New Executive Compensation Rules

Section 409A, which was added to the Internal Revenue Code effective January 1, 2005, creates an entirely new tax regime with respect to executive compensation arrangements and creates significant new penalties for violations of these new rules. Proposed regulations under Section 409A were issued September 29, 2005. These proposed regulations, for the first time, allow us to provide in-depth counsel to you regarding these new rules.

One consequence of these new rules is that many existing executive compensation arrangements will need to be amended prior to the end of 2006. These arrangements, however, need to be administered in compliance with the new rules now and inadvertent violations may be very costly to executives. In addition, certain planning opportunities are available only if implemented prior to December 31, 2005.

The Foley Employee Benefits Practice Group has prepared this article in a question and answer format to assist you in complying with these new requirements. However, the proposed regulations are quite detailed and need to be consulted directly. This article is not intended as a definitive detailed description of the applicable rules and requirements, but merely to increase your sensitivity to issues which may arise under Section 409A. The members of the Employee Benefits Practice Group are prepared to provide you with the assistance you need to bring your compensation arrangements into compliance with these new rules on a timely basis.

Section 409A became effective January 1, 2005. The proposed regulations give employers until December 31, 2006 to amend covered executive compensation arrangements to bring them into compliance with the new law. However, those arrangements must be administered in good faith compliance with the new law from and after January 1, 2005. Compliance with the proposed regulations will constitute good faith compliance.

Unless otherwise elected by the employer, Section 409A does not apply to amounts to which an executive had a legally binding right which was earned and vested on December 31, 2004 under an arrangement which was in existence on October 3, 2004 and not materially modified thereafter. An amount is considered earned and vested if it is not subject to a substantial risk of forfeiture or a requirement to perform additional services. For example, a bonus payable in 2005 based on services provided in 2004, would be earned and vested on December 31, 2004 if the executive could resign on December 31, 2004 and still receive payment of the bonus. Similarly, a stock option or other stock right which could be exercised for cash or vested property on December 31, 2004 would be considered earned and vested.

• However, if the arrangement under which an executive has an earned and vested right is materially modified after October 3, 2004, Section 409A will apply with respect to such arrangement. Generally, any material enhancement to an existing grandfathered right or benefit or granting any additional benefit or right with respect to an earned and vested right will be a material modification.

• Amounts or rights which were not earned and vested on December 31, 2004 are subject to Section 409A even though granted under an arrangement in existence on October 3, 2004. For example, a stock option which was granted in 2003, but which was not exercisable on December 31, 2004 would be subject to Section 409A. Similarly, a severance benefit under an employment agreement in effect on October 3, 2004 would normally be subject to 409A even though granted under a pre-October 3, 2004 arrangement unless the executive could have voluntarily resigned on December 31, 2004 and received the severance payments.

Section 409A applies to "deferred compensation plans," a term which is defined very broadly in the proposed regulations. Any time an executive has a legally binding right during a taxable year to compensation which is payable in a later taxable year there will generally be a deferral of compensation for purposes of Section 409A.

As a consequence of this broad definition, in addition to traditional voluntary deferred compensation plans, stock options, stock appreciation rights (SARs) and certain other equity rights, supplemental retirement and other excess benefit plans (SERPs), severance arrangements, and bonus plans and earn-out arrangements may be subject to Section 409A.

Section 409A also applies to arrangements benefiting independent contractors (e.g. directors).

Section 409A does not apply to qualified retirement plans and certain welfare benefit plans, including bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans or medical reimbursement arrangements under which the benefits are not currently taxable.

Section 409A does not apply to certain short-term deferrals. To fall within this exception, payment will normally have to be made within 2 ½ months of the end of the tax year in which the services were performed or the payment right became vested, if later. Multi-year bonus arrangements which provide for prompt payment at the end of the performance period will normally fall under this exception.

