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Published on January 11, 2008

Author: Matild

Source: authorstream.com

Nonqualified Deferred Compensation: Industry Trends and New Legislation February 2005 :  Nonqualified Deferred Compensation: Industry Trends and New Legislation February 2005 NQDC Plans Best Practices:  NQDC Plans Best Practices Introduction For purposes of this discussion, a Nonqualified Deferred Compensation (“NQDC”) Plan is defined as a nonqualified retirement plan under which a participant voluntarily elects to defer some portion of his or her salary, short-term incentives or other compensation. A typical NQDC plan allows a participant to elect to defer a portion of his or her salary and/or bonus until a future date, such as retirement or termination of employment. Generally, deferrals will be credited to an account and interest, or some other type of credit, will be applied to that account on a periodic basis. At the appropriate time, the balance of the account will be distributed to the participant, either in a lump sum or over time. The NQDC plan may include an employer contribution. NQDC Plans Best Practices:  NQDC Plans Best Practices Prevalent Practice As the 2004 chart below shows, 94% of respondents to the Survey offer some type of NQDC plan. This is an increase over the past four years. Of companies offering a NQDC plan, 79% also maintain a SERP for the benefit of executives. NQDC Plans Best Practices:  NQDC Plans Best Practices Eligibility NQDC plans have been designed to cover executives from the board of directors to vice presidents and highly compensated sales personnel. However, since the Omnibus Budget Reconciliation Act of 1993 (“OBRA”) lowered the limit on compensation for qualified pension calculations to $150,000 (currently indexed to $205,000 in 2004) while the limit on annual contributions to 401(k) plans is currently at $13,000, companies have responded by offering NQDC plans to middle management personnel. The following chart shows the percentage of Respondents that offer NQDC plans by specific position levels. 86% of Respondents with NQDC plans determine eligibility entirely, or in part, by position level. NQDC Plans Best Practices:  NQDC Plans Best Practices Eligibility (continued) Of the respondents to the Survey with NQDC plans, 74% determine eligibility using base salary compensation level as a criterion. 29% of respondents who use base salary to determine eligibility allow participants with compensation below $100,000 to participate in their plans, while 20% of those who base eligibility on Total Compensation permit participation by individuals earning less than $100,000. NQDC Plans Best Practices:  NQDC Plans Best Practices Deferrable Compensation (Impacted By New Legislation) Deferrable compensation is broken down into several categories, which include base salary, short-term incentives, long-term incentives, director’s fees/retainers, stock option gains and restricted stock. NQDC Plans Best Practices:  NQDC Plans Best Practices Payment Of Benefits (Impacted By New Legislation) Respondents to the Survey were asked to specify the times at which a participant becomes eligible to receive a benefit under the NQDC plan. The most commonly reported event that triggers a benefit distribution is termination of employment, with 93% of respondents requiring a distribution when the plan participant terminates employment. 66% indicated normal retirement, and 55% indicated early retirement as separate triggers. Normal retirement age varies between 55 and 65 for respondents. The median normal retirement age is 65. Some plans also require minimum years of service. 52% of respondents stated that their NQDC plan contains a special financial hardship provision. This provision typically allows early withdrawal in the case of financial hardship. *Includes “Hardship” and 25% in-service/unspecified. NQDC Plans Best Practices:  NQDC Plans Best Practices Change In Distribution Election (Impacted By New Legislation) The following chart shows the prevalence of the plan provision that allows a participant to make a change in his or her distribution election. NQDC Plans Best Practices:  NQDC Plans Best Practices Withdrawal Provisions (impacted by new legislation) 56% of respondents to the Survey have now adopted a provision for their plan that allows the participant, at any time, to withdraw the entire account balance, less a withdrawal penalty (typically 10%). NQDC Plans Best Practices:  NQDC Plans Best Practices NQDC Plan Informal Funding 72% of NQDC plans are informally funded, an increase from last year (69%). 