new tax rules applied to executive compensation presented by paul m. yenerall eckert seamans cherin...

New Tax Rules Applied to Executive Compensation

Presented by Paul M. YenerallEckert Seamans Cherin & Mellott, LLCContinuing Legal Education Seminar

August 11, 2005

New Tax Rules Applied to Executive Compensation

Presented by Paul M. YenerallEckert Seamans Cherin & Mellott, LLCContinuing Legal Education Seminar

August 11, 2005

Introduction and OverviewIntroduction and Overview

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004. Among other changes, the Act provides for a new section of the Internal Revenue Code of 1986, Section 409A. This section provides dramatic changes to the tax rules applicable to “nonqualified deferred compensation.”


The Act basically provides that unless the rules prescribed by Code Section 409A are followed, then amounts intended to be deferred will be included in income when deferred, or when no longer subject to a substantial risk of forfeiture, if later.

Introduction and OverviewIntroduction and Overview For example, if an executive elects to defer

$20,000 of bonus, and to have that amount credited to a nonqualified deferred compensation plan, then, notwithstanding the fact that the amounts are not actually received, the bonus will be included in income when deferred unless the receipt of the bonus is subject to a substantial risk of forfeiture. Note that most bonus arrangements, pursuant to which executives defer money that they would otherwise be eligible to receive, are not subject to a substantial risk of forfeiture.


The new rules are effective for deferrals of compensation after December 31, 2004. Deferrals earned and vested before 2005 remain subject only to prior law, except that amounts deferred under a plan that is materially modified after October 3, 2004 are subject to the new rules.

What is Subject to the New Rules?What is Subject to the New Rules?

The new rules apply to “nonqualified deferred compensation plans,” statutorily defined to mean any arrangement that provides for a deferral of compensation unless otherwise excepted.


An arrangement is considered to provide for a deferral of compensation if the service provider has a right to compensation that has not yet been actually or constructively received in one year and, pursuant to the terms of the arrangement, that compensation is payable to the service provider and included in the service provider’s income in a later year.

What is Subject to the New Rules?What is Subject to the New Rules?EXCEPTIONS

Short Term Deferrals:

If an arrangement requires that amounts are paid within a short period of time after the amount is fully earned and vested, the plan is not a nonqualified deferred compensation plan. This exception covers any arrangement under which compensation is required to be, and is, paid within 2½ months of the end of the year in which the amounts become vested. Therefore, multi-year long term bonus or incentive plans would not be considered to be a nonqualified deferred compensation plan as long as the arrangement requires payment, and amounts are paid, within the applicable 2½ month period after vesting.


EXCEPTIONS

Short Term Deferrals:

Many bonus plans require participants to be employed on the day the bonus is paid. These bonus plans will not be considered to be nonqualified deferred compensation plans. Similarly, if a service provider has a legally binding right to a bonus at the end of the year and is not required to be employed when the bonus is actually paid, then the bonus plan is not considered to be a nonqualified deferred compensation plan as long as the payments are made within the applicable 2½ month period.


EXCEPTIONS Stock Options:

Options to purchase stock of the employer are not nonqualified deferred compensation plans if the exercise price under the option cannot be less than the fair market value of the stock at the date of grant.

Incentive stock options or options granted under an employer stock purchase plan, including employer stock purchase plan options that are granted with a discounted exercise price, are also excluded from the definition of nonqualified deferred compensation.

What is Subject to the New Rules?What is Subject to the New Rules?EXCEPTIONS

Stock Appreciation Rights (“SARs”):

Published guidance provides two exceptions with respect to SARs. A SAR is not a nonqualified deferred compensation plan if 1) it is granted on stock of the employer that is traded on established securities market; 2) the SAR provides only for the transfer of stock on exercise; 3) the SAR exercise price can never be less than the fair market value of the stock at the original grant date; and 4) the SAR does not provide for the deferral of income other than the ability to exercise the SAR during the term of the SAR. The SAR must not be coupled with any other arrangement under which the employer will purchase the stock received on exercise of the stock.


EXCEPTIONS

Stock Appreciation Rights (“SARs”):

A SAR granted under a program in existence on October 3, 2004 will not be considered nonqualified deferred compensation, provided that the SAR provides only for the appreciation above fair market value of the stock at grant and does not provide for deferral of income other than through the ability to exercise the SAR during the term of the SAR. This exception applies without regard to whether the SAR is settled in stock or cash or is issued with respect to public or private stock.