Section 409A does not apply to certain foreign deferred compensation plans or compensation paid to non-resident aliens which would not otherwise be subject to U. S. tax.

If an employer wants to terminate an existing arrangement, the arrangement may be terminated and all benefits paid out in 2005 without the requirements of Section 409A being satisfied.

Employers with "aggressive" arrangements which could be challenged under pre-Section 409A law may want to utilize this option.

However, IRS guidance provides fairly significant alternative transition relief which may be considered:

• Plans can be amended to allow executives the right, until December 31, 2005, to make a new election regarding the time and/or form of payment payable in 2005 and 2006.

• With respect to amounts payable after 2006, plans may be amended to allow executives the right, until December 31, 2006, to make a new election regarding the time and/or form of payment.

• Plans may be amended prior to December 31, 2005, to allow executives to individually terminate participation in a plan or cancel a deferral election provided that the amount subject to the termination or cancellation is included in income in 2005.

Section 409A provides that a purported deferral of compensation will not be respected for tax purposes, unless the deferred compensation plan under which the deferral is made satisfies the requirements of Section 409A in both form and operation. These requirements include:

• The initial deferral election must be irrevocable and made prior to the year in which the services giving rise to the deferred compensation are performed.

• In certain circumstances, if an executive first becomes eligible to participate in a deferred compensation plan during a tax year, the election may be made within 30 days of the executive becoming eligible.

• If the compensation is payable under a performance-based compensation plan with a performance period of at least 12 months, the election may be made at any time which is at least six months prior to the end of the performance period.

The initial election also must specify the payment commencement date and the form of payment (e.g. lump sum or installments).

• Note: This election rule will impact SERPs and other excess benefit plans which are linked to qualified plans. Most such plans currently provide that benefits will be paid in accordance with the benefit election made under the qualified plan, which election is normally not made until retirement. Subject to a transition period ending December 31, 2006, the SERP election will need to be made up front and decoupled from the qualified plan election.

A deferral election specifying the time and manner of payment may only be modified if (i) the effectiveness of the modified election is deferred at least 12 months, (ii) the additional deferral is at least five years from the original commencement date, and (iii) the modified election is made at least 12 months prior to the original payment commencement date.

The time or schedule of payments may not be accelerated (with limited exceptions).

• Note:
"Hair cut’’ provisions which allow executives to accelerate payment in exchange for a forfeiture are no longer permitted.

• Note: Care must be exercised in amending agreements to avoid inadvertent benefit accelerations or deferral extensions.

Payments can only be made at the time or times specified in the deferral election or following death, disability, separation from service, unforeseeable emergency, a change in control with respect to the employer, or (under limited circumstances) when a plan is terminated.

• 409A includes specific definitions of the terms "disability," "separation from service," "unforeseen emergency," and "change in control."

• Special rules are provided to prevent use of the plan termination exception to avoid the limitations on payment acceleration.

• Note: If the executive is a "key employee" of a public company, any payments made on account of a separation from service must be deferred for at least six months following the date of separation. For this purpose, a key employee is an officer having annual compensation greater than $135,000 or a one percent owner having annual compensation of more than $150,000.

What are the consequences i there isa violation of Secon 409A?

If the terms of a deferred compensation plan do not comply with Section 409A or if the plan is not operated in compliance with Section 409A, in addition to the purported deferral not being effective and the executive being taxed on the amount of the deferral, the executive would be required to pay n an amount equal to 20 percent of the compensation and to pay interest at the deficiency rate plus one percent from the initial deferral date.

• Note: The proposed regulations provide rules which require the aggregation of similar types of plans for purposes of computing the 409A penalty. As a result, a violation in one plan can result in the acceleration of all deferred compensation under all similar plan types and assessment of the surtax and interest on the combined amount.

