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Retirement Benefits Planning Update
Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman PC, The Buhl Building, 535 Griswold Avenue, Suite 1900, Detroit, MI 48228–3679, firstname.lastname@example.org.
Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.
Nonqualified Deferred Compensation—Transition Rules
In carrying out the mandate of Section 885(b) of the Jobs Creation Act of 2004 (Pub. L. No. 108–357, 118 Stat. 1418), the IRS has published preliminary guidance regarding several aspects of new Code § 409A that governs certain nonqualified deferred compensation plans (NQDCPs). Notice 2005–1, 2005–2 I.R.B. 274 (the “Notice”), sets forth transition and interim compliance rules for existing NQDCPs. The Notice also amplifies the statutory definition of NQDCP, defines key terms that assist in determining whether Code § 409A applies to an existing NQDCP, and outlines the definition of employer “change of control” as a permissible distribution event. As the initial release in a series of releases expected in 2005, Notice 2005–1 provides the framework for the transition to Code § 409A. Section II of the preamble to the Notice states that, if additional guidance is issued on an issue addressed in the Notice that is less favorable to taxpayers, it is expected that any new position will be applied only on a prospective basis with adequate transition relief to allow plan modifications. As to issues not addressed in the Notice, taxpayers are directed to base their positions upon a good faith, reasonable interpretation of the statute and its purpose, which includes consideration of the legislative history. The Notice also adopts the nomenclature of “service provider” for the plan participant and “service recipient” for the sponsoring employer, emphasizing that Code § 409A also applies to independent contractors and partner-partnership relationships.
Code § 409A Requirements
NQDCPs that were in existence on October 3, 2004 (“existing plans”) and are not excluded from Code § 409A because the plan benefits are subject to a substantial risk of forfeiture will have to be amended, terminated, or their benefits frozen if the current plan provisions do not conform to the Code § 409A requirements as these requirements become defined during 2005. As outlined in the January/February column, Code § 409A generally—
• Prohibits distributions to NQDCP participants before the occurrence of a distribution event—the participant’s separation from service or death, the participant’s disability, an unforeseeable emergency, a change of employer ownership, or a specific time (or times) established at the date compensation is deferred. Code § 409A(a)(2).
• Does not permit the specified time or schedule of payments (whether stated in the plan or elected by a participant, in either case at the time compensation is deferred) to be accelerated except in limited circumstances to be provided in regulations—Notice 2005–1 contains the limited exceptions described in the Conference Report and also permits the accelerated payment of de minimis benefits ($10,000) in a lump sum. Code § 409A(a)(3).
• Does not permit the specified time or schedule of payments to be deferred except for participant deferral elections made at least 12 months before a scheduled payment (and effective no earlier than 12 months after the election’s date) and, except in the case of the participant’s death, disability, or unforeseen emergency, that defer payment for a period of at least five years. Code § 409A(a)(4)(C).
• Requires that a participant’s election to defer compensation be made before the close of the taxable year preceding the year in which the compensation is earned (or, upon first becoming eligible for the NQDCP, within 30 days of eligibility for services after the election). In the case of performance-based compensation over a multiyear period, an election must be made no later than six months before the period ends. Code § 409A(a)(4).
As described below, the transition rules permit a number of responses that existing plans may make to Code § 409A. Additional guidance will be required to assess the proper response and to determine how that response is to be implemented. In the case of existing NQDCPs, the monitoring of releases could prove important as transition deadlines are set. For example, Notice 2005–1 permits late deferral elections covering any compensation amounts that have not been paid (or become payable) for an existing plan that is expected to be amended to conform to Code § 409A but only allows such elections made by March 15, 2005.
Absent the transition rules adopted in the Notice, amendments to an existing plan, whether to conform to the new requirements of Code § 409A, to freeze the plan’s benefits as of December 31, 2004, or to terminate the plan, might cause the income inclusion and penalty provisions of Code § 409A, otherwise effective in all cases as of January 1, 2005, to apply. The Notice, particularly in A-19, A-20, A-21, and A-22, permits plan amendments to be made on or before December 31, 2005, without risk that the plan benefits will be considered to be accelerated or the Code § 409A penalties imposed. The permission to amend also applies to plans adopted in 2005. In each case, plans that are required to comply with Code § 409A must be administered in accordance with the guidance as it exists from time to time during 2005. For example, if a plan treats a change of employer control as a distribution event, the definition in the Notice must be applied in lieu of any differing plan definition (even though the plan may not be amended until later in 2005). In order to categorize existing plans so as to determine whether a plan must be amended to comply with Code § 409A, frozen, or terminated, a review of the Notice’s effective dates and definitions is needed.