25% of surveyed plans remain unfunded, with 3% of respondents considering Informal funding within the next 12-24 months. Prevalence of NQDC Plan Informal Funding NQDC Plans Best Practices:  NQDC Plans Best Practices Types of Informal Funding Vehicles Over the years, a variety of funding vehicles have been used to informally fund NQDC plans. The funding vehicle most commonly used is Corporate-Owned Life Insurance (“COLI”), reported by 61% of respondents to the Survey, followed by Mutual Funds (15%). The chart below indicates an increase in COLI funding (last year 55%), showing a return to the levels of previous years. NQDC Plans Best Practices:  NQDC Plans Best Practices Rabbi Trusts and Alternatives (impacted by new legislation) 70% of respondents to the Survey use a Rabbi Trust. 17% use a Springing Rabbi Trust. 11% do not use any device to protect participants from adverse decisions of the plan sponsors. View from Washington:  View from Washington American Jobs Creation Act of 2004:  American Jobs Creation Act of 2004 American Jobs Creation Act of 2004 (H.R. 4520) signed into law on October 22, 2004 Includes provision (section 885 of the Act) regarding the treatment of nonqualified deferred compensation (NQDC) Provision is the result of discussions over the past two years Issue arose, in part, because of payouts by Enron of NQDC amounts just as the company was going under Existing bankruptcy law was adequate to address this concern Prior Law - NQDC:  Prior Law - NQDC Prior to AJCA, the tax rules relating to NQDC were largely uncodified Determination of when NQDC was includible in income depended on facts and circumstances Various tax doctrines applied (e.g., constructive receipt, economic benefit, section 83) 1978 Congressional moratorium on Treasury guidance Overview of New NQDC Rules:  Overview of New NQDC Rules NQDC rules are contained in new Internal Revenue Code §409A Contains rules on: Timing of deferral elections Permissible times for distributions Permissible modifications to distributions Prohibition on financial health triggers and offshore trusts Information reporting and wage withholding New rules generally applicable to amounts deferred after December 31, 2004 Guidance from Treasury/IRS:  Guidance from Treasury/IRS New law directed the Treasury Department to issue transitional guidance within 60 days of enactment Treasury beat the deadline by one day and issued Notice 2005-1 on December 20, 2004 Notice subsequently “clarified” Subjects covered by initial guidance are extremely limited Additional guidance is necessary and is likely to be issued during the first half of 2005 What Does New §409A Provide?:  What Does New §409A Provide? General rule: All amounts deferred under a NQDC plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in income unless certain requirements are met. Consequences of failure to satisfy requirements: All amounts deferred under the plan for all taxable years for any participant to whom the plan failure relates are includible in income Includible amount is also subject to interest (reaching back to the year the compensation was first deferred) and a 20-percent penalty Effective Date:  Effective Date General rule: New §409A is generally effective for amounts deferred in taxable years beginning after December 31, 2004. Exception for material modifications: New rules will apply to 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. Date of deferral: An amount is considered deferred before January 1, 2005, if (i) the service provider has a legally binding right to be paid and (ii) the right to the amount is earned and vested. Material Modification:  Material Modification General rule: There is a material modification of a plan if a benefit or right existing as of October 3, 2004, is enhanced or a new benefit or right is added. Exception for suspension or termination of a plan: It is not a material modification to: amend a plan to stop future deferrals or before January 1, 2006, to amend a plan to terminate it and distribute the deferred amounts (provided those amounts are included in income in the year of termination) Exception for Equity-Based Compensation: It is not a material modification to cancel and reissue, before January 1, 2006, a stock option or SAR that would be a deferral of compensation (as discussed below) with one that would not. What is NQDC?:  What is NQDC? Broadly defined as any plan that provides for the deferral of compensation (elective or non-elective) Not limited to arrangements between employers and employees (i.e., can apply to arrangements with independent contractors or to arrangements between partners and partnerships) Exclusions for: Qualified employer plans (e.g., qualified retirement plan, tax-deferred annuities, SEP, SIMPLE) Certain welfare benefit plans (e.g., bona fide vacation, sick leave, compensatory time, disability pay, or death benefit plan, health savings account) Are These Deferred Compensation ?:  Are These Deferred Compensation ? Assess the Impact of the New Rules on other types Nonqualified Deferred Compensation Plans SERPs Stock Options Restricted stock SARs Stock option gain deferral plans, and Any other arrangements that might result in the “deferral of compensation” What is a Deferral of Compensation?:  What is a Deferral