• Example: Executive has an elective deferred compensation plan under which executive elects to defer a portion of the executive’s annual bonus. Executive also participates in an elective supplemental 401(k) plan under which matching employer contributions may be made as well. If executive were to receive a premature distribution under the elective deferred compensation plan in violation of Section 409A, the entire amount deferred under both the elective deferred compensation plan and the supplemental 401(k) plan would become immediately taxable and subject to the 20% surtax and the interest penalty.

Grants of ISOs and ESPP options are not subject to Section 409A.

Grants of nonqualified options or SARs are not subject to Section 409A provided that (i) the exercise price in the case of an option or the base value of the SAR may never be less than the fair market value of the underlying stock on the date of grant and (ii) the option or SAR does not have any other feature for the deferral of compensation (e.g. the accumulation of cash dividends).

• The proposed regulations expressly address questions regarding the determination of fair market value with respect to the stock of closely-held corporations. Care should be exercised in adopting a valuation method which is authorized under the regulations and in making sure such valuation method is used consistently.

• Note: Subsequent modification of existing options or other equity rights can cause Section 409A to apply to those options and subject the option holder to the surtax and interest penalty. Care must be exercised in modifying options or other equity rights.

• Note: Special rules govern the substitution of equity rights following an acquisition.

Grants of restricted stock or restricted stock units will generally not be subject to Section 409A provided that the value of the stock is taxable to the executive promptly following the lapse of the restriction.

Employers will have to modify existing discounted options and SARs which are subject to Section 409A and future use of discounted options or SARs will need to be closely monitored.

• Traditional options and SARs with extended exiolate the fixed payment requirement of Section 409A. Thus, any new discounted options or SARs will need to provide for a fixed, single exercise date.

• If executives hold discounted options or SARs which were not earned and vested on December 31, 2004, the employer may, prior to December 31, 2005, substitute new options or SARs with an exercise price at least equal to the fair market value of the underlying stock on the date of initial grant. In addition, the substitution may be made during calendar year 2006, provided that the value of the discount (other than with respect to equity rights vesting in 2006) is not paid out in cash or property in 2006.

• The employer may also modify an existing option or SAR to comply with Section 409A by substituting a fixed, single date on which the option or SAR may be exercised.

• The proposed regulations also allow, subject to certain limitations, the payment of cash or the issuance of new equity rights to compensate the executive for the economic value of the lost discount.

Severance arrangements will generally fall within the definition of deferred compensation for purposes of Section 409A.

The proposed regulations except from this general rule (i) collectively bargained separation pay arrangements, (ii) separation pay arrangements for involuntary termination (including "voluntary" termination as part of a reduction in force initiative) provided that the amount payable does not exceed two times the executive’s prior year compensation (or, if less, two times the amount of compensation which can be considered for qualified plan purposes (currently $210,000)) and is paid within two years, and (iii) certain nontaxable reimbursements .

Severance arrangements negotiated as part of a separation from service will generally comply with Section 409A, provided that the separation agreement meets the requirement that commencement time and form of payment be specified.

All employment agreements which include severance benefits will need to be reviewed for compliance with Section 409A.

• The agreement will need to specify the amount of the severance benefit and when it is payable.

• The agreement may need to be amended to incorporate the "separation from service" definition in the proposed regulations.

• Post-termination perquisites will have to be reviewed to conform to the Section 409A limitations with respect to such provisions.

• Note: If the executive is a key employee of a the employment agreement will need to be amended to incorporate the requirement that payments be deferred at least six months following a separation from service.

• Note: Care will also have to be taken to make sure that no amendment to the severance provision in the employment agreement could result in an impermissible acceleration or additional deferral of the benefit.

How does Section 409A affect split dollar insurance arrangements?

Section 409A does not apply to split dollar arrangement which are taxed under the loan arrangement method or arrangements which only provide death benefits.

Section 409A may apply to split dollar arrangements using the endorsement method.

SERPs are subject to Section 409A. As a result, except for a transition period ending December 31, 2006, executives will no longer be allowed to make an election under the qualified plan at retirement and have that election apply to the SERP. The election of the timing and form of payment with respect to the SERP will need to be made in accordance with the election requirements of Section 409A.