Substantial Risk of Forfeiture
The failure to comply with Code § 409A causes the inclusion of plan benefits in a participant’s taxable income (and interest and penalties) only to the extent the deferred income is not subject to a substantial risk of forfeiture (or the amounts have been previously included in the participant’s income). To assess whether an existing plan that does not conform to Code § 409A rules must be amended, plan sponsors need to determine if plan benefits are subject to a substantial risk of forfeiture and, if so, whether or not the plan will fail to conform with Code § 409A when the risk of forfeiture lapses in the future. A-10 of the Notice provides that, in addition to the statutory statement that a substantial risk of forfeiture exists if entitlement to benefits is conditioned upon the performance of substantial services by the participant, benefits that are contingent upon the occurrence of a condition related to a purpose of the compensation (such as the attainment of a prescribed level of employer earnings) are subject to a substantial risk of forfeiture. In either case, the possibility of forfeiture must be substantial. In determining whether a substantial risk of forfeiture exists, a potential forfeiture for the violation of a noncompetition clause is disregarded and a plan participant’s shareholdings and the corporate context (public or closely held) are taken into account. Notice, A-10(b).
Multiyear NQDCPs that delay vesting until the end of the service period are not considered subject to Code § 409A if the plan benefits are payable within two-and-one-half months after the end of the taxable year (either the employer’s or employee’s taxable year, whichever ends later) in which the benefit is no longer subject to a substantial risk of forfeiture. If, however, an employee exercises an election to further defer the payment provided under the plan, the plan is subject to Code § 409A. Notice A-4(c). The addition of a risk of forfeiture to the plan after the service period has begun or any extension of the service period to which the risk relates, whether initiated by the participant or the employer, will generally be disregarded. Notice, A-10(a). If, however, the total amount subject to any extended additional risk is materially greater (ignoring earnings on the continued deferral) than the amount the recipient could have elected to receive, an extended substantial risk of forfeiture elected by the participant will be recognized. The Notice does not state whether earned and vested benefits that are to be paid in installments that begin within two-and-one-half months of the taxable year in which the substantial risk of forfeiture expires are subject to Code § 409A.
Notwithstanding the Code § 409A general prohibition of the acceleration of the time or schedule of payments under the plan (and the prohibition cited below on the accelerated vesting of benefits as of December 31, 2004), an employer may waive or accelerate the satisfaction of a condition that represents a substantial risk of forfeiture applicable to a benefit. For example, an employer may reduce the 10-year vesting requirement for a participant who terminates service after 5 years (from 10 years to 5 years) even though the effect of the vesting reduction qualifies the terminated participant for a payment of benefits. Notice, A-(5)(a).
Effective Dates of Deferrals
The Code § 409A restrictions on benefits that are not subject to a substantial risk of forfeiture generally apply to (1) amounts deferred under NQDCPs after December 31, 2004, and (2) amounts deferred in taxable years beginning before January 1, 2005, if the plan under which the deferral is made is materially modified after October 3, 2004. For the purposes of the transition rule only, the Notice addresses at what time compensation amounts are considered to be deferred (and how the amount deferred is determined) as well as when a plan is deemed to be materially modified.
First, an amount is considered to have been deferred before January 1, 2005, only if (1) the participant has a legally binding right to be paid the amount and (2) the participant’s right to the amount is earned and vested (meaning, inter alia, that the amount is not subject to a substantial risk of forfeiture or a requirement to perform future services and may not be reduced in the discretion of the employer). Notice, A-16(b). If an existing plan contains a vesting schedule under which a portion of a participant’s benefits is earned and vested and a portion remains subject to a substantial risk of forfeiture on December 31, 2004, Code § 409A would apply to nonvested benefits, which would become post–January 1, 2005, deferrals when earned and vested.
Second, the determination of the amount of compensation considered to be deferred as of January 1, 2005, depends on the type of the NQDCP involved. In the case of a nonaccount balance plan, the deferred amount is the present value on December 31, 2004, of the earned and vested benefit the participant would receive upon a voluntary termination (without cause) if benefits were paid on the earliest possible date. The plan’s actuarial assumptions, if reasonable, apply (if not, reasonable assumptions must be used). For an account balance plan, the deferred benefit is the portion of the participant’s account that is earned and vested on December 31, 2004. For equity-based compensation, the December 31, 2004, benefit is the amount of earned and vested payment available (or that would have been available if the right were immediately exercisable). Notice, A-17.
