Deferred Comp. Rules A Mixed Bag For Public Companies

Proposed regulations on deferred compensation issued recently by the U.S. Department of The Treasury and IRS hold both good and bad news for public companies, experts tell Compliance Week.

The good news, according to some, is that the proposed regulations provide some desperately needed guidance on interpreting the deferred compensation rules, and extend transition relief that was originally provided under guidance

issued last December.

The proposed regulations, issued Sept. 29, implement new provisions established by the American Jobs Creation Act on deferred compensation under "Section 409A." That Section is the part of the Internal Revenue Code governing plans and arrangements that provide nonqualified deferred compensation to employees, directors or other service providers. The proposed regulations identify which plans and arrangements are covered under Section 409A, outline operational requirements for deferral elections, and illustrate permissible timing for deferred compensation payments made under the rules.

But the bad news for companies is that the proposed regulations, which span 238 pages, don’t address all of the questions they may have, nor do they extend all of the transition relief under the December guidance, known as "Notice 2005-1." That means companies will have to act quickly on some decisions related to their deferred compensation plans.

“Notice 2005-1 … provided transition rules and guidance on some basic issues; the proposed regs are the first big effort to put flesh on the bones of the statute,” notes Michael Collins, of counsel in the Washington, D.C., office of Gibson, Dunn & Crutcher.

According to Collins, who jokingly calls it, “The Full Employment Act For Executive Compensation Lawyers for the next year and a half,” the proposed regulations will impact nearly all copanies. “Virtually every company has some type of plan that is subject to the new rules,” says Collins. “Big companies will have dozens of plans and employment agreements subject to the new rules.”

Capwell

The proposed regulations “provide important interpretive guidance on new tax rules that have broad-ranging effect for any public company,” agrees Jeffrey Capwell, a partner in the Charlotte office of McGuireWoods and leader of the firm’s executive compensation and employee benefits group.

Capwell says Section 409A will “significantly complicate” the design and operation of non-qualified retirement plans as well as a number of other types of compensation arrangements, such as stock options, split-dollar life insurance, bonus plans with deferral features, and certain types of severance arrangements. “The new regs fill in areas that weren’t addressed and also extend certain special transition rules under 2005-1,” many of which were scheduled to terminate at the end of this year, adds Capwell.

Penalties Fall On Executives

While the proposed regulations don’t take effect until Jan. 1, 2007, companies already have to be in “good faith” compliance with 409A, which applies to amounts deferred on or after Jan. 1, 2005. Amounts earned and vested before Jan. 1, 2005 are generally exempt. And the penalties for noncompliance are steep.

409A

Section 409A To Nonqualified Deferred Compensation Plans

Section 409A provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. The proposed regulations address the requirements set forth in section 409A to avoid this immediate taxation. Specifically, the proposed regulations address the scope of nonqualified deferred compensation and the application of the statutory effective dates. The regulations also provide guidance with respect to the rules governing initial deferral elections, subsequent deferral elections and the acceleration of payments contained in section 409A. Finally, the preamble and the regulations provide certain additional transition relief, and extend certain transition relief contained in Notice 2005-1.

Source: IRS "Plain Language Regulations," Oct. 4, 2005

The new rules can impose “significant adverse tax consequences on employees and directors of public companies that participate in deferred compensation plans unless those plans are brought into compliance,” says Capwell.

“The penalties here fall exclusively on the executives,” he adds. “There’s no penalty on the company for failing to comply with the rules—executives who aren’t sophisticated about tax issues may the bear brunt.”

The tax consequences for noncompliance are threefold: The vested amount that a director or executive has accumulated under the plan becomes immediately taxable to them—even if the money hasn’t been paid to them. In addition, interest for the underpayment of taxes is applied from the date when the amount was first deferred, or, if later, when the executive or director first had a vested right to the amount. On top of that, the money is also subject to a 20 percent penalty tax.

So, Capwell notes, “somebody in a marginal 30 percent tax rate, with that 20 percent penalty, essentially would pay 50 percent tax on their deferred compensation, plus interest.”

“While the [409A] legislation itself is only a page and a half, it’s very broad,” notes Collins. And, he says, it applies to areas companies wouldn’t think it would, such as severance agreements and stock options. “Companies don’t usually think of severance pay or stock options as deferred compensation, but they can be subject to the rules,” he says. “Companies should review all of their compensation arrangements, even if they’re not usually thought to ‘defer’ compensation, first, to see if they’re subject to the rules and second, to see if they comply.”

The Good News...

Glover

There is, however, some good news, according to Marjorie Glover, partner-in-charge of executive compensation in the New York office of Chadbourne & Parke. In addition to giving companies another year to bring their plan documents into compliance and providing more exemptions than the previous guidance, Glover says that the new guidance “provides a much clearer road map on how public companies may comply with the new law."