Section 409A applies to all employers, including tax-exempt organizations and governmental entities. However, eligible deferred compensation plans under Section 457(b) as well as Section 403(b) tax sheltered annuities are exempt from Section 409A.

Nonqualified deferred compensation plans subject to Section 457(f) are subject to Section 409A. While Section 457(f) will generally result in taxable income at the time that a benefit is no longer subject to a substantial risk of forfeiture, failure to satisfy Section 409A would result in the surtax and interest penalties as well.

Section 457(f) deferral elections are subject to the usual Section 409A rules (e.g., they must generally be made in the prior calendar year and be irrevocable). Elections to extend or "roll" a vesting date must be made at least a year in advance and must push the vesting date out at least five years.

Section 457(f) plan benefits cannot be accelerated except that where Section 457(f) benefits cease to be subject to a substantial risk of forfeiture prior to the agreed-upon distribution date, taxes may be paid early from the participant’s Section 457(f) account to the extent provided in the plan.

Section 457(f) arrangements that provide for immediate payout upon vesting without any possibility of extension will not constitute deferred compensation under Section 409A.

The proposed regulations provide that non-compete claisks of forfeiture, two of the most popular risks of forfeiture currently used in 457(f) plans, do not constitute a substantial risk of forfeiture under Section 409A. It is unclear whether this definition of what constitutes a .substantial risk of forfeiture. for Section 409A also represents the IRS. position for Section 457(f) plans.

Employers who use non-compete clauses or rolling risk of forfeiture provisions in their Section 457(f) plans should carefully consider whether they want to continue using such clauses.

SERPs are subject to Section 409A. As a result, except for a transition period ending December 31, 2006, executives will no longer be allowed to make an election under the qualified plan at retirement and have that election apply to the SERP. The election of the timing and form of payment with respect to the SERP will need to be made in accordance with the election requirements of Section 409A.

• Identify arrangements that should either be terminated in 2005, or as to which participants should be given the opportunity to cancel their participation or specific deferral elections. Amend such arrangements by December 31, 2005, to implement the termination or opt out elections.

• Administer Section 409A arrangements in good faith compliance with the proposed regulations.

• Identify arrangements eligible for grandfathering and determine whether maintaining the grandfathered status of the applicable accrued benefits is appropriate or whether the grandfathering should be broken and the arrangement brought into compliance with Section 409A.

• Determine appropriate remedies in the case of discounted options or SARs.

The proposed regulations do not expressly address arrangements between a partnership and a partner, but it should be assumed that Section 409A does apply to such relationships, pending further guidance.

• The preamble to the proposed regulations temporarily includes under Section 409A guaranteed payments for services under Section 707(c) of the Code where the partner providing the service does not include the payment in income within 2 ½ months of the end of the year in which the service partner obtained a legally binding right to the payment or, if later, the taxable year in which the right is no longer subject to a substantial risk of forfeiture.

• Notice 2005-1 includes rules which can be foll pending further guidance regarding the treatment of payments to retired partners.

• For purposes of allowing payments to be accelerated following a change in control, the proposed regulations define a .change in control. only in the context of a corporation. Pending further guidance, taxpayers may apply these same rules by analogy to partnerships.

Section 409A is a direct response to IRS and Department of the Treasury concern about abuses in the executive compensation arena. For the past two years, the IRS has conducted detailed executive compensation examinations of 23 large employers. From the results of these examinations, the IRS has developed and published new executive compensation audit guidelines, developed new mandatory information requests which are to be made in all future audits, and hired and trained hundreds of new executive compensation audit specialists.

The IRS has also publicly announced that it will be fully prepared to conduct detailed 409A audits beginning in 2007. Audits in 2007 would pick up tax years beginning in 2005 . the critical transition year for Section 409A.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.