New Tax Rules Applied to Executive Compensation. Presente

1
New Tax Rules Applied to Executive
CompensationPresented by Paul M.
YenerallEckert Seamans Cherin Mellott,
LLCContinuing Legal Education SeminarAugust 11,
2005
2
Introduction and Overview

• On October 22, 2004, President Bush signed the
  American Jobs Creation Act of 2004. Among other
  changes, the Act provides for a new section of
  the Internal Revenue Code of 1986, Section 409A.
  This section provides dramatic changes to the tax
  rules applicable to nonqualified deferred
  compensation.

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Introduction and Overview

• The Act basically provides that unless the rules
  prescribed by Code Section 409A are followed,
  then amounts intended to be deferred will be
  included in income when deferred, or when no
  longer subject to a substantial risk of
  forfeiture, if later.

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Introduction and Overview

• For example, if an executive elects to defer
  20,000 of bonus, and to have that amount
  credited to a nonqualified deferred compensation
  plan, then, notwithstanding the fact that the
  amounts are not actually received, the bonus will
  be included in income when deferred unless the
  receipt of the bonus is subject to a substantial
  risk of forfeiture. Note that most bonus
  arrangements, pursuant to which executives defer
  money that they would otherwise be eligible to
  receive, are not subject to a substantial risk of
  forfeiture.

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Introduction and Overview

• The new rules are effective for deferrals of
  compensation after December 31, 2004. Deferrals
  earned and vested before 2005 remain subject only
  to prior law, except that amounts deferred under
  a plan that is materially modified after October
  3, 2004 are subject to the new rules.

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What is Subject to the New Rules?

• The new rules apply to nonqualified deferred
  compensation plans, statutorily defined to mean
  any arrangement that provides for a deferral of
  compensation unless otherwise excepted.

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What is Subject to the New Rules?

• An arrangement is considered to provide for a
  deferral of compensation if the service provider
  has a right to compensation that has not yet been
  actually or constructively received in one year
  and, pursuant to the terms of the arrangement,
  that compensation is payable to the service
  provider and included in the service providers
  income in a later year.

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What is Subject to the New Rules?

• EXCEPTIONS
• Short Term Deferrals
• If an arrangement requires that amounts are paid
  within a short period of time after the amount is
  fully earned and vested, the plan is not a
  nonqualified deferred compensation plan. This
  exception covers any arrangement under which
  compensation is required to be, and is, paid
  within 2½ months of the end of the year in which
  the amounts become vested. Therefore, multi-year
  long term bonus or incentive plans would not be
  considered to be a nonqualified deferred
  compensation plan as long as the arrangement
  requires payment, and amounts are paid, within
  the applicable 2½ month period after vesting.

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What is Subject to the New Rules?

• EXCEPTIONS
• Short Term Deferrals
• Many bonus plans require participants to be
  employed on the day the bonus is paid. These
  bonus plans will not be considered to be
  nonqualified deferred compensation plans.
  Similarly, if a service provider has a legally
  binding right to a bonus at the end of the year
  and is not required to be employed when the bonus
  is actually paid, then the bonus plan is not
  considered to be a nonqualified deferred
  compensation plan as long as the payments are
  made within the applicable 2½ month period.

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What is Subject to the New Rules?

• EXCEPTIONS
• Stock Options
• Options to purchase stock of the employer are
  not nonqualified deferred compensation plans if
  the exercise price under the option cannot be
  less than the fair market value of the stock at
  the date of grant.
• Incentive stock options or options granted under
  an employer stock purchase plan, including
  employer stock purchase plan options that are
  granted with a discounted exercise price, are
  also excluded from the definition of nonqualified
  deferred compensation.

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What is Subject to the New Rules?

• EXCEPTIONS
• Stock Appreciation Rights (SARs)
• Published guidance provides two exceptions with
  respect to SARs. A SAR is not a nonqualified
  deferred compensation plan if 1) it is granted on
  stock of the employer that is traded on
  established securities market 2) the SAR
  provides only for the transfer of stock on
  exercise 3) the SAR exercise price can never be
  less than the fair market value of the stock at
  the original grant date and 4) the SAR does not
  provide for the deferral of income other than the
  ability to exercise the SAR during the term of
  the SAR. The SAR must not be coupled with any
  other arrangement under which the employer will
  purchase the stock received on exercise of the
  stock.

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What is Subject to the New Rules?

• EXCEPTIONS
• Stock Appreciation Rights (SARs)
• A SAR granted under a program in existence on
  October 3, 2004 will not be considered
  nonqualified deferred compensation, provided that
  the SAR provides only for the appreciation above
  fair market value of the stock at grant and does
  not provide for deferral of income other than
  through the ability to exercise the SAR during
  the term of the SAR. This exception applies
  without regard to whether the SAR is settled in
  stock or cash or is issued with respect to public
  or private stock.

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What is Subject to the New Rules?

• EXCEPTIONS
• Restricted Stock
• A transfer of restricted property does not
  result in deferred compensation solely because no
  amount is included in income until the property
  is no longer to subject to a substantial risk of
  forfeiture. This exception applies only to
  transfers of restricted property, not to
  unfunded, unsecured promises to pay property in
  the future.

