IRS Issues Proposed Regulations on Nonqualified Deferred Compensation

IRS Issues Proposed Regulations on Nonqualified Deferred Compensation

On September 29, 2005, the IRS issued long-awaited proposed regulations governing nonqualified deferred compensation plans. The proposed regulations extend the period within which employers must amend their nonqualified deferred compensation plans to comply with Code Section 409A, provide detailed rules for determining whether an arrangement is subject to Section 409A, and address a variety of other issues. Although compliance with the proposed regulations is not mandatory until tax years beginning after 2006, taxpayers may rely on the proposed regulations until final regulations are issued. As a practical matter, most taxpayers will want to comply with the proposed regulations, retroactive to the effective date of Section 409A.

The IRS has Extended the Deadline for Amending Plans

Although the general effective date for Section 409A was January 1, 2005, IRS Notice 2005-1 gave employers and other service recipients until December 31, 2005, to adopt plan amendments necessary to comply with Section 409A, as long as the plan was administered in "good faith" compliance with Section 409A throughout 2005, and the amendment was retroactive to the beginning of 2005. The proposed regulations extend the amendment period and the "good faith" compliance period to the end of 2006. As discussed below, the fact that amendments no longer need to be adopted in 2005 does not mean that all decisions related to nonqualified deferred compensation plans can be delayed until 2006. Certain transition options currently available under Notice 2005-1 have not been extended by the proposed regulations and will expire on December 31, 2005.

Transition Options Expiring in 2005

Under Notice 2005-1, a plan may be terminated in 2005 and all benefits paid to participants by the end of 2005 (or, if later, the year in which plan benefits become vested) without violating Section 409A. In addition, participants may cancel plan participation or deferral elections in 2005 and receive distributions without violating Section 409A. The proposed regulations do not extend these transition options. Thus, any action under these transition options must be taken by December 31, 2005.

Transition Options Still Available in 2006

Transition options still available in 2006 include the following:

A plan may allow participants to make new payment elections in 2006 with respect to amounts deferred before the election, provided that the new election does not cover amounts otherwise payable in 2006 or cause payments to be made in 2006.

A nonqualified plan may continue through the end of 2006 to link the timing of payments to elections under a qualified plan, provided that the timing and form of payment is determined in accordance with plan provisions in existence on October 3, 2004.

A plan may cancel and replace a discounted option or stock appreciation right with a non-discounted option or right that is not subject to Section 409A until the end of 2006.

Rules for Severance Pay Arrangements

Commentators requested that the IRS exempt all severance pay arrangements from the requirements of Section 409A. Although the IRS rejected this request, the proposed regulations exempt arrangements providing for payment upon involuntary separation from service or pursuant to the terms of a window program, provided that (1) the payments do not exceed two times the lesser of (A) the employee's annual compensation or (B) the limit on annual compensation under Code Section 401(a)(17) ($210,000 for 2005), and (2) the arrangement requires that all payments be made by the end of the second calendar year following the year in which the employee terminates service. Certain collectively bargained severance arrangements are also excluded from coverage under Section 409A. Finally, the proposed regulations exclude from Section 409A a variety of reimbursements and other payments made on account of separation from service.

Stock Options and Stock Appreciation Rights

The proposed regulations provide detailed rules for determining when a stock option or stock appreciation right may be considered nonqualified deferred compensation subject to Section 409A. Under the proposed regulations, as under Notice 2005-1, options for the purchase of the stock of the service recipient (e.g., the employer or a related entity) at an exercise price that is not less than that fair market value of the underlying stock on the option grant date and that do not have any other deferral feature are exempt from Section 409A. Other options are generally subject to Section 409A. For example, the grant of an option to purchase stock other than the service recipient's stock will generally result in a deferral of compensation subject to Section 409A. The proposed regulations contain detailed rules for determining the fair market value of the underlying stock, including when valuation pursuant to an agreed upon formula will be presumed to be reasonable.

Under Notice 2005-1, many stock appreciation right (SAR) plans were subject to Section 409A. The proposed regulations generally treat SARs in the same way as they treat stock options. Therefore, a non-discounted SAR based on the increase in the service recipient's stock will generally be exempt from coverage under Section 409A, provided that it does not contain any other deferral feature. As in the case of stock options, the proposed regulations contain detailed rules designed to prevent circumvention of the purposes of Section 409A through deferred compensation disguised as a stock option or SAR.

The proposed regulations also clarify that the stock option rules apply to options for mutual company units and American depositary receipts.

Exceptions to Prohibition Against Acceleration of Payments

As a general rule, except as permitted by the Internal Revenue Service, payments under a plan subject to Section 409A cannot be accelerated. Notice 2005-1 created a very short list of exceptions to the general rule. The proposed regulations expand the list of exceptions.

A significant problem created by the anti-acceleration rule is that, once an employer has established a plan, the employer does not have the ability to terminate the plan and distribute benefits without violating Section 409A. The proposed regulations provide limited circumstances in which a plan may be terminated and assets distributed without violating Section 409A. For example, termination and payout may be permitted in certain cases of bankruptcy or dissolution. In addition, termination and payout is permitted under limited circumstances, provided that the service recipient does not adopt a new arrangement within five years of the termination.

Additional Issues Addressed by the Proposed Regulations

The proposed regulations, which repeat and expand many of the rules provided by Notice 2005-1, do the following:

· Clarify the application of Section 409A by defining key terms, such as "separation from service," "service recipient," "unforeseeable emergency," and "disability."

· Provide more detailed rules under which arrangements between employers and unrelated independent contractors (other than directors) are exempt from Section 409A.

· Clarify the definition of nonqualified deferred compensation and the exceptions to that definition.

· Establish workable rules for situations in which a payment cannot be made within a required period.

· Provide detailed rules for the permitted distribution of benefits upon an unforeseeable emergency.

· Provide detailed rules regarding the treatment of foreign arrangements and arrangements covering non-resident aliens.

· Refine the rules relating to the material modification of arrangements existing on October 3, 2004.

· Expand the rules relating to deferral elections and changes in deferral elections.

· Allow participants to choose among optional forms of annuity payment.

· Permit the delay of payments when the payment would be non-deductible under Section 162(m), would violate loan covenants or securities laws, or under certain other circumstances.

· Provide rules applicable to payment delays resulting from disputes.

· Confirm that an arrangement subject to Code Section 457(f) (ineligible deferred compensation plan) is subject to Section 409A as well, and provide that Section 409A will not result in an amount deferred under such an arrangement being taxed twice.

What Employers Should Do Before the End of 2005

Although the deadline for amending plans has been extended until the end of 2006, employers must take action this year if they wish to use one of the transition rules expiring on December 31, 2005. Therefore, employers should immediately identify any arrangements that may be subject to Section 409A and decide how they intend to bring covered arrangements into legal compliance.

For further information, please call or e-mail your contact in the Employee Benefits Group at Ice Miller.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.