. To avoid
the penalties section 409A imposes, NQDC plans
that do not comply must be amended by December
31, 2005, and must act in good-faith compliance
until then.
CPAs who work with NQDCs need
to be aware of some new definitions:
Deferred
compensation. Deferred compensation
includes payments to which participants have a
legally binding right but have not received or
included in their gross income, and which is
payable in a later year. Whether a right is
legally binding is determined by looking at the
plan and the relevant facts and circumstances. A
participant does not have a legally binding right
to compensation if the employer can unilaterally
reduce or eliminate it after the employee
performs the services. However, a
participant’s right is legally binding if
the compensation can be reduced or eliminated
only upon an unlikely condition, such as a 50%
drop in the Dow Jones industrial average during a
given calendar year.
The plan. A
plan includes any agreement, method or
arrangement, even if it applies only to one
individual. A company may adopt a plan
unilaterally or negotiate arrangements with
individual employees. Under section 409A a plan
is considered NQDC regardless of whether it
qualifies under the Employee Retirement Income
Security Act (ERISA).
Substantial risk of
forfeiture. Compensation is subject
to such risk if employees are entitled to it only
when they perform substantial future services or
when a condition related to the
compensation’s purpose occurs (such as
meeting certain earnings targets). The
substantial risk must be identified before the
beginning of the service period. A risk of
forfeiture generally will not be considered
substantial if it is based on refraining from
performing services (such as a covenant not to
compete), or on a condition extending beyond the
date or time the recipient otherwise could have
elected to receive the compensation (such as with
a salary deferral).
WHAT
THE RULES COVER…
All NQDC
arrangements must follow section 409A unless
specifically exempted. Examples of NQDC include
IRC section 401(k)
mirror, shadow and tandem plans. These
are defined contribution plans controlled by
payment elections participants make under a
qualified plan. Under section 409A it may no
longer be permissible for participants to
coordinate NQDC deferrals with qualified plan
elections. Short-term relief: For periods ending
on or before December 31, 2005, an election on
the timing and form of payments under a mirror
plan will not violate section 409A if the timing
and form are based on the plan’s terms as of
October 3, 2004.
IRC section 457(f)
plans. Maintained by state and
tax-exempt organizations these NQDC plans do not
meet the requirements of section 457(b) as
“eligible” deferred compensation
arrangements. Participants usually must report
and pay income taxes in accordance with section
457(f) when the benefit is vested, not when
it’s distributed.
Certain stock
option plans. A nonstatutory stock
option is deferred compensation if
 The amount required to
purchase the stock is less than its fair market
value on the date of grant.
The receipt, transfer or
exercise is not subject to IRC section 83.
There is a deferral feature
other than postponing income recognition until
the later of the exercise or disposition of the
option.
Under section 409A, discounted
nonstatutory stock option programs are considered
NQDC grants.
Certain stock
appreciation rights (SARs). SARs
generally are not NQDC unless they fit an
exemption described below. Notice 2005-1 does not
exempt SARs issued by privately held companies
from section 409A, although future guidance is
expected to address this issue.
Phantom stock
plans. These plans usually feature
awards based on hypothetical shares of company
stock. All cash and stock dividends and splits
are credited to the hypothetical shares in the
employee’s account. At distribution, the
employee receives the investment experience of
these shares.
Deferred stock. This
is the legally binding right to receive stock
from the employer in the future.
Certain bonuses. Cash
bonuses that do not meet short-term deferral
requirements.
…AND
WHAT THEY DON’T
Although taxpayers
don’t have to include the following
arrangements in income under section 409A, they
still may have to include them under other
applicable IRC provisions or common law tax
doctrines.
Certain severance
plans. These are benefits payable
under a plan upon an employee’s involuntary
termination. A plan that provides severance
benefits and is either collectively bargained or
covers key employees is not required to follow
section 409A during calendar year 2005.
Exempted SARs. A
stock appreciation right is not a deferral of
compensation if
The value of the stock is
not less than its fair market value on the date
it is granted.
The stock is traded on an established
securities market.
Only that specific stock may be
delivered in settlement.
