The U.S. Treasury Department has issued Notice 2005-1, containing its much-anticipated transition guidance concerning the new rules for non-qualified deferred compensation in section 409A of the Internal Revenue Code. Treasury is expected to follow up with proposed regulations next summer.

Section 409A significantly changed the rules regarding the timing of deferral elections under, and distributions from, non-qualified deferred compensation plans. The recent enactment of section 409A raised numerous questions as to which deferral arrangements are covered, as well as how 2004 and 2005 deferrals should be treated. Following are highlights from Treasury's transition guidance. 

1. Effective date. A participant's vested account balance as of December 31, 2004, under a defined contribution-style plan, plus earnings thereon, is not subject to section 409A. The present value of a participant’s vested benefit as of December 31, 2004, under a defined benefit-style plan (such as a SERP) is not subject to section 409A. These benefits may be distributed under the provisions of the plan in effect as of October 3, 2004, and will be subject to tax under the traditional (pre-section 409A) rules of constructive receipt. Subject to very limited exceptions (see below), all other benefits under a non-qualified deferred compensation plan—including amounts previously deferred but not vested as of December 31, 2004—are subject to section 409A.

2. Deferral of 2004 bonus. The deferral of a bonus payable in 2005 for pre-2005 services is generally subject to section 409A, but is eligible for limited relief under the deferral election timing rules. If the plan was in existence prior to January 1, 2005, the employee may elect to defer the bonus up until the date on which the bonus is paid or payable, but no later than March 15, 2005. However, a bonus payable in 2005 for pre-2005 services is not subject to section 409A if the employee has a legally binding right to the bonus as of December 31, 2004, and the employee does not have to perform services after December 31, 2004 in order to receive the bonus. In such a case, the bonus may be deferred under the terms of the plan in effect on October 3, 2004, consistent with traditional rules of constructive receipt.

3. Deferral of 2005 salary. Deferrals of 2005 salary are subject to section 409A. However, an employee may defer all or a portion of his or her 2005 salary by making a deferral election by March 15, 2005. The election may apply only to amounts that will be paid after the election is made.

4. Plan amendments. Existing plans must be amended to comply with section 409A by December 31, 2005. Until a plan is amended, it must be operated in good faith compliance with section 409A and the Treasury guidance. Keep in mind that a non-qualified deferred compensation plan may take many forms, including a deferral arrangement in an employment agreement for a single employee.

5. Equity-based compensation. Equity-based compensation, other than direct payment of stock, is subject to section 409A, with certain exceptions. In particular:

§ Equity-based compensation rights that are earned and vested as of December 31, 2004 generally are not subject to section 409A.

§ "Incentive stock options" under section 422 of the Code and options under a section 423 employee stock purchase plan are not subject to section 409A.

§ Nonqualified stock options are not subject to section 409A if the exercise price may never be less than the fair market value of the underlying stock on the date of grant.

§ Stock appreciation rights ("SARs") are not subject to section 409A if the appreciation is measured against the fair market value of the underlying stock on the date of grant, the stock is traded on an established securities market, and the SAR may only be settled in stock.

§ Until further guidance is issued, SARs granted pursuant to a program in effect on or before October 3, 2004 (including SARs that may be settled in cash) are not subject to section 409A if the appreciation is measured against the fair market value of the underlying stock on the date of grant.

These exceptions are all subject to the requirement that the right to receive equity-based compensation may not include any feature for the further deferral of compensation after the right is exercised, except that the right may provide for the issuance of non-vested stock upon exercise.

6. Severance pay arrangements. Severance pay arrangements generally are subject to section 409A. However, at least for 2005, a severance pay arrangement will not be required to satisfy the section 409A rules if it covers only non-key employees (as determined under the qualified plan rules) or collectively bargained employees. Thus, a severance pay arrangement that covers key employees is subject to the section 409A rules beginning in 2005. In the context of a publicly-traded company, this means that severance pay cannot be paid to key employees until six months following termination of employment.

7. Change of control. Section 409A permits distributions from a non-qualified deferred compensation plan upon a change in the ownership or the effective control of the corporation, or a change in ownership of a substantial portion of the assets of the corporation. The Treasury guidance includes a lengthy discussion of these terms. Generally, a corporation undergoes "a change in ownership" if more than 50% of the total fair market value or total voting power of the stock of the corporation is acquired by an unrelated third party. A corporation undergoes a change in "effective control" if 35% or more of the total voting power of the stock is acquired by an unrelated third party or a majority of members of the board of directors is replaced during a 12-month period. A change in the ownership of a "substantial portion" of a corporation’s assets occurs if 40% or more of the total gross fair market value of all of the assets of the corporation is acquired by an unrelated third party.

8. Coordination of SERP with qualified plan. Through the end of 2005, a non-qualified deferred compensation plan may continue to coordinate elections of forms and timing of distributions with elections under a qualified plan, under the terms of the non-qualified deferred compensation plan as of October 3, 2004. For elections and distributions after 2005, the election timing and distribution rules of section 409A may make it difficult to coordinate elections with qualified plan elections. 

9. No Acceleration of Benefits. Section 409A generally prohibits a non-qualified deferred compensation plan from permitting "the acceleration of the time or schedule of any payment under the plan, except as provided in regulations by the Secretary." Treasury’s transition guidance permits exceptions for domestic relations orders, to pay FICA taxes, and to pay an employee’s entire interest under the plan at termination of employment so long as such amount does not exceed $10,000. All other accelerations appear to be prohibited. Thus, a SERP that provides an annuity as the normal form may not allow a participant to elect a lump sum, except under limited circumstances. However, the SERP may provide a lump sum as a normal form and permit a participant to elect an annuity provided such election otherwise conforms to the new rules.

10. Opt-out provisions. During 2005, a participant (or the employer on behalf of a participant) may terminate participation in the plan or cancel a deferral election for amounts that were previously deferred and that are subject to section 409A. If an opt-out is desired, the plan must be amended by December 31, 2005 to permit this opt-out election, and this amendment will not be considered a “material modification.” The amounts subject to the election must be recognized as income when they become earned and vested.

11. Section 457(f) plans. Tax-exempt organizations and governmental employers may offer so-called "ineligible" deferred compensation plans to certain employees under section 457(f) of the Internal Revenue Code, pursuant to which employees are taxed when the deferred compensation becomes vested. Typically, the deferred compensation is paid when it vests. Section 409A applies to these plans. Moreover, since the account balance under these plans is not vested, the new rules will apply to the entire benefit, without grandfather relief for pre-2005 deferrals.

Section 409A and the transition guidance issued by Treasury are quite complex and contain a variety of exceptions and special rules that may apply to your specific situation. We would be happy to assist you in reviewing your non-qualified deferred compensation plans and arrangements to determine what steps you need to take to transition to section 409A compliance.


Copyright © 2005 by Ballard Spahr Andrews & Ingersoll, LLP. (No claim to original U.S. government material.) This publication is intended to alert recipients to new developments in the law. It does not constitute legal advice or a legal opinion on any specific facts or circumstances. The contents are intended as general information only. You are urged to consult your own lawyer concerning your situation and specific legal questions you may have.