of Compensation? Notice 2005-1 defines “deferral of compensation”: A plan provides for the deferral of compensation only if…the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that …is payable…in a later year. There is no legally binding right to compensation if the compensation may be unilaterally reduced or eliminated by the employer. Exception for short-term deferrals Pending additional guidance, there is no deferral of compensation if the plan provides that amounts must be paid within 2-1/2 months from end of the first year (service provider’s or recipient’s) in which the amount is no longer subject to a substantial risk of forfeiture Equity-Based Compensation:  Equity-Based Compensation In general, stock options, stock appreciation rights (SARs), and other equity-based compensation will be treated as providing for a deferral of compensation. Exception for statutory stock options. Notice 2005-1 says that grant of an incentive stock option or an option under an employee stock purchase plan (including a grant with a permissible discount) does not constitute a deferral of compensation. Exception for nonstatutory stock options. Notice 2005-1 provides that nonstatutory stock options will not be a deferral of compensation if: Option exercise price may never be less than the fair market value of the underlying stock on the date the option is granted Receipt, transfer, or exercise of the option is subject to tax under section 83 and The option does not include any feature for the deferral of compensation other than the deferral of income recognition until the later of exercise or disposition of the option Equity-Based Compensation - SARs:  Equity-Based Compensation - SARs Exception for certain SARs: Under Notice 2005-1, a SAR does not provide for a deferral of compensation if: (1) the SAR exercise price may never be less than the fair market value of the underlying stock on the date the SAR is granted (2) the stock of the service recipient is traded on an established securities market (3) only such traded stock may be delivered upon exercise, and (4) the SAR does not include any feature for deferral of compensation other than the deferral of recognition of income until exercise. Temporary Rule: Until further guidance, a payment of stock or cash pursuant to the exercise of a SAR will not be treated as a deferral of compensation if (1) and (4) above are satisfied (e.g., if the service recipient’s stock is not publicly traded). Equity-Based Compensation – Restricted Stock:  Equity-Based Compensation – Restricted Stock Exception for Restricted Property: Under Notice 2005-1, receipt of restricted property (e.g., restricted stock) is not treated as a deferral of compensation, even though the value of the property may not be includible in income in the year of receipt under sec. 83 because the property is not yet vested. Caution: The right to receive property in the future (whether or not the property is restricted property) may be treated as a deferral of compensation. E.g., restricted stock units New Rules for Deferral Elections:  New Rules for Deferral Elections General rule: Compensation for services performed during a year may be deferred electively only if the election to defer is made before the beginning of the year or at such other time as provided in regulations. Transition relief: Notice 2005-1 says generally that election timing rule will not apply to any elections made before March 15, 2005, with respect to services performed before January 1, 2006. This transition relief is subject to several conditions (see Q-21) Exception – first year of eligibility: For the first year in which an individual is eligible to participate, the election can be made within 30 days of eligibility, but only as to compensation earned after the election. Exception – performance-based compensation: For “performance-based compensation” based on services performed over a period of at least 12 months, the deferral election may be made up to 6 months before the end of the service period. Performance-Based Compensation:  Performance-Based Compensation Definition: Legislative history says performance-based compensation is to be defined by the Treasury to include compensation that is: Variable and contingent on the satisfaction of preestablished organizational or individual performance criteria and Not readily ascertainable at the time of the election. Temporary guidance for bonuses: Under Notice 2005-1, deferral elections for “bonuses” for services performed over 12+ months will be timely if made at least 6 months before end of the service period. Bonuses defined as compensation where: Payment of the compensation (or the amount) is contingent on satisfaction of individual or organizational performance criteria (including, certain subjective criteria) Performance criteria are not substantially certain to be met at the time the deferral election is permitted. Permissible Distributions:  Permissible