The proposed rules extend the deadline (which was initially Dec. 31, 2005) for documentary compliance with the new rules to Dec. 31, 2006. “While the rules are already in effect beginning Jan. 1, 2005, and have to be complied with…companies have lots of time to bring their documentation up to date,” notes Collins.

KEY PROVISIONS

The excerpt below is from, "IRS Issues Long-Awaited Proposed Deferred Compensation Regulations," Gibson Dunn & Crutcher, Oct. 2005. The excerpt summarizes some of the key issues addressed in the proposed regulations. According to the firm, "Of particular interest to employers, the proposed regulations extend to December 31, 2006, the deadline for amending arrangements to comply with the new rules." Reprinted with permission.

Transition Relief and Effective Date

Extended Transition Relief from Notice 2005-1

Effective Date/Good Faith Reliance. Section 409A applies to amounts deferred on or after January 1, 2005. Previous deferrals generally are "grandfathered" unless the arrangement is materially modified. For these purposes, deferred compensation amounts that were not earned and vested as of December 31, 2004 are not protected by the grandfathering rules.

The regulations are proposed to be effective for taxable years beginning on or after January 1, 2007. Notice 2005-1 generally provided that "good faith" compliance with Code section 409A was sufficient through December 31, 2005. The proposed regulations extend that rule for an additional year, providing that a plan adopted on or before December 31, 2006 will be treated as complying with Code section 409A if the plan is operated through December 31, 2006 in good faith compliance with the provisions of Code section 409A and Notice 2005-1. If any other guidance of general applicability under section 409A is published by the IRS with an effective date prior to January 1, 2007, the plan must also comply with that published guidance as of its effective date. To the extent an issue is not addressed in Notice 2005-1 or other published guidance, the plan must follow a good faith, reasonable interpretation of Code section 409A, and, to the extent not inconsistent with section 409A, the plan’s terms. In addition, compliance with the proposed regulations is automatically deemed to be good faith compliance with Code section 409A.

Plan Amendments. Notice 2005-1 generally provided that plans had to be amended no later than December 31, 2005 to reflect Code section 409A. The proposed regulations extend this deadline to December 31, 2006. Thus, employers have an additional one-year "remedial amendment period" to bring their documents into compliance with the new rules.

Changes in Payment Elections. Notice 2005-1 generally permitted plan amendments to change the form and timing of distributions to be made through December 31, 2005 without violating the rules under Code section 409A that generally prohibit acceleration of benefits and impose significant restrictions on additional deferral of benefit payments. The proposed regulations extend this relief through December 31, 2006, subject to the restriction that election changes cannot be made in 2006 to defer payments that otherwise would be made in 2006 or to accelerate payments into 2006.

Mirror Elections under Qualified Plans. Elections as to the timing and form of payment under a nonqualified plan or arrangement may be controlled by payment elections made under a corresponding qualified plan through December 31, 2006 (e.g., a Code section 415 excess benefit plan), provided that the payment is in compliance with the terms of the plan or arrangement as of October 3, 2004. Thus, the regulations extend for one-year this transition relief from Notice 2005-1.

No Extension of Transition Relief

Deferral Elections. Subject to certain exceptions, Code section 409A generally requires deferral elections to be made no later than December 31 of the year preceding the year in which the compensation is to be paid. Notice 2005-1 extended that deadline to March 15, 2005 for compensation earned in 2005 with respect to services performed after that date. The proposed regulations do not extend this special rule.

Cancellation of Deferrals/Termination of Plan Participation. Notice 2005-1 permitted participants to terminate participation in a nonqualified plan or to cancel a deferral election for previously deferred amounts no later than December 31, 2005. This relief is not extended.

Termination of Grandfathered Plans. Notice 2005-1 permitted termination of grandfathered plans by December 31, 2005 as long as various requirements were satisfied, including distribution of all amounts in 2005. The proposed regulations do not modify this transition relief. One key item emphasized in the preamble to the proposed regulations is that a plan amendment that provides a participant a right to elect whether to terminate participation in the plan or to continue to defer amounts under the plan would be a material modification of the plan, and thus would lose "grandfathered" status for pre-2005 amounts.

Stock Options, Stock Appreciation Rights and "Ad Hoc" Awards

The proposed regulations include some welcome liberalization of the rules set forth in Notice 2005-1 regarding the application of Code section 409A to nonqualified stock options and stock appreciation rights ("SARs"). (Incentive stock options ("ISOs") are not subject to Code section 409A unless they are modified so as to lose ISO status.) Notice 2005-1 generally provided that a discounted stock option would be subject to section 409A (and, in most cases, would fail to meet the applicable requirements, in particular the rules regarding distributions, since optionees generally have the right to elect when to exercise the option). In addition, Notice 2005-1 provided that SARs were exempt from Code section 409A only if various requirements were met, including that (i) they were issued by a publicly-traded company, and (ii) they were settled only in stock, and not in cash.

