70 West Madison St.
Chicago, Illinois 60602
COMPENSATION RULES 2006
Section 409A was added to the Code
and is generally effective with respect to all subject deferrals
that vest on or after January 1, 2005. All covered deferred
compensation arrangements must be amended by December 31, 2006.
Relevant transition rules allow covered plans to operate in the
meantime so long as they are operated in compliance with Section
409A or a good faith interpretation of IRS authority issued pursuant
thereto, which includes proposed regulations issued by the IRS on
September 29, 2005. Benefits that are fully vested under
existing plans as of December 31, 2004 are "grandfathered" under
old law, but only if the existing plan is not "materially
modified" after October 3, 2004.
Because of the broad sweep of Section
409A, almost every arrangement that provides employee compensation
payable in a form other than basic salary should be reviewed for
compliance purposes. Failure of a covered arrangement to
comply with the new rules will cause affected employees to be taxed
when deferred compensation benefits vest, even if actual payment of
benefits does not occur until years later. Vesting for this
purpose occurs when benefits are no longer subject to a "substantial risk of forfeiture." A substantial risk of
forfeiture exists if receipt of benefits is conditioned on the
performance of substantial future services by the participant.
Adherence to any non-compete provisions is not considered to present
a substantial risk of forfeiture. Further, there is an
additional twenty percent (20%) penalty tax on affected employees.
Consequently, employees in the thirty-five percent (35%) tax bracket
would be taxed at an aggregate rate of fifty-five percent (55%) upon
vesting of non-compliant deferred compensation benefits.
Section 409A applies to all "nonqualified deferred compensation plans," which term includes
any arrangement that provides a "service provider" (employee or
independent contractor) a legally binding right to compensation that
is not currently received (either actually or constructively) but is
paid in a later taxable year. A legally binding right may
exist even when the future benefit payment is conditioned on
services to be rendered by the participant pursuant to applicable
The definition of "nonqualified
deferred compensation plans" extends to both elective and
non-elective arrangements, including individual employment and
consulting agreements that defer receipt of any portion of earned
income. An employer-employee relationship is not required as
Section 409A applies to otherwise covered arrangements that benefit
directors and independent contractors.
Expressly excluded from this
definition are qualified retirement plans under Section 401(a) of
the Code (this category includes pension plans, profit sharing plans
and Section 401(k) plans), SEPs and SIMPLE plans, Section 403(b) and
Section 457(b) plans for employees of tax-exempt organizations, as
well as vacation, sick leave, compensatory time, disability pay and
death benefit plans. Common stock option plans having an
exercise price not less than the fair market value of the underlying
stock at the time of grant are also excluded from the definition
along with plans providing stock appreciation rights so long as
those plans do not pay benefits based on dividends between the date
of grant and the date of exercise. Guidance as to equity
compensation plans of partnerships and limited liability companies
There is a limited exception for
severance pay plans that meet certain requirements, including a
limit on the aggregate amount of severance payments to the lesser of
(1) two times the statutory limit on annual compensation for
qualified plan purposes (the statutory limit is $220,000 in 2006) or
(2) two times the employee’s compensation in the calendar year
prior to termination of employment. Further, all payments must
be made only on account of an involuntary termination of employment
and must be completed no later than the end of the second calendar
year following the year in which termination occurs. However,
broad-based severance pay plans that provide the employer a
unilateral right to reduce or eliminate benefits at any time may
defer income until termination of employment notwithstanding Section
There also is an exception for
arrangements providing "short-term deferrals" of income.
Such arrangements that provide for the payment of benefits within 2½
months of the end of the taxable year in which benefits are no
longer subject to a substantial risk of forfeiture are exempt from
Section 409A, even if the benefits cover several years of services.
This exception is illustrated by an example of a bonus arrangement
that is not subject to Section 409A from the preamble to IRS Notice
For example, a three-year bonus
program requiring the performance of services over three years and
entitling the service provider [employee] to a payment within a
short specified period [2½ months] following the end of the third
year generally would not constitute a deferral of compensation.
Similarly, annual discretionary bonus
arrangements which are paid to an employee or independent contractor
within 2½ months following the end of the year are exempt from
Employers may also negotiate good
faith severance agreements with employees at the time of termination
of employment, and such agreements may provide for deferred payments
determined at that time.
Bearing in mind that many employment
agreements provide severance payments following termination of
employment, it follows that employers will need to review their
employment agreements, bonus arrangements, equity incentive plans,
severance pay plans, split-dollar life insurance arrangements and
any post-retirement consulting agreements in addition to all
traditional deferred compensation plans (nonqualified elective
salary and bonus deferral arrangements, supplemental executive
retirement plans ("SERPs"), and excess benefit plans) for
compliance with Section 409A.
Covered deferred compensation
arrangements will have to be retroactively amended to reflect the
following requirements and will have to be operated in accordance
with these requirements until such amendment:
- For arrangements that allow
participants to choose to defer a portion of current
compensation ("elective plans"), participants generally must
make an irrevocable election to defer compensation before the
services generating the compensation are performed (limited
exceptions apply for initial eligibility, when the new
participant has a thirty (30) day period to make the initial
deferral election, and performance based compensation governed
by pre-established individual and/or entity performance
criteria). Such elections also must specify the form of
payment (typically lump sum or installment) and designate one or
more of the permitted distribution triggers for benefit payment.