The only deferral-of-compensation
feature is postponing income until the employee
exercises the right.
Until the IRS gives further
guidance, both public and private companies need
to meet only the third and fourth requirements if
the SAR was granted under a program in effect on
or before October 3, 2004.
Restricted stock. Actual
shares granted subject to time or
performance-based vesting.
Short-term
deferrals. There is no deferral of
compensation if the participant receives payment
by the later of 21/2 months from the end of the
employer’s first taxable year in which the
amount is no longer subject to a substantial risk
of forfeiture, or 21/2 months from the end of the plan
participant’s first taxable year in which
the amount is no longer subject to a substantial
risk of forfeiture.
Nonstatutory stock
option plans. An option to purchase
employer stock (other than IRC section 422
incentive stock options or section 423 employee
stock purchase plan options) does not defer
compensation if: The exercise price is not 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 section 83; and the
option’s only deferred compensation feature
is postponing income until the later of exercise
or disposition of the option.
Statutory stock
option plans. An incentive stock
option grant, described in section 422, or an
option grant under an employee stock purchase
plan described in section 423.
Tax-qualified
employer plans. NQDC does not
include qualified retirement plans, tax-deferred
annuities, simplified employee pensions (SEPs),
SIMPLEs, IRC section 501(c)(18) trusts, section
457(b) deferred compensation plans or any plan
described in IRC section 415(m).
Certain welfare
benefits. NQDC does not include
vacation or sick leave, compensatory time,
disability pay or death benefit plans; IRC
section 220 Archer Medical Savings Accounts; IRC
section 223 Health Savings Accounts or most other
medical reimbursement arrangements.
 360
Degrees of Financial Literacy Is Gaining
National Recognition In April, the AICPA
participated in a financial literacy fair
on Capitol Hill hosted by Rep. Ruben
Hinojosa (Texas) and Rep. Judy Biggert
(Ill.), cofounders and cochairs of the
Financial and Economic Literacy Caucus,
and by Jump$tart, Junior Achievement and
the National Council on Economic
Education. The event attracted
legislators and their staffs wanting to
learn more about financial literacy
programs.
In his floor remarks on House
Resolution 148, “Supporting the
Goals and Ideals of Financial Literacy
Month,” Congressman Hinojosa cited
360 Degrees along with other programs to
improve Americans’ financial
literacy.
360 Degrees of Financial
Literacy won the 2005 Communicator
Crystal Award of Excellence, honoring
programs that exceed a high standard of
excellence and serve as a benchmark for
the communications industry.
Thank you to all CPAs
and state CPA societies for helping to
spread the word about the 360 Degrees
effort and mobilizing CPAs at the
grassroots to get involved.
Financial literacy
information for consumers is available at
www.360financialliteracy.org. CPA Resources are available at
www.aicpa.org/financialliteracy/index.asp.
|
DISTRIBUTION EVENTS
Under the new
rules in section 409A, NQDC plan distributions
are permitted only in the event of
Separation from
service. If a plan participant who
leaves a publicly traded company is a key
employee (a “specified employee”),
distributions cannot occur until six months after
service ends (or at death).
Disability. Participants
are disabled if they suffer from a physical or
mental impairment that is expected to last at
least 12 months or to result in death, and which
prevents them from engaging in any substantial
gainful activity or entitles them to receive
benefits under an employer-sponsored accident and
health plan for a period of at least three
months.
Death. NQDC
plans may make immediate distributions upon the
participant’s death.
Specified time or
fixed schedule. Amounts payable at
specified times or under a fixed schedule must be
stated in the plan at the time of deferral;
amounts payable when a given event occurs are not
treated as payable at a specified time. (Amounts
payable when an individual attains age 65 are
considered payable at a specified time; amounts
payable when a child begins college are not.)
Change in employer
control. A plan may allow a payment
when there is a change in ownership or effective
control of a corporation or of a substantial
portion of its assets (collectively called a
“change in control event”). To qualify,
an occurrence must be objectively determinable
and any requirement that another person certify
the occurrence must be strictly ministerial and
not involve discretionary authority. For example,
a director who certifies that a change in control
has taken place based solely on the objective
criteria in section 409A is performing a
ministerial function. A director who makes such a
certification based on his or her subjective
judgment has used discretionary authority.
