Several provisions of the American Jobs Creation Act of 2004 have required tax advisors to be very proactive with their clients to consult with them about the impact of the statutory changes, as well as subsequent regulatory developments.Among the more significant areas requiring immediate attention have been the new domestic manufacturing deduction, the brief window for repatriation of dividends, the tax shelter reporting and disclosure rules, and the new requirements with respect to nonqualified deferred compensation.
Code Sec. 409A requires current income inclusion of, and imposes interest and penalties on, deferred compensation that does not meet the new, more stringent deferral, acceleration of benefits, and distribution requirements. The new requirements apply broadly to tens of thousands of nonqualified deferred compensation plans.
The new requirements were generally effective for amounts deferred after Dec. 31, 2004, or deferred before but vested after Dec. 31, 2004. The new provisions can also apply to amounts deferred before Dec. 31, 2004, under a plan that was materially modified after Oct. 3, 2004.
Under statutory direction to get out quick guidance, the Internal Revenue Service issued Notice 2005-1 on Dec. 20, 2004. In response to the large number of comments received in response to Notice 2005-1, the IRS on Sept. 29, 2005, issued proposed regulations to further expand on the scope of the new requirements and to provide some additional time to make plan amendments.
The proposed regulations are lengthy, and cover a wide range of issues arising from submitted comments.
The proposed regulations preserve the broad definition of deferred compensation plans as set forth in Notice 2005-1. However, they go into some detail as to how the requirements apply to certain types of compensation arrangements.
In general, a deferred compensation plan subject to these requirements is any plan that provides for the deferral of compensation, but only if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a tax year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to, or on behalf of, the service provider in a later year.
Qualified plans, such as qualified retirement plans, tax-deferred annuities, SEPs, Simple plans and certain welfare benefits, are not subject to the new rules. However, bonus plans, stock options, stock appreciation rights, excess benefit plans and severance pay can all fall within the scope of the rules.
The proposed regulations exclude from their scope short-term benefits paid within two-and-a-half months of the end of the year in which the amounts are earned. The proposed regs relax the requirement that all of these short-term benefit plans must be in writing, but only a written plan will provide some protection if the two-and-a-half month period is inadvertently violated at some point.
The proposed regulations address a number of issues with respect to the application of Code Sec. 409A to independent contractors and directors.
They provide several clarifications with respect to the application of Code Sec. 409A to stock options and stock appreciation rights. In response to comments received by the IRS, the agency has dropped distinctions between stock appreciation rights based on whether the underlying stock is tradable on an established securities market. The proposed regulations also expand the exception for stock options granted on service recipient stock by defining what constitutes service recipient stock more leniently.
The proposed regulations also include a number of clarifications as to what constitutes a reasonable valuation method for determining whether the exclusion requirements for a nonstatutory stock option have been met, and what constitutes a modification of a stock right.
Other clarifications address a promise to transfer restricted property in a subsequent tax year, arrangements between partnerships and partners, foreign arrangements, separation pay arrangements, and split-dollar life insurance arrangements.
The proposed regulations include a number of clarifications with respect to the requirements for the initial deferral election. Generally, deferral elections must be made no later than the close of the year before the amounts will be earned. The clarifications in the proposed regulations address evergreen elections and nonelective arrangements.
With respect to performance-based compensation, the proposed regulations provide a definition and timing for establishing performance-based criteria; clarify that either the amount must not be readily ascertainable or the right to the amount must not be substantially certain; and revise the definition of bonus compensation.
Clarifications are also included in the regs with respect to the impact of an initial deferral election in the context of short-term deferrals, certain forfeitable rights, fiscal year compensation and compensation in the form of commissions.
Time and form of payment
Code Sec. 409A requires that payments under deferred compensation plans be made at a fixed date or under a fixed schedule, or upon any of five events: a separation from service, death, disability, a change in the ownership or effective control of a corporation, or an unforeseeable emergency. The proposed regulations provide clarifications as to when a payment is made based on one of these events.
A de minimis rule is included to allow for minor variations from a fixed schedule. Specific dates are not required in order to constitute a fixed schedule - specifying the year of payment can suffice. A fixed schedule can also be based upon an objectively determinable date based upon the date of the lapsing of a substantial risk of forfeiture. Also, once an event upon which payment has been made has occurred, the payments called for then may constitute a fixed date that may be adjusted according to the limits on adjusting fixed payment dates under the regulations, such as the five-year rule discussed later herein.
The proposed regulations would permit a plan to provide that payments may be made upon the earlier of, or later of, two or more specified permissible payment events or times, as well as permit a different form of payment for each payment event. The regulations also address payment delays where a payment would otherwise violate loan covenants or securities laws, or where there is a dispute between the parties delaying payment.
In general, Code Sec. 409A prohibits acceleration of payments, except as permitted by regulations. Notice 2005-1 recognized domestic relation orders, payments under conflict-of-interest rules, payments for employment taxes and certain de minimis payments as possible permissible accelerations.
The proposed regulations add to this list with certain payments related to the service provider being required to include amounts in income associated with failing Code Sec. 409A requirements, specified circumstances involving plan terminations, and payments necessary to prevent an S corporation sponsoring an employee stock ownership plan from having a non-allocation year. The regulations would also permit terminations of a deferral election following an unforeseeable emergency or a hardship distribution.
Changes in the time and form of payment
Generally, Code Sec. 409A requires that, for an election to delay a payment, or for a change to its form to be permitted, the plan must require that such election not take effect until at least 12 months after the dates on which the election is made and, except for payments on account of death, disability or the occurrence of an unforeseeable emergency, the first payment under the election be deferred for a period of not less than five years.
Further, if the payment was to be made at a specified time or pursuant to a fixed schedule, the election may not be made less than 12 months prior to the date of the first scheduled payment. The proposed regulations provide clarifications as to the definition of a payment and the application of the rules to multiple payment events.
Also included in the proposed regulations are clarifications with respect to plan aggregation rules, the written plan requirement and the definition of a substantial risk of forfeiture. The regulations further address the application of the rules to nonqualified plans that are linked to qualified plans.
While Code Sec. 409A was generally effective as of Jan. 1, 2005, the guidance in Notice 2005-1 for the most part will be effective as of Jan. 1, 2006. The proposed regs are generally applicable for tax years beginning on or after Jan. 1, 2007, but they may be relied upon by taxpayers until the effective date of the final regulations.
Employers have the opportunity to utilize transition relief provisions that are spelled out in the proposed regulations, but that relief expires on Dec. 31, 2005.
While Notice 2005-1 required plan documents to be amended to comply with Code Sec. 409A by Dec. 31, 2005, these proposed regulations extend the deadline for the election, distributions and acceleration provisions of Code Sec. 409A to Dec. 31, 2006. Plans are required to operate in good faith compliance with Code Sec. 409A during that period.
Where a plan amendment is required to permit a participant to cancel an outstanding election or terminate participation in a plan adopted before Dec. 31, 2005, that plan amendment must still be made by Dec. 31, 2005. The extended plan amendment date does not permit participants to change a payout election for payments that would otherwise have been received in 2006.
Practitioners will need to pay very close attention to these dates. The proposed regulations also include clarifications as to amounts considered earned and vested before Jan. 1, 2005, the calculation of the grandfathered amount, and what constitutes a material modification that would result in loss of grandfathered status.
All in all, these are very complicated rules, applicable to a large number of taxpayers, with a variety of effective dates, some of which have already passed and some of which occur at the end of 2005. The consequences of noncompliance can be very severe.
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