EXCEPTIONS

Restricted Stock:

A transfer of restricted property does not result in deferred compensation solely because no amount is included in income until the property is no longer to subject to a substantial risk of forfeiture. This exception applies only to transfers of restricted property, not to unfunded, unsecured promises to pay property in the future.


EXCEPTIONS

Qualified Retirement Plans:

Qualified retirement plans and tax qualified deferred annuities, simplified employee pension plans, SIMPLE retirement accounts and Section 457 plans are not nonqualified deferred compensation plans. In addition, arrangements that provide for vacation, sick leave, compensatory time off, as well as disability and death benefit plans are not considered nonqualified deferred compensation plans.

Important DefinitionsImportant Definitions Plan:

A “plan” may cover only a single individual (e.g., an executive’s employment agreement), may cover independent contractors as well as common law employees, and does not have to be in writing (although failure to be in writing may result in failure to comply with certain requirements of Section 409A). Under the new rules, if there is a failure with respect to a nonqualified deferred compensation plan all amounts deferred by the participant in that plan are included income. Separate arrangements maintained for the same service provider are considered a single plan to the extent the arrangements are considered non-account balance plans, account balance plans, or other plans, including options, SARs and equity based plans.

Important DefinitionsImportant Definitions Plan:

Under the new rules, if there is a failure with respect to a nonqualified deferred compensation plan, then all amounts deferred by the service provider under that plan are included income. As a result of this definition, a failure with respect to an account balance plan will result in inclusion in income of all amounts under the particular account balance plan with respect to which the failure occurred and all amounts deferred under any other account balance plan. For example, because both a bonus deferral arrangement and a supplemental savings plan will be considered account balance plans, if there is a failure to follow the rules with respect to a bonus deferral plan, then the amounts deferred under both the bonus deferral plan and the supplemental savings plan will be taken into consideration in computing the tax and penalties.

Important DefinitionsImportant Definitions Substantial Risk of Forfeiture:

A “substantial risk of forfeiture” requires that the receipt of deferred compensation be conditioned on the performance of substantial future services or the occurrence of a condition related to a purpose of the compensation. Published guidance provides that a requirement to refrain from the performance of services (such as a covenant not to compete) cannot be a substantial risk of forfeiture. In addition, any addition or extension of a substantial risk of forfeiture after the beginning of the service period is not considered to be a substantial risk of forfeiture.

What are the New Rules?What are the New Rules?

Basically, the new law imposes specific rules related to the timing of deferral elections and distributions, including a prohibition on acceleration of distributions.

What are the New Rules?What are the New Rules? Timing of Elections:

The new law requires that an election to defer compensation for services performed during a taxable year (or performance period) must be made before the beginning of that year or performance period.

What are the New Rules?What are the New Rules? Timing of Elections:

There are two exceptions to this rule. First, a service provider who first becomes eligible to participate in a plan during a year may make a deferral election within 30 days after initial eligibility. Second, with respect to “performance based compensation,” deferral elections are permitted as late as 6 months before the end of the performance period, if the performance period is at least 12 months long. Pending further guidance, compensation is performance based if it is contingent on organizational or performance criteria that are not substantially certain to be met at the beginning of the performance period. Significantly, bonus compensation is not considered performance based if it is based solely on the value of, or appreciation in the value of, the service recipient or its stock.


The new rules also require that the plan or election must include the timing and form of distribution. If the plan gives participants a choice of when to receive a distribution, that choice must be made at the same time the deferral election is made.


The new law permits a nonqualified deferred compensation plan to make distributions only following the occurrence of one of the events described below.

Change of Control:Distributions are permitted upon a change

of control or effective control of the employing corporation or a change in ownership of a substantial portion of the employing corporation’s assets.

What are the New Rules?What are the New Rules?A change of control occurs if a person, or persons

acting as a group, acquires, together with stock held by the person or group, more than 50% of the stock of the corporation, measured by voting power or value.

Change in effective control occurs if a person, or persons acting as a group, acquire 35% of the voting stock of the corporation over a 12 month period, or a majority of the members of the board of directors is replaced by directors not endorsed by the members of the board before appointment. A change in board is relevant only if the change occurs with respect to the parent corporation.


A change in control based on the sale of assets occurs if a person, or persons acting as a group, acquires 40% or more of the gross fair market value of the assets of a corporation over a 12 month period.

What are the New Rules?What are the New Rules? Separation from Service:

A service provider may receive a distribution on separation from service, except that a distribution to a “specified employee” must be delayed at least 6 months (or until death, if earlier). “Specified employees” are employees of a corporation with publicly traded stock who (i) own more than 5% of the stock of the corporation; (ii) own more than 1% of the stock of the corporation and have compensation from the corporation in excess of $150,000 a year; or (iii) are officers of the corporation with compensation in excess of $130,000. No more than 50 employees can be considered officers.

