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 January 1, 2006, employers may rely on the proposed regulations until final regulations are issued. As a practical matter, most employers 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 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.

Application of Section 409A to Section 457(f) Plans

Most nonqualified deferred compensation plans sponsored by colleges and universities are covered by Code Section 457(f). Notice 2005-1 stated that the requirements of Section 409A apply to Section 457(f) ineligible deferred compensation plans in addition to any requirements already applicable to such plans under Section 457(f). Even if an arrangement complies with Section 409A, Section 457(f) may require that amounts deferred under the arrangement be included in taxable income before they are received. Amounts subject to Section 457(f) must be included in taxable income as soon as they are no longer subject to a substantial risk of forfeiture. For purposes of Section 457(f), a substantial risk of forfeiture generally exists if the employee's right to the amount is conditioned on the employee's future performance (or refraining from performance) of substantial services or some the occurrence of a condition related to the purpose of the benefits. Although the term "substantial risk of forfeiture" is used for purposes of Section 457(f) as well as Section 409A, the meaning of this term is not the same for both Sections.

The regulations confirm that an arrangement subject to Section 457(f) 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.

Short Term Deferral Exception

Notice 2005-1 provided a short term deferral exception from Section 409A if the deferred compensation arrangement provides that benefits are paid to a participant within 2 ½ months of the later of the end of the employee's or employer's taxable year in which the participant vests in the benefit, and the benefit is actually paid by that date. The regulations continued the short term deferral exception, but removed the requirement that the arrangement include the 2 ½ month deadline in writing. Thus, if an amount is actually paid by the 2 ½ month deadline, it is not subject to Section 409A. However, there are reasons why an employer may want to include the deadline in the written arrangement. If the deadline is not specified in the arrangement and payment is not made within the 2 ½ months, the payment is automatically subject to and in violation of Section 409A. In addition, if the deadline is not included in the arrangement, employers cannot take advantage of the limited discretion the proposed regulations gives them to delay payment in certain circumstances, nor of the new grace period set forth in the proposed regulations allowing employers to avoid violation of Section 409A by paying benefits within the taxable year if the 2 ½ month deadline is missed.

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. Collectively bargained severance arrangements that provide for payment upon involuntary separation from service or pursuant to the terms of a window 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.

Exceptions to Prohibition Against Acceleration of Payments

As a general rule, except as permitted by the IRS, 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 is permitted where the employer terminates all nonqualified deferred compensation plans that would be required to be aggregated under the proposed regulations if the service provider participated in all of them, the employer does not adopt a new arrangement within five years of the termination, and certain other requirements are satisfied.

The proposed regulations make clear that it is not an impermissible acceleration to provide for payment of benefits under a nonqualified deferred compensation plan on the earlier of two permissible distributable events, or to provide different forms of payment for different permissible distributable events.

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 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.

· Provide rules applicable to payment delays resulting from disputes.

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 contact your Employee Benefits attorney. If you do not have a contact in the Ice Miller Employee Benefits Group, please feel free to contact Tara Schulstad Sciscoe or Marc Sciscoe.

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.