Distributions Under §409A, distributions from a NQDC plan may be made no earlier than: Separation from service (6 months after separation for “key employees” of public companies) Disability Death A specified time (or pursuant to a fixed schedule) specified under the plan as of the date of the deferral Unforeseeable emergency, but only to the extent necessary to satisfy the emergency (and pay taxes on the distribution) Change in control (as permitted by the IRS) Notice 2005-1 provides guidance implementing change in control. Modifications of Distributions:  Modifications of Distributions Subsequent elections to delay a payment or change the form of payment may be made, provided that: The subsequent election is made at least 12 months before the first scheduled payment Payments that are subject to the election (other than for death, disability, or emergency) are delayed at least 5 years from the originally scheduled payment date and The election will not take effect for at least 12 months The plan may not permit any acceleration of the specified time (or fixed schedule) for paying benefits, except as provided in regulations. Transition relief: Under Notice 2005-1, for amounts subject to new rules, plan may be amended to permit new payment elections to be made on or before December 31, 2005. Financial Health Triggers:  Financial Health Triggers New NQDC rules generally permit continued use of rabbi trusts. However, new rules are violated if the plan provides that assets will become restricted to the provision of benefits under the plan in connection with a change in the employer’s financial health, whether or not the assets are available to satisfy claims of general creditors. Thus, providing for funding of a rabbi trust upon a change in the employer’s financial health would trigger adverse consequences. Pending “technical correction” would make this rule effective on January 1, 2005 (even as to old deferrals) Correction period is contemplated. Offshore Trusts:  Offshore Trusts New NQDC rules generally prohibit setting aside assets in an offshore trust Exception for assets located in a foreign jurisdiction where substantially all of the services were performed Pending technical correction would make this rule effective on January 1, 2005 (even as to old deferrals) Correction period is contemplated Coming Into Compliance With §409A:  Coming Into Compliance With §409A Every NQDC plan will have to be amended to comply with the new rules. Notice 2005-1 gives taxpayers until December 31, 2005 to make necessary changes to plan documents Treasury officials have urged taxpayers to refrain from making any amendments until additional guidance is issued NQDC plans will have to be in “good faith” operational compliance with the new rules starting January 1, 2005. Transition relief: A plan adopted before December 31, 2005 may be amended to allow a participant during all or a part of calendar year 2005 to terminate participation in the plan or cancel a deferral election. Transition to §409A – Key Dates under Notice 2005-1:  Transition to §409A – Key Dates under Notice 2005-1 Plans must be in operational compliance with the new rules of §409A beginning 1/1/05. Deadline for existing plan participants to increase existing deferral election or to make new deferral elections (if not yet made), provided the amounts subject to the elections are subject to §409A and not yet payable. (Q&A-21 of Notice 2005-1.) For a bonus program with a service period based on a calendar year, which qualifies as “performance-based compensation,” this is the deadline to increase existing elections to defer the bonus earned in 2005 (payable in 2006), or to make new deferral elections for such compensation if not yet made. Deadline for: Employers to bring their plan documents into compliance with §409A. Employers to allow participants to terminate participation in a plan or cancel (or reduce) outstanding deferral elections. Plan participants to submit new payment elections for amounts subject to §409A (including amounts deferred prior to the date the payment election is submitted). 1-1-05 3-15-05 6-30-05 12-31-05 Period of Time to: Complete Plan Documents Allow Participants to Terminate Plan Participation or Cancel Deferral Elections Make New Payment Elections First 6 Months of Service Period for CY Bonus Payable in 2006 Limited Relief from the General Timing Rule for Deferral Elections §409A – The Bottom Line:  §409A – The Bottom Line What should plan sponsors be thinking about? Assemble a project team and review all plans “Amend and restate“ vs. “Freeze and adopt new” Review Rabbi Trust documents Consider March 15, 2005 “window of opportunity” Do not attempt to re-write plan documents yet Current problems and issues for plan sponsors Communication to participants Administration and record-keeping challenges §409A – The Bottom Line:  §409A – The Bottom Line Impact summary

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