Current developments (Part I: this two-part article provides an overview of current developments in employee benefits, including executive compensation, welfare benefits and retirement plan requirements. Part I focuses primarily on executive compensation.).

• Author: Walker, Deborah

EXECUTIVE SUMMARY

* The AJCA added a new layer of compliance requirements, to avoid present taxation of NQDCs and restrict funding structures for such arrangements; it also added reporting requirements.

* Long-expected changes came in the form of final statutory stock option regulations and SFAS 123R, requiring corporations to begin expensing equity-based compensation.

* IRS guidance dealt with the proper sourcing of compensation performed partly within and outside the U.S., employment tax treatment of payments for employment termination, taxation of transferred partnership interests and salary reduction plans.

In the past year (August 2004-July 2005), dramatic changes have occurred in the benefits practitioner's landscape. This two-part article covers the most significant of these. Part I, below, details fundamental changes to executive compensation under the American Jobs Creation Act of 2004 (AJCA), including the introduction of Sec. 409A and other changes. Part II, in the December 2005 issue, will focus on updates and changes in the taxation of fringe benefits and qualified retirement plans.

AJCA

Sec. 409A

On Oct. 22, 2004, President Bush signed the AJCA. AJCA Section 885(a) added new Sec. 409A, which significantly alters the tax regime applicable to nonqualified deferred compensation (NQDC), effective Jan. 1, 2005. According to Sec. 409A, amounts deferred under an NQDC plan are included in income when deferred, unless the plan complies with requirements on timing deferral elections, distributions and funding. If a plan fails to comply with Sec. 409A as to a participant, then all amounts deferred by that participant are included in income in the year deferred, or, if later, when no longer subject to a substantial risk of forfeiture. In addition, under Sec. 409A(b) (4), there is an additional 20% tax on the includible amount, plus interest at the underpayment rate plus 1% from the time the amount was first deferred (or when no longer subject to a substantial risk of forfeiture, if later) to the time the amount is included in income.

Sec. 409A complements the existing body of law governing NQDC. Prior law on Sec. 83 transfers of property in connection with the performance of services, and Sec. 451 income timing based on actual or constructive receipt, continues to apply. In addition, Sec. 409A has not changed the timing and amount of deductions associated with NQDC (governed by Secs. 83, 162 and 404(a)(5)).

Sec. 409A is effective for compensation deferrals after 2004. Deferrals earned and vested before 2005 remain subject to prior law, except that amounts deferred under a plan "materially modified" after Oct. 3, 2004 are treated as post-effective-date deferrals subject to Sec. 409A.

Notice 2005-1: To help interpret and implement the necessary changes to plans, the IRS released Notice 2005-1 in late December 2004. (1) The notice provided information on the definition of an NQDC plan for Sec. 409A purposes. Additionally, it offered guidance to help determine which amounts were grandfathered and not subject to the new law, provided transition relief for 2005 and addressed other specific issues, such as the definition of a change in control.

On the definition of deferred compensation, Notice 2005-1 provided an important carve-out for so-called "short-term deferrals." If a plan requires that amounts be paid within 2 1/2 months after the end of the tax year in which they become vested, it does not "defer compensation" for Sec. 409A purposes. The 2 1/2-month period is measured from the end of the employee's or employer's tax year, whichever is later. This exception does not apply if the service provider has a choice on timing payment.

Notice 2005-1 also excludes non-statutory stock options on employer stock from the definition of deferred compensation, if (1) the exercise price is never less than the fair market value (FMV) of the underlying stock at the time of grant, (2) the tax treatment of the option is otherwise subject to Sec. 83 and (3) the option does not provide for income deferral (other than the ability to exercise the option at will). All statutory stock options (e.g., incentive stock options (ISOs) or options under an employee stock purchase plan (ESPP)) are excluded from the definition of NQD C. Additionally, restricted property (i.e., property taxable on substantial vesting) is not considered deferred compensation.

Similarly, Notice 2005-1 does not consider a stock appreciation right (SAP,.) plan to be a deferred compensation plan, if it (1) is granted on stock of the service provider's employer and such stock is traded on an established securities market, (2) provides only for the transfer of that stock on exercise, (3) pays an amount based solely on the appreciation of the value of the employer stock over the FMV as of the grant date (thus, the SAP, contains no built-in gain) and (4) contains no provisions further deferring the amounts received on exercise of the SAR. However, the IRS provided a greater exemption from Sec. 409A for pre-existing SAR programs.

Specifically, the exercise of a SAR granted under a plan in existence on Oct. 3, 2004 will not be considered an NQDC arrangement as long as the SAR. provides only for appreciation above the FMV of the stock at grant, and the plan does not provide for income deferral other than through the ability to exercise the SAR at will.

Funding: Sec. 409A not only changes the requirements for unfunded NQDC plans, but also disallows funding techniques for securing the payment of deferred compensation to executives. Under Secs. 83 and 402(b), NQDC is includible in gross income to the extent the employer secures payment by placing assets beyond the reach of its creditors. However, employers may place assets in a "rabbi trust" (subject to the claims of the employer-grantor's general creditors in the event of the employer's bankruptcy), without resulting in income recognition to the employee until distribution.

Some employers secured the payment of deferred compensation by providing that assets would be placed beyond the reach of creditors if its financial condition deteriorated. This technique was designed to prevent taxation of the deferred amounts until, based on certain financial criteria, payment was unlikely to be made. Under Sec. 409A(b)(2), a plan that includes such a provision is treated as though it has transferred the amounts to the employee, usually resulting in immediate tax liability. (2)

Another technique that some employers used to secure the payment of deferred compensation was locating a trust outside of the U.S., preferably in a country in which creditor access would be complicated by local laws. Sec. 409A(b)(3) provides that a trust located outside the U.S., regardless of whether it is subject to the claims of creditors, is treated as though the amounts were transferred to the service provider. Importantly, this rule does not apply if substantially all of the services that gave rise to the deferred compensation were performed outside the U.S., in the same jurisdiction in which the assets are located.

The application of the funding restrictions are complicated by a...