Unforeseeable
emergency. Distributions may be
given in the amount needed to satisfy emergencies
resulting in severe financial hardship such as
illness or accident of plan participants, spouses
or dependents or extraordinary unforeseeable loss
of property due to casualty; plus any resulting
taxes.
EXCEPTIONS
TO EVERY RULE
NQDC plans can
permit accelerated payments only in these
circumstances:
Participant waiver
or acceleration. A plan may waive
or accelerate the satisfaction of a condition
representing a substantial risk of forfeiture
without violating section 409A. For example, if
the plan provides for a lump-sum payment of the
vested benefit on separation from service that
vests only after 10 years of service, it is not a
violation of section 409A if the vesting
requirement is reduced to 5 years of
service—even if the participant becomes
vested as a result and qualifies for a payment
upon separation from service.
Domestic relations
order. A payment to an individual
other than the participant required to fulfill a
domestic relations order.
Conflicts of
interest. A payment to comply with
a certificate of divestiture (the disposal of
assets by certain public officials to avoid
conflicts of interest).
Section 457(f)
plans. When payment is made to a
section 457(f) plan participant to cover income
taxes due upon a vesting event, provided the
amount is not more than the withholding the
employer would have remitted had there been a
wage payment.
Amounts under
$10,000. A plan may be amended to
allow (for the first time only) accelerated
payments to a participant, provided the payment
is less than $10,000; accompanies the termination
of the participant’s entire interest in the
plan; and is made on or before the later of
December 31 of the calendar year the plan
participant separates from service or 21/2 months after the actual separation
date. The amendment can apply to previously
deferred amounts as well as future deferrals.
Specified amounts. An
NQDC plan may be amended so that if the value of
a participant’s account falls below a
specified amount, the entire interest will be
distributed as a lump sum.
Employment taxes. A
payment that enables the participant to pay FICA
taxes on deferred amounts as well as any federal
or state income taxes due on the FICA payment.
The total payment may not exceed the FICA amount
and related withholding.
Termination of
participation/cancellation of deferral election. A
plan adopted before December 31, 2005, may be
amended during 2005 to allow an employee to
terminate participation or cancel a deferral
election during calendar year 2005, provided the
amounts involved are includable in the
participant’s income in the year they are
earned and vested.
 DEFERRAL
TIMING
Prior to section
409A, many NQDC plans allowed participants to
alter the form or timing of distributions as long
as the changes occurred before the deferred
compensation payments began. Under the new rules,
a participant’s election to defer
compensation must be made no later than the end
of the preceding tax year. The time and form of
distributions must be specified either in the
plan document or at the time of initial deferral.
Some exceptions to these rules
apply, however. The first year an employee
participates in an NQDC plan, the election may be
made within 30 days of eligibility. A deferral
election for performance-based compensation paid
for services over a period of at least 12 months
may be made no later than six months before the
end of the period. Additional guidance is
expected to outline the requirements for
compensation to qualify as performance-based. It
likely will be more restrictive than the guidance
in notice 2005-1, Q&A 22. For purposes of
transitional relief, the IRS defines “bonus
compensation” as contingent on satisfying
organizational or individual performance criteria
not substantially certain to be met at the time
of the election.
NQDC plans also may be amended
to provide for new payment elections on amounts
deferred before the new law. Elections will not
be treated as changes in the form and timing of
payments if the participant makes them on or
before December 31, 2005.
Unless otherwise excepted, NQDC
plans may allow a subsequent election to delay
the timing or form of distributions only if the
election cannot be effective for at least 12
months after it is made or 12 months before the
first scheduled payment; and the plan requires
the additional deferral be for a period of not
less than five years from the date the payment
would otherwise have been made except for
distributions on account of death, disability or
unforeseeable emergency.
INITIAL
DEFERRALS IN TRANSITION
For deferrals
involving services performed on or before
December 31, 2005, the code requirements for the
timing of elections will not apply to elections
made on or before March 15, 2005, provided
Amounts deferred have not
been paid or will not become payable at the time
of election.
