This article is reprinted with permission
from the
edition of
New York Law Journal.
© 2003 NLP IP Company.
New Legislation on
Deferred Compensation
On
Rules Under Present
Law
Basic rules under present law providing that
unfunded deferred compensation generally is not subject to income tax until it
is actually or constructively received continue in effect [subject, of course,
to compliance with the new rules unless the deferral is
"grandfathered" as discussed below]. Also, present rules relating to
funded deferred compensation that is not in the form of a tax-qualified
arrangement continue in effect. These rules provide, generally, that such
funded deferred compensation is taxed when the employee's right to the
"funds" [e.g., employer securities or a beneficial interest in a
trust] is not subject to a substantial risk of forfeiture or is transferable
free of such risk of forfeiture. Of course, an important exception to the
"funding" rule is a so-called "rabbi trust," the assets of
which are subject to the claims of the employer's creditors in the event of
bankruptcy or insolvency [but otherwise are held for the exclusive benefit of
the employee[s] for whose benefit it was created].1 [As discussed further
below, the new legislation contains changes affecting rabbi trusts in certain
circumstances.2]
Basic Rule Changes
1.
Introduction.
Amounts includible in taxable income due to a
failure to meet the new deferred compensation requirements of Code § [409A will
be includible in taxable income in the year in which there is such a failure.
In no event, however, will such amounts be includible prior to the year in
which they are no longer subject to "a substantial risk of
forfeiture" which is defined in Code § [409A[d][4] as follows:
[t]he rights of a person to compensation are
subject to a substantial risk of forfeiture if such person's rights to such
compensation are conditioned upon the future performance of substantial
services by an individual.
In the event of taxability due to a failure
to meet the requirements of Code § [409A, an additional 1 percent interest rate
on the amount of the underpayment [calculated, together with the regular rate
of interest on an underpayment, from the year in which the amount should have
been included in income under the new rules] plus an additional 20 percent tax
rate on such amount will apply. These consequences are discussed further below.
2.
Covered Plans
[Code § [409A[d][1]-[3]].
The new rules apply to "non-qualified deferred compensation plans" [NQDCPs]. Code § [409A[d][1] defines an NQDCP as any plan
that provides for the deferral of compensation other than "[A] a qualified
employer plan, and [B] any bona fide vacation leave, sick leave, compensatory
time, disability pay, or death benefit plan."
A "qualified employer plan" for
this purpose includes a qualified retirement plan, tax-deferred annuity,
simplified employee pension, a SIMPLE, a qualified governmental excess benefit
arrangement under Code § [415[m] and an eligible deferred compensation plan
under Code § [457[b].3 By definition, a nonqualified supplemental retirement
plan [frequently called a SERP] is an NQDCP.
Code § [409A[d][3]
provides that the term "plan" includes "any agreement or
arrangement, including an agreement or arrangement that includes one
person." An NQDCP is not limited to an arrangement between an employer and
an employee. It includes arrangements with an independent contractor; thus, it
will include deferral arrangements applicable to compensation of asset
managers, consultants and nonexecutive directors.
The Conference Report accompanying the act
provides that a nonqualified stock option plan is not an NQDCP if it provides
for the grant of an option on employer stock that is not less than the fair
market value of the stock on the date of grant and does not include a deferral
feature other than the right to exercise the option at some point in the
future. H.R. Conf. Rep. No. 108-755, at 524 [2004]
[Conference Report]. The Conference Report leaves open the question
whether a stock appreciation right is an NQDCP, stating that the Treasury
"may ... address in regulations issues relating to stock appreciation
rights."4 Conf. Rep. at 525. The Conference
Report is silent as to whether a deferred stock unit is an NQDCP.
3.
Permissible Distributions
[Code § [409A[a][2]].
With limited exceptions, deferral of taxes under an NQDCP will be permitted only
if distributions of the deferred compensation are limited to the occurrence of
one or more of the following:
[a] separation from
service [a term to be defined by the Treasury]; certain specified employees of
a corporation the stock of which is publicly traded cannot receive payment, if
"separation from service" is the basis for the distribution, for six
months after separation;5
[b] a disability as
defined in Code § [409A[a][2][C];
[c] death;
[d] a specified time
[or pursuant to a fixed schedule] specified under the NQDCP at the date of
deferral of such compensation;
[e] a change in
control [defined in Code § [409A[a][2][A][v] to mean "to the extent
provided by the [Treasury], a change in the ownership or effective control of
the corporation, or in the ownership of a substantial portion of the assets of
the corporation"]; and
[f] an unforeseeable
emer- gency as defined in
Code § [409A[a][2][B][ii].6
The new law intends that the Treasury will
prescribe rules pursuant to which other circumstances may permit distribution.
