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IRS Issues Nonqualified Deferred
Compensation Guidance
On December 20,
the IRS issued Notice
2005-1 , which provides guidance
and transitional rules for nonqualified deferred
compensation plans subject to Code Section 409A.
The IRS is expected to issue further guidance by
mid-2005. For a discussion of the new law, visit
our recent
article about Section
409A.
Immediate Plan Amendments Not
Necessary
For most plans,
the new law will become effective on January 1,
2005. Confirming the IRS's prior assurances, the
Notice indicates that plan documents do not need to be
amended to comply with Section 409A until the end of
2005, as long as the plan is administered in "good
faith" compliance with the new law throughout
2005. When adopted, the amendment would be
retroactive to the beginning of 2005. This will
allow employers and other plan sponsors to evaluate
their options in light of the IRS's guidance before
adopting amendments.
Transitional Options Available in
2005
The Notice
acknowledges that employers and other plan sponsors have
not had adequate time to make necessary adjustments for
2005. To address this issue, the Notice provides a
number a special rules for 2005, including the
following:
- A plan may be
terminated and the deferred amounts under the plan
distributed in 2005 without violating Section
409A.
- A plan may
allow participants to make new payment elections in
2005 with respect to amounts deferred before the
election.
- A plan may
allow some or all participants to terminate
participation in the plan or cancel a deferral
election during 2005.
- In the case of
plans in existence before 2005, the requirement that
salary deferral elections be made before the beginning
of the year will not apply to deferral elections made
on or before March 15, 2005.
- In the case of
nonqualified plans that link the timing of benefit
payments under the plan to elections under a qualified
plan, the plan may continue to link such elections
through the end of 2005, provided that the
determination of the timing and form of payment is
made in accordance with plan provisions in existence
on October 3, 2004.
Each of these
transition rules is subject to conditions and
restrictions, which you will need to evaluate
carefully.
Material
Modifications
Section 409A does
not apply to amounts deferred and vested before 2005, if
the deferral occurred under a plan in existence on
October 3, 2004, and the plan has not been materially
modified since that date. The Notice further
provides guidance on what the IRS considers to be a
material modification. In general, any addition of
a new benefit or enhancement of a benefit after
October 3, 2004 will be considered a material
modification. This is true, regardless of whether
the modification occurs because of an amendment or the
exercise of the plan sponsor's discretion under the
terms of the plan. For example, if a plan document
allows the employer to accelerate vesting in its
discretion, the exercise of that discretion will be a
material modification, subjecting the plan to Section
409A. The Notice lists a number of changes,
including the termination of a plan before the end of
2005, that will not be considered a material
modification.
Acceleration of
Payments
Section 409A
prohibits a plan from permitting the acceleration of
payments, except as provided by the IRS. The
Notice provides several exceptions to this rule in
addition to the special rules for 2005. Payments
may be accelerated to comply with a domestic relations
order, to comply with federal rules against conflicts of
interest, and to pay employment (i.e., FICA and
Medicare) taxes. In addition, plans may be amended
to provide for the lump sum payment of a participant's
benefits upon termination of employment, as long as the
lump sum payment is not more than $10,000.
Stock
Appreciation Right Plans
The Notice
confirms the IRS's informal statements that the typical
stock appreciation right (SAR) arrangement is a
nonqualified deferred compensation plan subject to
Section 409A. Because payment under an SAR
typically occurs at the time of the participant's
election, the SAR will not satisfy the requirements of
the new law. Despite this general prohibition, the
Notice provides several special rules, including the
following:
- Until the IRS
issues further guidance (which may be in 2005), a
sponsor may continue to grant SARs under an
arrangement in existence on October 3, 2004, without
violating Section 409A, provided that (i) the exercise
price is not less than the fair market value of the
underlying stock on the date of grant, and (ii) the
SAR does not include any deferral feature other than
the delayed recognition of income until
exercise.
- A publicly
traded company may continue to grant SARs, if (i) the
exercise price is not less than the fair market value
of the underlying stock on the date of grant, (ii) the
SAR is paid in the form of the company's stock (as
opposed to cash), and (iii) the SAR does not include
any deferral feature other than the delayed
recognition of income until exercise.
Stock
Options
The Notice makes
it clear that discounted stock options (i.e., the
exercise price is less than the fair market value of the
underlying stock on the date of grant) are subject to
Section 409A. In addition, the Notice provides
that where options are granted in tandem with stock
appreciation rights, the entire arrangement is subject
to Section 409A. More guidance on stock options is
expected in the next round of guidance.
As previously
promised by the IRS, the Notice provides employers and
other sponsors of nonqualified deferred compensation
plans with time in 2005 to consider their existing plans
in light of the guidance contained in the Notice as well
as additional guidance expected in 2005. It gives
employers the right to avoid Section 409A by terminating
existing arrangements and distributing assets before the
end of 2005. It also allows participants to change
existing elections in 2005 to comply with the new
law.
To discuss this
matter with your contact in the Employee Benefits Group
at Ice Miller, please use this link to access our directory
of attorneys. If you do not have a contact in the
Ice Miller Employee Benefits Group, please feel free to
contact Marc
Sciscoe
or Jim Kemper, who prepared this
article with the assistance of Jennifer
Frahm.
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.
Ice Miller is a
full-service law firm with offices in Chicago,
Indianapolis and Washington, D.C.
The employee benefits professionals of Ice Miller
provide legal and consulting services regarding
retirement, executive compensation and health and
welfare benefits to public and private employers,
financial institutions, insurance companies and other
types of benefit service providers.
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additional copies of current publications, contact the
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