The plan was in writing and in effect
on or before December 31, 2004.
Elections are made under the plan
terms.
The plan is otherwise operated in
accordance with section 409A.
The plan is amended before December
31, 2005, to comply with section 409A.
FOREIGN
TRUSTS AND SPRINGING PLANS
Assets set aside
(directly or indirectly) in a trust or similar
arrangement to pay NQDC are treated as property
transferred in connection with the performance of
services under section 83 at the time they are
set aside if the assets (or the trust holding
them) are located outside the United States or
are later transferred outside the United States.
Any subsequent increase in the value of, or any
earnings on, such assets are treated as
additional transfers. This provision specifically
applies to foreign trusts and arrangements
(usually called offshore Rabbi trusts) that
effectively shield assets intended to satisfy
NQDC arrangements from the claims of general
creditors.
In a typical springing plan, an
adverse change in the employer’s financial
condition (such as a declining net worth) causes
the NQDC plan assets to become distributable to
the participant or to be transferred to a
separate trust offering additional creditor
protection. It is a violation of section 409A for
a plan to provide that employer assets will
become restricted only to fund a deferred
compensation obligation in the event the
employer’s financial health changes.
NEW
REPORTING REQUIREMENTS
New reporting
rules apply to NQDC plans. They are effective for
amounts deferred in calendar years beginning
after December 31, 2004, as well as to income
attributable to such amounts. The Treasury
Department and the IRS anticipate issuing
additional guidance that will provide CPAs with a
way to calculate the deferral amount for
non-account-balance plans. Some of the key
requirements include
Annual reporting on form
W-2 or form 1099 of all amounts deferred, whether
or not includable in income for the year.
For calendar year 2005,
amounts includable in gross income under section
409A but neither actually nor constructively
received by a plan participant for income tax
withholding purposes may be treated as having
been paid on any date on or before December 31,
2005. Amounts includable in gross income under
section 409A that a participant actually or
constructively receives during calendar year 2005
are considered wages when the participant
receives them for purposes of withholding,
depositing and reporting income taxes.
There is no reporting
requirement where deferrals benefit a person for
whom a form 1099-MISC or a form W-2 does not have
to be filed, do not exceed $600 for an individual
participant or are not reasonably ascertainable.
ACCOUNTING
FOR GRANDFATHERED AMOUNTS
Grandfathered
amounts refer to deferred compensation not
subject to section 409A.
Non-account-balance
plans. Compensation deferred before
January 1, 2005, under non-account-balance plans
equals the present value—as of December 31,
2004—of the amount participants would be
entitled to if they voluntarily terminated
services without cause on December 31 and
received a full payment from the plan on the
earliest possible date allowed to the extent the
right to the benefit is earned and vested as of
December 31, 2004. To determine the present
value, CPAs should use the actuarial assumptions
in the plan, if reasonable. Otherwise, reasonable
assumptions must be substituted. Amounts
participants would not be entitled to at
termination, such as early retirement subsidies,
are not includable as compensation deferred as of
December 31, 2004.
Account-balance
plans. The amount of compensation
deferred before January 1, 2005, under such a
plan equals the earned and vested portion of the
participant’s account balance as of December
31, 2004.
Equity-based
compensation plans. To determine
the amounts deferred before January 1, 2005,
under such a plan, CPAs should apply the rules
governing account-balance plans with one
exception. The account balance is the earned and
vested amount available on December 31, 2004 (or
available if the right were immediately
exercisable). The payment available excludes any
exercise price or other amount participants must
pay.
Earnings. Earnings
on amounts deferred under an NQDC plan before
January 1, 2005, include only income attributable
to deferrals as of December 31, 2004. For
non-account-balance plans, earnings include the
increase in the present value of the future
payments to which the participant has obtained a
legally binding right. Thus, earnings will
increase each year due to the shortening of the
discount period before future payments are made,
plus any applicable increase in present value
because the participant survived another year.
