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Additional Analysis on IRS Nonqualified Deferred Compensation Guidance
IRS Notice 2005-1 provides the first round of guidance on the new deferred compensation rules enacted on October 22, 2004 as a part of the American Jobs Creation Act (AJCA) or Section 409A. The notice primarily addresses the types of plans covered by the new rules and effective date and transitional issues. The notice does not address many of the substantive requirements under the new rules, which are expected to be addressed in future guidance to be issued in the first half of 2005, possibly in the form of proposed regulations.
Following are some of the key points of the first guidance.
Definitions of Nonqualified Plans. The new rules generally apply to all "nonqualified deferred compensations plans," which are defined broadly to include any plan (including those covering only one person) that provides for the deferral of compensation.
Change in Control Events. Under the new rules, distributions can only be made upon the occurrence of one of six distribution triggers, one of which includes a change in control. Notice 2005-1 generally does not address the substantive requirements of the other five triggers, but does prescribe detailed rules regarding what constitutes a change in the ownership of a corporation.
It includes the following:
- The acquisition of more than 50% of the value of voting power of the corporation's stock by a person or group;
- The acquisition in a period of twelve months or less of at least 35% of the corporation's stock by a person or group;
- The replacement of a majority of the corporation's board in a period of twelve months or less by directors who were not endorsed by a majority of the current board members; or
- The acquisition in a period of twelve months or less of 40% or more of the corporations' assets by an unrelated entity.
Plans may provide for distributions automatically upon a change in control or may permit the exercise of discretion to make payments within twelve months following a change in control.
Acceleration. Section 409A generally does not permit the acceleration of the time or schedule of any payment of deferred compensation. If an employer waives or accelerates the satisfaction of a condition that constitutes a substantial risk of forfeiture (e.g. vesting), it is not an acceleration for this purpose as long as the new law's other requirements are satisfied with respect to the deferral. Also, the Notice permits the acceleration and payment of certain de minimis deferred amounts credited to the accounts of participants who are completely terminating participation in a NQDC plan. In addition, the Notice permits the acceleration of payments under certain other limited circumstances, including:
- Any acceleration necessary to satisfy a domestic relations order (e.g., certain divorce settlements);
- The acceleration under a Section 457(f) plan of the minimum amount necessary to satisfy income taxes due at the time of a vesting event; and
- The acceleration of the minimum amount necessary to satisfy FICA taxes due on deferred amounts and the income tax withholding related to such FICA amount.
Effective Date and Transition Guidance. (1) General Effective Date: The new rules are generally effective with respect to: (a) amounts deferred in taxable years beginning after December 31, 2004; and (b) amounts deferred in taxable years beginning before January 1, 2005 if the plan under which the deferral is made is materially modified after October 3, 2004.
(2) Determining the Amount of Compensation Deferred: Notice 2005-1 prescribes the following rules for determining the amount of compensation deferred before January 1, 2005 (i.e., for the effective date provisions): (a) Non-account Balance Plans: The amount deferred before January 1, 2005 for non-account balance plans equals the present value as of December 31, 2004 of the amount to which the participant would be entitled under the plan if the participant voluntarily terminated services without cause on December 31, 2004, and received a full payment of benefits from the plan on the earliest possible date allowed under the plan following the termination of services. (b) Account Balance Plans: The amount deferred before January 1, 2005 for account balance plans equals the portion of the participant's account balance as of December 31, 2004. (c) Equity-based Compensation Plans: The same manner as account balance plans except that the account balance is deemed to be the amount of the payment available to the participant on December 31, 2004 (or that would be available tot the participant of the right were immediately exercisable). (d) Earnings: Earnings on amounts deferred under a plan before January 1, 2005 are not subject to the new rules to the extent the amounts deferred are not subject to the new rules. Notice 2005-1 prescribes special rules for equity-based compensation plans and non-account balance plans for purposes of determining earnings on amounts deferred before January 1, 2005.
(3) Material Modifications: (a) General Rule: A modification of a plan is a material modification if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added. Any modification should be reviewed with legal counsel if grandfathering is important. (b) Adoption of New Arrangement: Notice 2005-1 provides that it is presumed that the adoption of a new arrangement or the grant of an additional benefit under an existing arrangement after October 3, 2004 will constitute a material modification of a plan. (c) Suspension of Termination of a Plan: Notice 2005-1 provides that amending a plan to stop future deferrals is not a material modification. (d) Equity-Based Compensation: Notice 2005-1 provides that cancellations and reissuances of stock options or SARs on or before December 31, 2005 (e.g., to replace one that constitutes a deferral of compensation under the new rules with one that does not) will not be a material modification under certain circumstances.
(4) Compliance During Transition Period: (a) General Rule: Notice 2005-1 provides that a plan adopted before December 31, 2005 will satisfy the new rules if (i) the plan is operated in good faith compliance with the provisions of new Code section 409A and Notice 2005-1 during the calendar year 2005 (i.e., the "transition period"), and (ii) the plan is amended on or before December 31, 2005 to conform to the provisions of new Code section 409A with respect to amounts subject to the new rules.
(5) Transition Rules for 2005 Deferrals: With respect to deferrals subject to the new rules that relate all or in part to services performed on or before December 31, 2005, the requirements relating to the timing of elections will not be applicable to any elections made on or before March 15, 2005, provided that (a) the amounts to which the deferral election relate have not been paid or become payable at the time of election, (b) the plan under which the deferral election is or was made was in existence on or before December 31, 2004, (c) the elections to defer compensation are made in accordance with the terms of the plan in effect on or before December 31, 2005 (other than a requirement to make a deferral election after March 15, 2005), (d) the plan is otherwise operated in accordance with the new rules and (e) the plan is amended to comply with the new rules on or before December 31, 2005.
The guidance also includes information on the treatment of performance-based compensation and mirror plans.
Information Reporting and Wage Withholding Requirements. (1) Information Reporting: Notice 2005-1 provides guidance on the mechanics of reporting nonqualified deferred compensation on either a Form W-2 or Form 1099-MISC. However, the determination of amounts that are includible in income and subject to withholding as a result of the new rules is left to future guidance. (2) Withholding: Amounts that are includible in income solely because of the new rules do not have to be treated as wages subject to withholding until December 31, 2005.
Source: AALU Bulletin 04-173.
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