- Non-elective plans also must
designate in advance the form of payment of benefits and a
future distribution time or permitted event for benefit payment.
The permitted distribution triggers are separation from service,
death, disability, a specified time (such as attainment of a
specified age), an employer’s change in control, and an
unforeseeable emergency. Note that a specified time does
not include events over which an employee may have some control,
such as when a child begins college or when the employee elects
a retirement plan distribution. There are very specific
definitions for each of these terms provided in the 2005
proposed regulations. For example, the definition of "disability" requires, in effect, complete and total
disability, and the common practice of linking a deferred
compensation distribution to the definition of disability
included in the employer’s group disability plan may not be
permissible, depending on the disability plan’s definition.
In other words, a liberal definition of "disability"
contained in an employer’s group disability plan cannot be
used to avoid the intended statutory limitation on
- With limited exceptions, covered
arrangements cannot permit the acceleration of benefits (this
eliminates the so-called "haircut" provisions permitting
employees to elect an early distribution of benefits at any time
the employee is willing to forfeit a portion of that benefit).
Permitted exceptions include the acceleration of benefits in the
case of qualified domestic relations orders, the cash-out of
benefits not in excess of $10,000, and cash distributions to
participants in Section 457(f) plans for the payment of income
taxes due on the vesting of benefits.
- Subsequent participant elections
to defer the receipt of benefits are permitted, but only if the
election is made at least twelve (12) months in advance of the
scheduled payment and the election defers the payment at least
five (5) years from the original payment date (except in the
case of death, disability and unforeseeable emergency).
The proposed regulations permit employers to defer payments in
order to comply with the securities law or loan covenants in
financing agreements, or to preserve the deductibility of
compensation paid to a participant under Section 162(m) of the
Code, which provides a $1 million annual limit on deductible
compensation. Also note that there is a mandatory
six-month postponement of the payment of benefits that applies
to "key employees" of publicly-traded companies.
- Plan or trust provisions that
require an employer to set aside assets to secure benefit
payments in the event there is an adverse development in the
employer’s financial health will trigger immediate taxation to
- Generally, payment of deferred
compensation benefits cannot be accelerated by termination of
the deferred compensation arrangement. However, the 2005
proposed regulations do permit termination distributions in any
of the following circumstances: (1) the plan termination
takes place within twelve (12) months of a change in control;
(2) all plans of the same "type" are terminated, all benefit
payments are made within twenty-four (24) months of such
termination(s) and no new deferral arrangements are adopted for
five (5) years; and (3) the termination occurs on corporate
dissolution or with approval of a bankruptcy court.
- Employment agreements, consulting
agreements and other arrangements for payment of compensation to
former employees cannot be used to circumvent the restrictions
of Code Section 409A. Accordingly, where an employee
enters into an agreement with the employer providing for future
payments in consideration of the employee merely being available
to perform services if requested to do so, and the parties do
not intend that the employee provide more than "insignificant
services," the employee may (depending on the surrounding
facts and circumstances) be treated as having terminated
employment for purposes of Section 409A. A safe harbor
provision recognizes the validity of such an agreement if the
employee provides services at an "annual rate equal to at
least 20 percent of the services rendered and the annual
remuneration for such services is equal to at least 20 percent
of the average remuneration earned during the immediately
preceding three full calendar years of employment. . .".
- Overseas "rabbi trusts" used
to secure payment of deferred compensation benefits with assets
not located in the United States will trigger taxation to
affected participants. Domestic rabbi trusts are not
impacted by Section 409A.
Section 409A compliance requires the
review of existing employment and post-retirement consulting
agreements, bonus arrangements, equity incentive plans and severance
pay plans as well as traditional deferred compensation plans to
establish whether or not those agreements are subject to Section
409A. Arrangements in existence as of October 3, 2004 need to
be examined to determine if they provide for the accrual and vesting
of benefits by December 31, 2004, and if they have been "materially modified" since October 3, 2004. If so,
amendments reflecting the requirements of Section 409A will be
required. For this purpose (and in view of the required
operation of all covered deferred compensation arrangements in
compliance with Section 409A or a good-faith interpretation of the
regulations thereunder), it makes sense to review those covered
arrangements providing for the vesting or payment of benefits in
early 2006 first so that only benefit vesting and payment in
compliance with Section 409A will in fact occur.
Bear in mind that the 2005 proposed
regulations reflected above are not effective until January 1, 2007,
and they are subject to modification until that time. It is
reasonable to expect that existing authority under Section 409A
(which includes IRS Notice 2005-1 as well as the 2005 proposed
regulations) will be fleshed out in a number of respects before the
end of this year. Such modification could, of course, affect
the substance of this article.
Although the above general
information about Code Section 409A can serve as an important
starting point for employer consideration of its Section 409A
compliance, this information cannot be relied upon as legal advice.
For consideration of your specific compliance concerns, please
discuss your individual situation with competent legal counsel.
Golan & Christie LLP
70 West Madison St.
Chicago, Illinois 60602