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What is Subject to the New Rules?

• EXCEPTIONS
• Qualified Retirement Plans
• Qualified retirement plans and tax qualified
  deferred annuities, simplified employee pension
  plans, SIMPLE retirement accounts and Section 457
  plans are not nonqualified deferred compensation
  plans. In addition, arrangements that provide
  for vacation, sick leave, compensatory time off,
  as well as disability and death benefit plans are
  not considered nonqualified deferred compensation
  plans.

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Important Definitions

• Plan
• A plan may cover only a single individual
  (e.g., an executives employment agreement), may
  cover independent contractors as well as common
  law employees, and does not have to be in writing
  (although failure to be in writing may result in
  failure to comply with certain requirements of
  Section 409A). Under the new rules, if there is
  a failure with respect to a nonqualified deferred
  compensation plan all amounts deferred by the
  participant in that plan are included income.
  Separate arrangements maintained for the same
  service provider are considered a single plan to
  the extent the arrangements are considered
  non-account balance plans, account balance plans,
  or other plans, including options, SARs and
  equity based plans.

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Important Definitions

• Plan
• Under the new rules, if there is a failure with
  respect to a nonqualified deferred compensation
  plan, then all amounts deferred by the service
  provider under that plan are included income. As
  a result of this definition, a failure with
  respect to an account balance plan will result in
  inclusion in income of all amounts under the
  particular account balance plan with respect to
  which the failure occurred and all amounts
  deferred under any other account balance plan.
  For example, because both a bonus deferral
  arrangement and a supplemental savings plan will
  be considered account balance plans, if there is
  a failure to follow the rules with respect to a
  bonus deferral plan, then the amounts deferred
  under both the bonus deferral plan and the
  supplemental savings plan will be taken into
  consideration in computing the tax and penalties.

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Important Definitions

• Substantial Risk of Forfeiture
• A substantial risk of forfeiture requires that
  the receipt of deferred compensation be
  conditioned on the performance of substantial
  future services or the occurrence of a condition
  related to a purpose of the compensation.
  Published guidance provides that a requirement to
  refrain from the performance of services (such as
  a covenant not to compete) cannot be a
  substantial risk of forfeiture. In addition, any
  addition or extension of a substantial risk of
  forfeiture after the beginning of the service
  period is not considered to be a substantial risk
  of forfeiture.

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What are the New Rules?

• Basically, the new law imposes specific rules
  related to the timing of deferral elections and
  distributions, including a prohibition on
  acceleration of distributions.

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What are the New Rules?

• Timing of Elections
• The new law requires that an election to defer
  compensation for services performed during a
  taxable year (or performance period) must be made
  before the beginning of that year or performance
  period.

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What are the New Rules?

• Timing of Elections
• There are two exceptions to this rule. First, a
  service provider who first becomes eligible to
  participate in a plan during a year may make a
  deferral election within 30 days after initial
  eligibility. Second, with respect to
  performance based compensation, deferral
  elections are permitted as late as 6 months
  before the end of the performance period, if the
  performance period is at least 12 months long.
  Pending further guidance, compensation is
  performance based if it is contingent on
  organizational or performance criteria that are
  not substantially certain to be met at the
  beginning of the performance period.
  Significantly, bonus compensation is not
  considered performance based if it is based
  solely on the value of, or appreciation in the
  value of, the service recipient or its stock.

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What are the New Rules?

• The new rules also require that the plan or
  election must include the timing and form of
  distribution. If the plan gives participants a
  choice of when to receive a distribution, that
  choice must be made at the same time the deferral
  election is made.

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What are the New Rules?

• The new law permits a nonqualified deferred
  compensation plan to make distributions only
  following the occurrence of one of the events
  described below.
• Change of Control
• Distributions are permitted upon a change of
  control or effective control of the employing
  corporation or a change in ownership of a
  substantial portion of the employing
  corporations assets.

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What are the New Rules?

• A change of control occurs if a person, or
  persons acting as a group, acquires, together
  with stock held by the person or group, more than
  50 of the stock of the corporation, measured by
  voting power or value.
• Change in effective control occurs if a person,
  or persons acting as a group, acquire 35 of the
  voting stock of the corporation over a 12 month
  period, or a majority of the members of the board
  of directors is replaced by directors not
  endorsed by the members of the board before
  appointment. A change in board is relevant only
  if the change occurs with respect to the parent
  corporation.

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What are the New Rules?

• A change in control based on the sale of assets
  occurs if a person, or persons acting as a group,
  acquires 40 or more of the gross fair market
  value of the assets of a corporation over a 12
  month period.

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What are the New Rules?

• Separation from Service
• A service provider may receive a distribution on
  separation from service, except that a
  distribution to a specified employee must be
  delayed at least 6 months (or until death, if
  earlier). Specified employees are employees of
  a corporation with publicly traded stock who (i)
  own more than 5 of the stock of the corporation
  (ii) own more than 1 of the stock of the
  corporation and have compensation from the
  corporation in excess of 150,000 a year or
  (iii) are officers of the corporation with
  compensation in excess of 130,000. No more than
  50 employees can be considered officers.