Code § [409A[a][3]. Otherwise, acceleration of
distribution is prohibited except in connection with one of the triggers noted
above. Conf. Rep. at 521.7
4.
Elections to Defer
Requirements with respect to elections to
defer [Code § [409A[a][4]]. Elective deferrals under
an NQDCP, in order to qualify under the new deferral rules, must meet the
following requirements.
[a] In the case of an NQDCP that is not
"performance-based" [see next paragraph], if the compensation is for
services rendered during a taxable year, the election must be made before the
beginning of that year, except for the first year of eligibility in which case
the election may be made within 30 days of eligibility. Code § [409A[a][4][B][i]-[ii].
[b] If the compensation is "performance-based"
and the services are to be performed over a period of at least 12 months, the
election may be made no later than six months prior to the end of the service
period. Code § [409A[a][4][B][iii].8
A deferral arrangement may allow subsequent
election to delay the originally elected timing for the distribution. Code §
[409A[a][4][C]. But the arrangement providing for the
subsequent election to further delay receipt must meet certain requirements.
The arrangement must require that [a] the election cannot be effective for 12
months from the date of the election to delay, [b] except in the case of death,
disability or unforeseen emergency, the minimum period for the additional
deferral is five years and [c] in the case of a distribution based on a specified
time, there must be a minimum period of 12 months between the election to delay
and the first scheduled payment pursuant to the schedule specified at the date
of the deferral. Code § [409A[a][4][C][i]-[iii].
5.
Certain Funding Rules
[a] [Code § [409A[b]].
Foreign Trusts. The new rules include provisions
directed at assets located outside the
[b] [Code § [409A[b]]. Other
"Securitization" Arrangements. These include arrangements
intended to enhance security of an NQDCP that are triggered by "a change
in the employer's financial health." The statute describes them as
arrangements in which "assets will become restricted to the provision of
benefits under the plan in connection with" such a change.10 This new
provision applies even if, after the "restriction," the assets remain
subject to the claims of general creditors of the employer. An example given in
the Conference Report is a transfer of assets to a rabbi trust triggered by a change
in the employer's financial health.11 Code § [409A[e] provides that the
Treasury shall prescribe regulations covering such exceptions as well as
defining "financial health."
6.
'Original Underpayment'
Additional One Percent Rate of Interest on
"Original Underpayment" and Additional 20 percent Tax Rate [Code §
[409A[a][1][B]].
[a] An additional 1
percent interest rate is charged on top of the regular interest charged on the
underpayment of income tax as a result of failure to comply with new rules.
Such additional interest is charged on the underpayment of tax that would have
occurred if the NQDCP amounts had been "includible" in income for the
taxable year in which originally deferred or, if later, the first taxable year
in which it ceases to be subject to a substantial risk of forfeiture. As noted
above, the meaning of a substantial risk of forfeiture is contained in Code §
[409A[d][4].
[b] In addition, a 20 percent additional tax
rate on top of the regular ordinary income tax rate is imposed on any
compensation that is required to be included in gross income because the NQDCP
does not comply with the new NQDCP rules [i.e., failure to comply with any of
the new rules applicable to distributions, elections and funding and other
securitization].
7.
Effective Date
Section 885[d]. Section 885[d] of the act provides that "[t]he
amendments made by this section shall apply to amounts deferred after
Section 885[d] also provides that the
amendments "shall apply to earnings on deferred compensation only to the
extent that such amendments apply to such compensation."
Amounts deferred in taxable years beginning
before Jan. 1, 2005 will nonetheless be subject to the new rules if the plan or
other arrangement pursuant to which they are deferred is materially modified
after Oct. 3, 2004 [except in compliance with Treasury guidance rules noted in
the next paragraph].12
The act further provides for the Treasury to
issue guidance "no later than 60 days after the date of enactment" to
allow plans "adopted before Dec. 31, 2004" [presumably, the date of
Jan. 1, 2005 was actually intended] to be amended [1] to allow participants,
subject to certain conditions, to terminate participation and [2] to comply
with the new rules in respect of deferrals made after Dec. 31, 2004. Act § [885[f].
8.