Key provisions of the proposed regulations include the following:

SARs generally are treated the same as options, can be issued by either a public or a private company, and can be settled in cash or stock.

Discounted stock options and SARs that were not vested and exercisable as of December 31, 2004 generally are subject to Code section 409A. The proposed regulations extend to December 31, 2006 the ability to cancel a discounted stock option or SAR and substitute a non-discounted option or SAR not subject to Code section 409A. (The revised exercise price is based on the fair market value of the stock on the original grant date, not the date of cancellation/regrant.) In addition, a cash payment may be provided by December 31, 2005 to make up for the lost discount, but any later payment for the lost discount may be subject to Code section 409A.

The proposed regulations include various rules for valuing the stock underlying options and SARs. Of particular note, for a public company, there is substantial flexibility in valuing the stock (e.g., the strike price of an option/SAR does not have to be based on the opening or closing price on the date of grant, but can be based on an average price as long as certain requirements are satisfied). For a private company, the proposed regulations provide that stock value must be determined by a "reasonable application of a reasonable valuation method" and list a number of factors to be considered in the valuation process. The regulations further provide that a valuation is not reasonable if the valuation date is more than 12 months earlier than the date for which the valuation is being used (e.g., the stock option grant date) or if the valuation fails to reflect a material change that affects the value of the company (e.g., a material litigation settlement or the issuance of a patent).

A "modification" of an option or a SAR generally will be treated as a new grant (and must satisfy the various rules as of the date of new grant). The proposed regulations provide that a modification generally means a change in the terms of the option or SAR that directly or indirectly reduces the exercise price, creates an additional deferral feature, or extends or renews the option or SAR. An acceleration of the exercisability of a stock option or SAR is not a modification. In addition, the regulations also allow short-term extensions of option/SAR exercise periods following termination of employment or when exercise of the option/SAR would otherwise violate applicable securities laws.

In addition, many commentators had expressed concerns with the application of the timing of deferral election rules to restricted stock unit and other award grants. Those rules, which in most cases require a deferral election to be made in the calendar year before the year of grant, are unworkable when it is unknown in advance whether such awards will be granted and, if so, the amount of the grant. In response, the proposed regulations establish a new rule for "ad hoc" awards made during a year that are subject to a forfeiture condition requiring the continued performance of services for a period of at least 12 months after the grant date. In that event, the regulations permit an initial deferral election to be made as late as 30 days after the date of grant.

"Separation Pay" Arrangements

Many commentators have expressed concern regarding the extent to which Code section 409A applies to severance pay plans and severance payments under employment agreements. The proposed regulations provide a good deal of guidance on these issues. Some of the key features of the guidance include the following:

Severance arrangements (including early retirement windows) generally are exempt from Code section 409A if the amount of the payment does not exceed two times the lesser of the employee's annual compensation or the limitation in effect under Code section 401(a)(17) (currently $210,000) as long as payments are completed no later than the end of the second calendar year following the year in which the employee terminates employment. Thus, (i) payments to "specified employees" (generally top-50 officers) of publicly-traded companies that fall within these guidelines generally will not be subject to the requirement for a six-month delay in payments, but (ii) severance payments to specified employees in excess of $420,000 (based on 2005 dollar limitations) will always be subject to section 409A and the six-month rule.

Where severance pay due to an involuntary termination by the employer has been the subject of bona fide, arm's-length negotiations, the election as to the time and form of payment of any severance that does not fall under the exception noted above may be made on or before the date the employee obtains a legally binding right to the payment. This rule is significantly more flexible than many practitioners expected. (However, it does not apply to terminations initiated by the employee, including "good reason" resignations, although the IRS has requested comments as to how severance payable upon a good reason resignation should be treated under section 409A.)

Severance plans are treated as a separate type of plan and are not required to be aggregated with other nonqualified plans. Thus, a violation of Code section 409A with respect to a severance arrangement generally will not "taint" other arrangements (e.g., supplemental retirement plans) that cover the individual.

Source

"IRS Issues Long-Awaited Proposed Deferred Compensation Regulations" (Gibson Dunn & Crutcher)

Also extended for a year is a transition rule that allows companies to make certain changes in the time or the manner in which deferred compensation is going to be paid. That rule “gives companies a freer right to make changes to deferred compensation plans until the end of 2006,” says McGuireWoods' Capwell.