What are the New Rules?What are the New Rules? Disability:

An employee is disabled if the employee is unable to engage in any substantial gainful activity, or if the employee receives benefits for at least 3 months under the employer’s disability plan, as a result of any medically determinable physical or mental impairment that is expected to result in death or continue for at least 12 months.

What are the New Rules?What are the New Rules? Death:

Hopefully, it is apparent when it occurs.

Other:

A specified time (or pursuant to a fixed schedule) specified under the plan. At the time of deferral, the plan may allow a participant to specify a fixed time or schedule when a distribution will be made. The participant must select a currently ascertainable date, not one that is contingent on some event.

What are the New Rules?What are the New Rules? Unforeseeable Emergency:

A distribution may be made upon the occurrence of an unforeseeable emergency. Included are severe financial hardships arising from illness or accident (of the employee, his spouse or dependents), casualty loss or “other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant.” The amount distributed may not be more than what is reasonably necessary to meet the emergency and to pay any anticipated tax on the distribution.

Redeferral ElectionsRedeferral Elections

A participant may elect to postpone distributions that the participant would otherwise receive if the following conditions are met:

1. A redeferral election is made not less than 12 months before a scheduled payment.

2. The election is effective no earlier than 12 months after it is made.

3. The redeferral must be for at least an additional 5 years or upon death, disability or unforeseeable emergency. Distribution cannot be made for separation from service or change in control during that period.

Prohibition on Acceleration of DistributionsProhibition on Acceleration of Distributions

With certain exceptions discussed below, the new law prohibits any acceleration of a distribution.


Exceptions:

Accelerated distribution can be made if payment occurs before 2½ months after the end of the year in which the participant separates from service if the distribution does not exceed $10,000. In addition, a plan can add a distribution provision with respect to future deferrals that sets the allowable distribution threshold at any level (e.g., to override an installment election if the participant’s entire interest does not exceed a certain amount).


Other situations in which accelerations are permitted include:Domestic Relations Order.As necessary to comply with federal

conflicts of interest requirements.Under a Section 457 plan to allow for

compliance with withholding requirements.Under any plan to allow for payment of

applicable employment taxes and any additional taxes as a result of these distributions.

Remaining Transition ReliefRemaining Transition Relief

Grandfathered Amounts:

Amounts that are both earned and vested prior to January 1, 2005 (as well as earnings on those deferred amounts) are “grandfathered” from the application of the new rules. This means that the constraints imposed on the timing of deferral elections and distributions previously discussed will not apply to these amounts. Many employers are considering a separate accounting or creating separate plans that will apply to amounts vested and deferred prior to January 1, 2005. In other words, all of the old rules, which were much more flexible, may be applied to these amounts.


Published guidance provides flexibility to amend an arrangement or deferral election during 2005 to bring it into compliance with the new rules through revisions or to terminate it. The plan must be operated in good faith compliance with the new rules and the plan documents must be amended by December 31, 2005.


Plan are permitted to offer participants the ability to change payment elections on or before December 31, 2005. This relief applies to amounts that otherwise comply (or are brought into compliance with) the new rules. This permits participants to elect to accelerate payments or delay payment without regard to whether there is an election 12 months in advance of a scheduled payment or a 5 year redeferral period.


Options or SARs issued at a discount may be reissued without a discount or modified to otherwise comply with the new rules provided a cancellation and reissuance occurs before December 31, 2005.


For plans adopted before December 31, 2005 another alternative is to allow for revocation of elections or termination of the plan. The plan may be amended to give participants the right to revoke, completely or in part, a deferral election without causing the plan to fail to satisfy the new rules.

Changes in Rules Relating to Funding ArrangementsChanges in Rules Relating to Funding Arrangements

Under current law, nonqualified deferred compensation is includable in gross income to the extent the employer secures payment by placing assets beyond the reach of its creditors. The new law adds two circumstances in which funding associated with nonqualified deferred compensation results in current income: offshore rabbi trusts and financial health trigger trusts.


A rabbi trust is subject to the claims of the employer’s general creditors in the event of the employer’s bankruptcy. The new law provides that a trust located outside of the United States, regardless of whether the trust is subject to the claims of the employer’s creditors, results in current income.


Some employers adopted rabbi trusts that provided for a “springing” trust beyond the reach of the employer’s general creditors if the employer’s financial condition deteriorates. The new law provides that if a plan includes a provision of this sort, it will result in immediate tax liability.