Play by the Rules: IRC section 409A imposes new requirements on nonqualified deferred compensation

• 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.
  
   

There’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.


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.

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.

MARK PAPALIA, CLU, ChFC, CFP, is founder and president of Papalia Financial in Danville, Pa. His e-mail address is mpapalia@papaliafinancial.com BARTON J. BRADSHAW, JD, is an advanced marketing attorney with Genworth Financial Inc. in Richmond, Va. Neither Genworth Financial nor Papalia Financial engage in the practice of law or provide legal advice.

Reprinted from the July 2005 issue of the Journal of Accountancy.