However, he notes that “there are some technical limits to use of that rule.” Nonqualified plans that are linked to underlying qualified retirement plans can continue until the end of 2006 to make payments based on the payment election that an employee made under the qualified retirement plan, so long as such "linkage" was a feature of the nonqualified plan's terms as in effect on Oct. 3, 2004 (the date the new tax laws were enacted into law), notes Capwell.

The proposed regulations also clarify the six-month delay rule—which says that key employees (the top 50 paid employees) aren’t allowed to take a distribution after termination of employment at least six months—and offer “helpful guidance in determining who those employees are from year to year,” says Capwell.

Other good news for public companies, says Glover at Chadbourne & Parke, is that the guidance sets out very favorable rules for exempting stock options and stock appreciation rights. “Before the new guidance was issued, there was only an exemption for ‘non-discount’ stock options and limited relief for SARs,” she says. “The new guidance makes clear that non-discount stock rights in American Depositary Receipts and stock traded on foreign exchanges and over-the-counter may be exempt from 409A.”

It also broadens the exemption for SARs to include stock of public companies that are settled in stock or cash. Previously, Glover notes, the U.S. Treasury and the IRS had limited the SAR exemption for public companies to "stock settled SARs," and provided a temporary exemption for certain SARs under arrangements in effect before Oct. 4, 2005.

Glover adds that the new guidance generally provides favorable rules for substituting or adjusting stock rights in connection with mergers and acquisitions, and allows companies to terminate plans and make some changes in connection with certain corporate transactions.

While many severance arrangements are subject to the new rules, the guidance adds two new exceptions: One for certain limited amounts paid following an involuntary termination of the executive's employment, and another for severances under a window program—which allows certain employees to leave during a specified period and receive severance for a period of no more than one year, notes Capwell.

Severance paid in connection with an involuntary termination can also be exempt if it is paid shortly following the termination. However, Capwell and Glover note that severance paid following a "good reason" termination of employment will not be exempt. “Treasury and IRS have asked the public for comments on how to apply the 409A rules to employment agreements with 'good reason' triggers," says Glover. "This will be a big issue for public companies, many of which have employment agreements with good reason triggers”

She notes that the exemption applies to severance pay of up to two times annual compensation to a maximum based on IRS limits (currently $420,000 total) as long as the severance is paid out completely by the end of the second calendar year after the separation. The new guidance also exempts certain reimbursement arrangements, such as outplacement, which she says “should help some middle management and lower paid executives.” However, since many employment agreements provide severance pay in excess of the $420,000 limit, Glover notes that the exception won’t be as helpful to senior executives of many public companies.

...And The Bad News

The bad news is that companies don’t have much time to act on some of the transition relief that expires at the end of the year.

Companies that want to terminate a deferred compensation plan to avoid 409A have to do so by the end of this year, notes Glover, who warns that in the future, “it will be difficult to terminate a plan even if the company reserved the right to terminate and the plan participants agree.”

Companies also need to decide whether to let employees cancel participation in any plans, which must also be done by year-end, Glover advises. “Companies get a free pass on terminating plans by the end of this year,” she says. “But in the future, if they terminate a plan, they will have to terminate all plans of a similar type and they have to wait five years before setting up a new similar plan.” For example, she says, if a company decided next year to terminate its supplemental 401(K) plan, it would also have to terminate its deferred compensation plan.

“Companies may need to cancel or restructure certain employment agreements, because they may not work under the new law,” warns Glover. As examples, she cites discounted stock option plans or employment agreements with “good reason” triggers. While Glover says some companies may want to terminate supplemental pension plans to avoid 409A, “in reality,” she says, “they're probably going to need to keep them—executives need them and like them.”

Capwell adds that, after Dec. 31, 2005, the new rules allow the payout of deferred compensation benefits because of plan termination only in some very limited circumstances, such as a change in control of the company. “Going forward plan termination will not generally be an accepted basis for benefit pay out,” he says.

Experts note that additional guidance is expected some time next year on areas that weren’t addressed in the Sept. 29 guidance.

Collins says one of the biggest issues for public companies that isn’t addressed in the guidance is how to calculate the penalties for noncompliance. “Companies are still in the dark if there’s a violation as to how the tax hit is calculated,” he says.

“A lot of companies are using LLCs—rather than corporations—that are treated as partnerships for tax purposes; the guidance doesn’t address how the grant of interest in an LLC is treated under Section 409A,” Collins adds.

According to the McGuireWoods partner, another area for public companies where the rules are “still somewhat unclear,” is the extent to which the rules may affect split-dollar life insurance arrangements. Certain types of split-dollar life insurance arrangements will be subject to the rules and will need to be carefully analyzed by companies, says Capwell.

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