Commentary: Nonqualified deferred compensation plans subject to

On October 22, 2004, the President signed into law the American Jobs Creation Act of 2004, thereby adding new Section 409A to the Internal Revenue Code. Section 409A will govern the inclusion in gross income of deferred compensation under nonqualified deferred compensation plans, and the new law is generally effective for amounts deferred after December 31, 2004. The new law has been described as deceptively simple. It raises many questions and issues, and affected employers need to address this law promptly or risk creating highly adverse tax consequences for executive-level employees.

Even amounts deferred before 2005 could become subject to the new law if the plan under which deferrals were made is the subject of a material modification after October 3, 2004. For example, the acceleration of vesting after October 3, 2004, would be a material modification, thereby subjecting pre-2005 deferrals to the new law. The Treasury Department expects to issue transition guidance by December 21, 2004, implementing certain provisions of the new law. The Treasury Department also expects to issue detailed operating rules as soon as possible in 2005.

Because there are various concerns and questions about the application of Section 409A, because the first guidance will be issued in late December, and because the January 1, 2005 effective date is close at hand, employers need to make an inventory as soon as possible of deferred compensation plans they have established which will be subject to the new law. Employers should not, however, make amendments to existing deferred compensation plans before regulations are issued, in order to avoid the risk of inadvertently making a material modification to an existing plan, and thereby subjecting pre- 2005 deferrals to the new law (which could mean immediate taxation under the new law).

In order for an employer to make an accurate inventory of its existing deferred compensation plans, it is necessary to understand the statutory definition of nonqualified deferred compensation plan, which is defined as any plan that provides for the deferral of compensation- subject to certain exceptions discussed below. Unfortunately, there is no statutory definition of deferred compensation but it is probable that the regulations will provide that there has been a deferral of compensation in any case where there is a delay in the taxation of a payment or the taxation of a transfer of property beyond 2-1/2 months after the taxable year in which such compensation is earned and vested.

Beginning with the broad definition of nonqualified deferred compensation plan set forth above, the statute then excludes from the definition various categories of plans such as: (1) all plans which are qualified under Section 401(a) of the Code; (2) any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan; and (3) any eligible deferred compensation plan under Section 457(b) of the Code. The legislative history of the Act confirms that it is not intended to change the tax treatment of incentive stock options under Code Section 422 or options granted pursuant to an employee stock purchase plan under Code Section 423.

Apart from the above carve-outs, virtually all other forms of deferred compensation plans, whether set forth in a plan document or in an individual employment contract, will arguably be subject to the new law. In making an inventory, employers will need to look at equity plans, supplemental pension plans, elective deferred compensation arrangements, incentive arrangements, severance plans and 457(f) plans. Obviously, the new law applies not only to plans which benefit senior executives and officers; the new law is also applicable to deferred compensation plans for the benefit of mid- level management employees.

By the end of calendar 2004, employers should have completed their inventories of nonqualified deferred compensation plans, and particularly after Treasury Regulations are issued, should be in the process of reviewing plans for possible changes required by the new law. All plans subject to the law will need to comply as written and will also need to comply in operation; either a document failure or an operational failure could result in highly negative tax consequences for the affected employees. Employers should review current plan administration procedures to insure that elections being made now to defer amounts in 2005 are consistent with the new law.

In the course of this analysis, one question to be answered for each plan is whether it should be amended to conform as necessary with the new law, or, whether it should be frozen and receive no further deferrals after December 31, 2004, with the understanding that all deferrals after December 31, 2004 would be made into a replacement plan which conforms to the new law in every respect. The point of freezing a current plan and adopting a new plan in its place is to avoid an unintended material modification (the meaning of which is at least somewhat uncertain at present) which could cause adverse tax consequences to affected employees, and also to insure that an operational error does not result in the loss of grandfathered status of pre-2005 deferrals.

Whether a current plan is amended or a new plan is adopted, deferrals of compensation after December 31, 2004 must be made under a plan document providing that distributions may not be made earlier than:

*Separation from service (as defined by IRS);

*The date on which the participant becomes disabled (as defined in the new law);

*Death;

*A time specified under the plan at the date of the deferral of such compensation;

*A change in ownership or effective control of the employer, or in the ownership of a substantial portion of the assets of the employer (as defined by IRS); or

*The occurrence of an unforeseeable emergency.

If the plan does not contain these provisions, or, is not operated on the basis of these provisions, then all compensation deferred under the plan for the taxable year and all preceding taxable years will be includable in gross income for the taxable year (and be subject to ordinary income tax, interest, and a twenty percent (20%) additional tax) to the extent that it is not subject to a substantial risk of forfeiture and to the extent that it has not previously been included in the employee's gross income.

In addition to new restrictions on distributions, the law contains new election requirements, including:

*The requirement that an initial election to defer compensation for services performed during a taxable year must generally be made by the employee no later than the close of the preceding taxable year (before services are performed). A newly eligible employee could make the election within 30 days after first becoming eligible to participate in the plan;

*The requirement that a participant may elect to defer performance- based compensation (based upon services performed over at least 12 months) not later than 6 months before the end of the service period; and

*While an employee will be permitted to make a subsequent election to delay a payment or to change the form of a payment, there are restrictions on such an election. In the first place, the election cannot take effect for at least 12 months after the date on which the election is made. In addition, the first payment for which an additional deferral election is made (except for payments due to death, disability or emergency) must be deferred for at least 5 years from the date on which the payment would otherwise have been made. Finally, an election regarding a payment to be made at a specific time or under a fixed schedule cannot be made earlier than 12 months before the date on which the first payment was originally scheduled to be made.

It is hoped that the impending Treasury Regulations will include transition guidance providing that taxes will not be imposed with regard to any amount deferred that is attributable to services performed before January 1, 2005, solely because the timing of a deferral election does not satisfy the election timing requirements set forth above. In that connection, a representative of the Treasury Department had intimated in general terms that transition relief will be forthcoming, and that it will be very liberal. More recently, however, the Treasury Department has indicated that transition guidance will be limited, and will not address the requirements for elections. Employers will be expected to make a good faith effort to comply with the new law.

While there are various other aspects to the new law, one other point worth noting here is that the Form W-2 (or Form 1099) will change on account of this law beginning in 2005. Obviously, amounts which are required to be included in income must be reported on an individual's Form W-2 (or Form 1099) for the year in which amounts are includable in income. The change for 2005 and thereafter involves the fact that under the new law the total amount of an employee's deferrals under a nonqualified deferred compensation plan will need to be reported for information purposes on the Form W-2 (or Form 1099), even where amounts are not includable in the employee's gross income for that year.

Compliance with this law, as amplified by future regulations, will require careful analysis and attention to the specifics of each deferred compensation plan and each individual participant in the plan, in an effort to avoid a difficult tax burden. If you desire assistance in considering your plan, please call us at your convenience. Until regulations are issued, however, certain questions will remain unanswered or subject to further interpretation.

John C. Baldwin and Marika M. Ostendorf are principals practicing in the Employee Benefits Group of the national law firm Ober|Kaler. Mr. Baldwin is chair of the practice and can be reached at 410-347- 7685 or [email protected]. Ms. Ostendorf can be reached at 410-347- 7390 or [email protected].

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