Advisories & Insights

Earlier this year, Congress enacted Code Section 409A providing guidance and requiring sweeping changes in deferred compensation plans effective January 1, 2005. On December 20, 2004, the IRS issued Notice 2005-1 providing clarification to many of the provisions required under Section 409A and offering guidance for the implementation of these rules. Given the short period until January 1, the new regulations fortunately offer a relatively smooth transition for compliance steps. Code Section 409A contains stiff penalties for noncompliance equal to 20 percent of the taxable income and potential interest in addition to income taxes owed leaving participants in a far worse position than if they had never deferred. Because of the timing of the new regulations, companies should immediately begin evaluating their current deferred compensation arrangements and determining the required changes for 2005 as well as taking advantage of the grandfathering rules for benefits deferred as of December 31, 2004.

Plans Affected. Code Section 409A applies to all arrangements involving the deferral of compensation. This includes elective deferral arrangements and supplemental programs as well as severance plans, certain bonus programs, and equity-based plans such as stock appreciation rights ("SARs"), phantom stock and certain stock option plans. However, qualified retirement plans and other employee benefit plans are generally exempt from the legislation.

Applies to Deferrals. Generally, Code Section 409A applies to amounts deferred after December 31, 2004. Under Code Section 409A, a deferral election must be made prior to the calendar year in which the compensation is earned. An amount is considered deferred on the date the amount is earned and vested (no longer subject to substantial risk of forfeiture) and there is a legally binding right to be paid that amount.

We have summarized several important provisions of the guidance for your convenience:

Grandfathered Amounts. Section 409A allows benefits to avoid Section 409A if they are deferred prior to 2005. To determine the pre-2005 benefit, a company must evaluate its current deferred compensation benefits. Plans with an account balance are grandfathered based on the earned and vested benefits as of December 31, 2004 and all subsequent earnings. For a nonaccount balance plan, the grandfathered amount is the present value of the earned and vested benefit that would be paid upon a separation of service "without cause" as of December 31, 2004. For equity plans, the grandfathered amount is the earned and vested amount as of December 31, 2004, net of any exercise price.

Good Faith Compliance. The guidance allows plan amendments to be made by December 31, 2005 for plans to comply with Section 409A. Additionally, for any topics not covered by the guidance, such as distribution options, the plan may operate in good faith compliance based on its interpretation of the statute, guidance and commentary.

Transition Rules. Deferrals. For plans in existence by December 31, 2004, deferral elections may be made by March 15, 2005. A plan adopted by December 31, 2005 may allow a participant to cancel a deferral election with respect to amounts subject to Section 409A.

Termination. A company may terminate a pre-October 2004 plan by December 31, 2005 and avoid potential penalties relating to a "material modification" of the plan's terms.

Severance and Quasi-Retirement Plans. Severance plans which do not cover key employees or are collectively bargained are not required to comply in 2005, provided they are amended by December 31, 2005. Plans which are linked to qualified retirement plans will comply with Section 409A provided that the plan operates in accordance with the nonqualified plan terms as of October 3, 2004.

Exempt From Compliance. Fiscal year bonus arrangements and multi-year compensation arrangements are not subject to Section 409A if payments are made within 2½ months after the fiscal year end or the tax year end for which the vesting provision lapses. No election to delay receipt of the compensation is allowable. Additionally, the guidance clarifies that medical reimbursement arrangements are exempt from compliance.

Equity Plans. Discount to Non-Discount. Discount options/SARs may be replaced by nondiscount options/SARs before December 31, 2005 and avoid any potential penalties under Section 409A.

Pre-October 2004 SARs. Nondiscount SARs in effect prior to October 2004 are excluded from coverage if the SAR does not include a deferral feature other than the participant's exercise right.

Restricted Property. The guidance makes clear that restricted stock is not subject to Section 409A's provisions even thought the receipt of the property may be subject to a substantial risk of forfeiture.

Action Required. Plan sponsors must immediately evaluate their current deferred compensation plans and ensure that benefits deferred prior to December 31, 2004 are properly grandfathered and protected. Additionally, plan sponsors must immediately begin evaluating their current deferred compensation arrangements for compliance with Code Section 409A during 2005 to avoid any potential deferrals subject to the Code's penalty provisions. Bullivant Houser Bailey has assembled a group of experienced deferred compensation attorneys who are uniquely positioned to assist your company with the impact of the new regulations and grandfathering your existing plans.

If you have any questions regarding Code Section 409A or your deferred compensation plan, please contact Jeff Robertson at (503) 499-4686, Chrys Martin at (503) 499-4420, or Darin Christensen at (503) 499-4497.