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What are the New Rules?

• Disability
• An employee is disabled if the employee is unable
  to engage in any substantial gainful activity, or
  if the employee receives benefits for at least 3
  months under the employers disability plan, as a
  result of any medically determinable physical or
  mental impairment that is expected to result in
  death or continue for at least 12 months.

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What are the New Rules?

• Death
• Hopefully, it is apparent when it occurs.
• Other
• A specified time (or pursuant to a fixed
  schedule) specified under the plan. At the time
  of deferral, the plan may allow a participant to
  specify a fixed time or schedule when a
  distribution will be made. The participant must
  select a currently ascertainable date, not one
  that is contingent on some event.

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What are the New Rules?

• Unforeseeable Emergency
• A distribution may be made upon the occurrence of
  an unforeseeable emergency. Included are severe
  financial hardships arising from illness or
  accident (of the employee, his spouse or
  dependents), casualty loss or other similar
  extraordinary and unforeseeable circumstances
  arising as a result of events beyond the control
  of the participant. The amount distributed may
  not be more than what is reasonably necessary to
  meet the emergency and to pay any anticipated tax
  on the distribution.

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Redeferral Elections

• A participant may elect to postpone
  distributions that the participant would
  otherwise receive if the following conditions are
  met
• A redeferral election is made not less than 12
  months before a scheduled payment.
• The election is effective no earlier than 12
  months after it is made.
• The redeferral must be for at least an additional
  5 years or upon death, disability or
  unforeseeable emergency. Distribution cannot be
  made for separation from service or change in
  control during that period.

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Prohibition on Acceleration of Distributions

• With certain exceptions discussed below, the new
  law prohibits any acceleration of a distribution.

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Prohibition on Acceleration of Distributions

• Exceptions
• Accelerated distribution can be made if payment
  occurs before 2½ months after the end of the year
  in which the participant separates from service
  if the distribution does not exceed 10,000. In
  addition, a plan can add a distribution provision
  with respect to future deferrals that sets the
  allowable distribution threshold at any level
  (e.g., to override an installment election if the
  participants entire interest does not exceed a
  certain amount).

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Prohibition on Acceleration of Distributions

• Other situations in which accelerations are
  permitted include
• Domestic Relations Order.
• As necessary to comply with federal conflicts of
  interest requirements.
• Under a Section 457 plan to allow for compliance
  with withholding requirements.
• Under any plan to allow for payment of applicable
  employment taxes and any additional taxes as a
  result of these distributions.

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Remaining Transition Relief

• Grandfathered Amounts
• Amounts that are both earned and vested prior to
  January 1, 2005 (as well as earnings on those
  deferred amounts) are grandfathered from the
  application of the new rules. This means that
  the constraints imposed on the timing of deferral
  elections and distributions previously discussed
  will not apply to these amounts. Many employers
  are considering a separate accounting or creating
  separate plans that will apply to amounts vested
  and deferred prior to January 1, 2005. In other
  words, all of the old rules, which were much more
  flexible, may be applied to these amounts.

34
Remaining Transition Relief

• Published guidance provides flexibility to amend
  an arrangement or deferral election during 2005
  to bring it into compliance with the new rules
  through revisions or to terminate it. The plan
  must be operated in good faith compliance with
  the new rules and the plan documents must be
  amended by December 31, 2005.

35
Remaining Transition Relief

• Plan are permitted to offer participants the
  ability to change payment elections on or before
  December 31, 2005. This relief applies to
  amounts that otherwise comply (or are brought
  into compliance with) the new rules. This
  permits participants to elect to accelerate
  payments or delay payment without regard to
  whether there is an election 12 months in advance
  of a scheduled payment or a 5 year redeferral
  period.

36
Remaining Transition Relief

• Options or SARs issued at a discount may be
  reissued without a discount or modified to
  otherwise comply with the new rules provided a
  cancellation and reissuance occurs before
  December 31, 2005.

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Remaining Transition Relief

• For plans adopted before December 31, 2005
  another alternative is to allow for revocation of
  elections or termination of the plan. The plan
  may be amended to give participants the right to
  revoke, completely or in part, a deferral
  election without causing the plan to fail to
  satisfy the new rules.

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Changes in Rules Relating to Funding Arrangements

• Under current law, nonqualified deferred
  compensation is includable in gross income to the
  extent the employer secures payment by placing
  assets beyond the reach of its creditors. The
  new law adds two circumstances in which funding
  associated with nonqualified deferred
  compensation results in current income offshore
  rabbi trusts and financial health trigger trusts.

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Changes in Rules Relating to Funding Arrangements

• A rabbi trust is subject to the claims of the
  employers general creditors in the event of the
  employers bankruptcy. The new law provides that
  a trust located outside of the United States,
  regardless of whether the trust is subject to the
  claims of the employers creditors, results in
  current income.

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Changes in Rules Relating to Funding Arrangements

• Some employers adopted rabbi trusts that provided
  for a springing trust beyond the reach of the
  employers general creditors if the employers
  financial condition deteriorates. The new law
  provides that if a plan includes a provision of
  this sort, it will result in immediate tax
  liability.