Earnings attributable to grandfathered pre–December 31, 2004, deferrals (or the income from such deferrals) are also excluded from Code § 409A. In the case of equity plans, increases in the December 31, 2004, amount payable because of appreciation in the value of the underlying stock are treated as earnings on the deferred amount. In the case of a nonaccount balance plan, increases in the December 31, 2004, present value of the plan benefit due solely to the passage of time (such as the increase, using the interest rate used to determine the December 31, 2004, benefit, that results from the shortening of the discount period before payments are to be made plus any increase from the participant’s survivorship during the year) are treated as earnings. An increase in benefits because of the application of a formula that takes into account increases in compensation after December 31, 2004 (such as a final average pay formula) or the participant’s subsequent eligibility for an early retirement subsidy, however, does not constitute earnings attributable to pre-January 1, 2005, deferrals.
Material Modifications to Existing Plans
Except as otherwise permitted under the transition rules, a plan modification (whether by plan amendment or an employer’s exercise of discretion under the plan terms) is a material modification if a benefit or right existing under a plan as of October 3, 2004, is enhanced or a new benefit or right is added. For example, an amendment permitting payments at a participant’s request (subject to a 10% forfeiture or “haircut”) or an employer’s exercise of discretion to accelerate the vesting of a benefit as of December 31, 2004, would be considered a material modification of an existing plan. An amendment made to bring a plan into compliance with the more restrictive provisions of Code § 409A will not be treated as a material modification. A material modification will be deemed to occur, however, even if an enhanced benefit adopted is one permitted by Code § 409A (for example, the addition of a right to payment upon the occurrence of an unforeseeable emergency). Notice, A-18(a). Notwithstanding the general rule, the grant of an additional benefit under an existing plan that consists solely of a deferral of additional compensation not otherwise provided as of October 3, 2004, will not be treated as a material modification of the plan if the plan identifies the additional deferral and provides that it will be subject to Code § 409A. Notice, A-18(b).
No material modification of a grandfathered NQDCP occurs because of a plan participant’s exercise of discretion over the time and manner of payment of a benefit if that discretion is provided under the terms of the existing plan or if an employer exercises discretion over the time and manner of payment under the terms of the existing plan. An amendment eliminating future deferrals under an existing plan is not a material modification. An amendment adopted on or before December 31, 2005, that terminates an existing plan will also not be treated as a material modification as long as all amounts deferred under the existing plan are included in income in the taxable year in which termination occurs. Notice, A-18(c). Grants under existing equity-based plans, stock options, or stock appreciation rights granted after October 3, 2004, that fail to meet the Code § 409A requirements for exclusion as deferred compensation (for example, an option issued with an exercise price discounted below the value of the shares at the time of grant) may be canceled and reissued on or before December 31, 2005. Notice, A-18(d).
Elections to Cancel Deferrals
If a plan amendment is adopted before December 31, 2005, by either an existing plan or a plan adopted after October 4, 2004, a plan may permit plan participants (or certain plan participants selected in the plan sponsor’s discretion) to elect to terminate participation in the plan or to cancel a deferral election for amounts subject to Code § 409A without penalty, provided that the amounts subject to termination or cancellation are includible in the participant’s income in the taxable year in which such amounts are earned and vested. Notice, A-20. For the purposes of the Notice, the requirements of Code § 409A are applied as if a separate NQDCP is maintained for each employee. If an employee participates in more than one type of NQDCP (an account balance plan, a nonaccount balance plan, and/or a stock-based plan), compensation deferred under each type of plan is treated as a separate plan for the purposes of the transition rules. But, for purposes of applying the effective date and material modification rules as well as participant elections to terminate post–December 31, 2005, participation or cancel deferral elections, the general requirement that a participant’s interest in all account balance, nonaccount balance, and stock-based NQDCPs be separately aggregated is suspended. Notice, A-9.
Because equity-based plans such as nonqualified stock option or stock appreciation right plans do not provide for payments to participants on any of the Code § 409A distribution events because a participant may “accelerate” the benefit by exercising the option before the option’s expiration date, these plans must fit within the exclusions from Code § 409A described in the Conference Report to the Act and detailed in A-4(d) and (e) of the Notice. A nonqualified stock option will not be subject to Code § 409A if (1) the exercise price may not be less than the value of the underlying stock at the date of grant, (2) the transfer or exercise of the option is subject to taxation under Code § 83, and (3) the option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of the option’s exercise or transfer. The Notice suggests that tandem stock option and stock appreciation right arrangements may allow for the additional deferral of compensation but that the receipt of nonvested stock on exercise will not. Notice, A-4(d)(iii).
The Notice states that the terms of a stock appreciation right with a fixed payment date generally will comply with the provisions of Code § 409A. Two transition exceptions are provided for SARs. One involves publicly traded securities if rules similar to those for nonqualified stock options are met. Second, a payment of stock or cash upon the exercise (or a cancellation for consideration) of an SAR granted before October 3, 2004, will not be subject to Code § 409A if (1) the SAR exercise price may never be less than the value of the underlying stock at the date of grant and (2) the right does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the right. Notice, A-4(d)(iv).