PENALTIES
If an NQDC plan
fails to meet all the requirements of section
409A, or is not operated in accordance with those
rules, all compensation for the taxable year and
all preceding years is includable in
participants’ gross incomes to the extent it
is not subject to a substantial risk of
forfeiture (and not previously included in
income). Significant additional tax penalties
also apply. First, the amount is increased by the
IRS underpayment rate plus 1% from the time it
should have been includable in income for the
year first deferred (or, if later, the first
taxable year the amount is not subject to a
substantial risk of forfeiture). The law also
levies an additional tax of 20% of the
compensation included in gross income.
TAKE
ACTION TODAY
The new rules
offer a number of planning opportunities CPAs
should consider with their employers or clients.
Review existing
plans. Companies need to
immediately determine whether their existing NQDC
plans are affected by the new rules. In addition
to a CPA, the review team ideally should include
the plan administrator, legal counsel and
investment consultant. Participants should be
notified of the review and, if appropriate, asked
to participate. To avoid the appearance of a
conflict of interest, participants may wish to
retain independent legal or tax counsel.
Accounting firms also should review their own
plans to make sure they are in compliance with
the new rules.
Make necessary
notifications and approvals. The
company should notify all affected parties as
soon as possible about the new rules and any
recommended actions. For most companies, amending
an NQDC plan or adopting a new one will require
the approval of the board of directors as well as
plan participants.
Amend existing
plans. Most existing NQDC plans can
be safely amended to comply with the new rules.
CPAs should be sure the company makes only
“nonmaterial modifications” that do not
enhance a benefit or right existing as of October
3, 2004, or add a new benefit or right. (See the exhibit below for examples of material and
nonmaterial modifications.)
| Material
Modifications: Proceed With Caution |
Prohibited
material modifications
 Amending a plan to
allow payments upon request if
participants forfeit a percentage of the
payment (a “haircut”). Adding a right to payments
upon an unforeseeable emergency.
Granting an additional
benefit under an existing arrangement
that consists solely of a deferral of
additional compensation not otherwise
provided under the plan as of October 3,
2004. Only the additional deferral will
be treated as a material modification if
the plan explicitly identifies it and
says the additional deferral is subject
to section 409A.
Permitted
nonmaterial modifications
Exercising
discretion over the time and manner of a
benefit payment to the extent allowed
under the terms of the plan as of October
3, 2004.
Exercising a right permitted
under the plan in effect on October 3,
2004.
Changing a notional
investment measure to eliminate or add a
measure that qualifies as a predetermined
actual investment.
Removing a
“haircut” provision.
Removing a provision allowing
plan participants to revoke or change
deferral elections in midyear.
Removing a provision
permitting distributions when an
impermissible event, such as a
participant’s wedding, occurs.
Removing funding triggers
related to the employer’s financial
health.
Amending a plan to stop
future deferrals (freezing an old plan).
|
Terminate
existing plan. If an NQDC plan is
terminated by amendment on or before December 31,
2005, and plan assets are distributed, no
violation of section 409A occurs, although all
amounts deferred will be included in income in
the year the termination occurs. If the amendment
terminates a participant’s interest but not
the plan itself, then only the payout to that
individual will be considered a taxable
distribution.
Adopt a new plan. As
shown above, there is a presumption that all NQDC
plans enacted after October 3, 2004, are subject
to the new rules and should be drafted
accordingly. A new plan that does nothing more
than supplement an existing plan still may be
considered a material modification; this
presumption may be rebutted by demonstrating the
new plan is consistent with the
participant’s historical compensation
practices. For example, the presumption that the
grant of a stock appreciation right on November
1, 2004, is a material modification to the plan
may be rebutted by demonstrating the grant was
consistent with the company’s historic
practice of granting substantially similar stock
appreciation rights (both as to terms and
amounts) to employees each November for a
significant number of years.
LOOKING
AHEAD
For the remainder
of 2005, CPAs should concentrate on helping
employers and clients fully understand the impact
of section 409A on existing NQDC plans and on
bringing those plans into full compliance by
yearend. Then CPAs can focus on helping companies
turn the new rules to their advantage by
recommending creative compensation strategies
that follow the letter of the law but also meet
the specific goals of the company and its
employees.
|
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