Other Provisions
The statute directs the Treasury to issue
regulations in a number of areas, including definitions [e.g., a "change
in control" [as used in Code § [409A[a][2][A][v]]
and "financial health" of a corporation [as used in Code §
[409A[b][2]].13 The statute also provides for aggregation of affiliated
employers for certain purposes and not for others. Code § [409A[d][6]. As a new reporting requirement, Act § [885[b][1] amends Code § [6051[a] to require "the total
amount of deferrals for the year under a nonqualified deferred compensation
plan [within the meaning of Code § [409A[d]]" to be reported on an
individual form W-2 [or Form 1099].14
FOOTNOTES:
[1] In a 1980 Private Letter Ruling [PLR],
the Internal Revenue Service [IRS] held that such a trust did not constitute a funding
of the deferred compensation that it was intended to secure. PLR 8113107 [
[2] Apart from ordinary income tax rules,
compensation that has been "earned" [i.e., is not subject to future
performance or other substantial conditions to its becoming an entitlement of
the employee] is subject to Social Security and Medicare taxes. This is so
whether or not its receipt is deferred. These rules continue. [For most
executives, Social Security taxability is not relevant because their current income
levels already exceed the taxable wage base for Social Security taxes.]
[3] The Conference Report indicates that the
new rules are not applicable "to annual bonuses or other annual
compensation amounts paid within two and one-half months after the close of the
taxable year in which the relevant services required for payment have been
performed." Conf. Rep. at 525.
[4] In Revenue Ruling 80-300, 1980-2 C.B.
165, the IRS held that a taxpayer is not in constructive receipt under a stock
appreciation right, reasoning that the exercise is the equivalent of
surrendering a valuable right [the loss of all further appreciation].
[5] See Code § [409A[a][2][B][i], which defines a "specified employee" as a key
employee as defined under Code § [416[i]. Code §
[416[i] generally defines a key employee as an
officer having annual compensation greater than $130,000 [adjusted for
inflation and limited to no more than 50 employees], five percent owners and
one percent owners having annual compensation from the employer greater than
$150,000.
[6] Code § [409A[a][2][B][ii] defines
"unforeseeable emergency" as "a severe financial hardship to the
participant resulting from illness or accident of the participant, the
participant's spouse or a dependent [as defined in [Code] § [152[a]] of the
participant, loss of the participant's property due to casualty, or other
similar extraordinary and unforeseeable circumstances arising as a result of
events beyond the control of the participant." Code § [409A[a][2][B][ii][II] provides that offsetting reimbursements such
as those attributable to insurance must be taken into account.
[7] The Conference Report provides examples
of circumstances, in addition to those set out in Code § [409A[a][2], in which it intends that the Treasury permit acceleration
of distributions. See Conf. Rep. at 521.
[8] For this purpose, the Conference Report
indicates that the Treasury is to define the meaning of "performance-based
compensation" to include compensation that is "[1] variable and
contingent on the satisfaction of pre-established organizational or individual
performance criteria and [2] not readily ascertainable at the time of the
election." Conf. Rep. at 522. The Conference
Report indicates that performance-based compensation may be required to meet
certain requirements similar to Code § [162[m]. For example, the Conference
Report states that performance criteria will be deemed pre-established,
"if it is established in writing no later than 90 days after the
commencement of the service period, but the requirement of determination by the
compensation committee of the board of directors would not be required."
[9] The statute provides, however, that it
"shall not apply to assets located in a foreign jurisdiction if
substantially all of the services to which the nonqualified deferred
compensation relates are performed in such jurisdiction." Code § [409A[b][1].
[10] The statute provides that the deemed
"transfer" attributable to a covered "restriction" will
occur on the earlier of the date the NQDCP provides for the restriction or the
date on which the assets are so restricted. Code § [409A[b][2].
[11] Examples of exceptions to the new rule
given in the Conference Report are transfers, or other restrictions, as a
result of a change in control of the employer or other events unrelated to a
change in the employer's financial health. Also excluded are transfers, or
other restrictions, occurring based on a predetermined schedule having nothing
to do with a change in the employer's financial health.
Discussion of the "financial health" triggers, and intended
exceptions, are contained in pages 523 and 524 of the Conference Report.
[12] The Conference Report states that the
"addition of any benefit, right or feature is a material
modification." On the other hand, the exercise or reduction of an existing
"benefit, right or feature" is not a material modification. Conf. Rep. at 526. The Conference Report provides a few
examples of what is or is not a "material modification" at page 526.
The Conference Report also states that
Operating under the terms of a deferred
compensation arrangement that complies with current law and is not materially
modified after
[13] The act also requires the Treasury to
adopt regulations as to when a "substantial risk of forfeiture" is to
be disregarded. Code § [409A[e][5]. The Conference
Report suggests disregarding a substantial risk of forfeiture if it is
"illusory" or otherwise inconsistent with the purposes of the new
rules. Conf. Rep. at 525.
[14] In the year in which such amounts are
required to be includible income they are required to be reported on an
individual's Form W-2 [or Form 1099] for that year. Provision is made for the
Treasury's excluding from the requirements amounts below a minimum threshold.
Wage withholding and other reporting requirements reflecting the new rules are
contained in Act § [885[b][2] and [3].