On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (the “Act”). The Act contains comprehensive changes to the federal tax laws governing nonqualified deferred compensation plans, including a surprising expansion of the reach of such laws to cover certain forms of equity compensation. Since the Act will apply to amounts deferred after 2004, we discuss in this Alert the actions that employers will need to take in the weeks and months ahead.

1. Identify Deferred Compensation Plans Affected by the Act. The Act applies to all plans and arrangements that provide for the deferral of compensation, with the exceptions of tax-qualified retirement plans and bona fide vacation leave, sick leave, compensatory leave, disability pay and death benefit plans. Certain types of equity compensation awards, such as stock appreciation rights (SARs), restricted stock units (RSUs) and options granted with exercise prices below fair market value, would be affected by the Act. An employer should identify all of its plans and arrangements that are or might be covered by the Act.
   
   
2. Consider Plan Revisions Required by the Act. Assuming that an employer will want to continue existing deferred compensation plans into 2005 and beyond, the following changes may be necessary:
   

   Deferral elections with respect to performance-based compensation covering services over a period of 12 months or more must be made at least 6 months before the end of the performance period; deferral elections for other compensation, as before, will need to be made before the taxable year when earned. Elections to defer payment or change the form of payment of a previously scheduled distribution must be made at least 12 months before both the effective date of the election and the first scheduled payment and must defer payment at least 5 years from the original payment date. So-called “haircut” provisions that, in the past, have permitted in-service withdrawals upon forfeiture of a portion (typically 10%) of the withdrawn amount will need to be deleted. "Key employees” of public companies will not be able to receive distributions within the first 6 months following separation from service. Plans that permit distributions on account of “disability” or “unforeseeable emergency” will need to take account of the Act’s definitions of those terms. Plans that provide for distributions on change of control events will need to await further guidance from the Secretary of the Treasury (required by January 22, 2005) as to the nature of such events and the manner in which distributions will be allowed. Provisions for the restriction of assets upon the change in an employer’s financial health to pay deferred compensation benefits (for example, the funding of a rabbi trust, even though its assets remain subject to the claims of an employer’s general creditors) will have to be eliminated.

   
   
3. Assess the Effect of the Act on Equity Compensation Practices. As noted above, the Act will affect certain equity compensation practices — particularly SARs and RSUs — that are starting to gain greater currency in light of anticipated changes in the accounting rules for equity compensation. Accordingly, the continued use of such types of awards, and the effect of the Act on unvested awards of these types, should be examined in light of the Act and subsequent guidance.
   
   
4. Consider Whether to Amend Existing Plans or Establish New Plans. The Act “grandfathers” amounts deferred under plans and arrangements prior to 2005. An amount is considered deferred prior to 2005 if it is “earned and vested” before that year; earnings on such grandfathered amounts are also grandfathered. However, grandfathering will be lost if the plan or arrangement is “materially modified” after October 3, 2004. Employers thus will need to decide how to preserve the grandfathered status of deferrals that are earned and vested prior to 2005. The choice would be either to freeze a plan as of the end of 2004 and create a new post-2004 plan or, through separate accounting within a single plan, to reflect the new rules as to post-2004 deferrals in the existing plan. Either choice will require close communication with plan administrators and employees. Attention should be given to restrictions on plan amendments contained in existing plans. Agreements with plan service providers and trustees of any rabbi trusts also may require amendment to reflect new plans or amendments to existing plans.
   
   
5. Consider the Manner and Timing for Plan Amendments or the Establishment of New Plans. Action by an employer’s Board of Directors (or one of its committees, such as the Compensation Committee) may be necessary to amend plans in light of the Act or to establish new plans. Alternatively, consider delegating to one or more designated officers the authority to make changes to plans necessary under the Act to enable them to operate in 2005. The Conference Report on the Act states that it is expected that the Secretary of the Treasury will provide a reasonable transition period after guidance is issued for plans to be amended and approved. Informal statements from Treasury representatives have indicated that year-end 2004 plan amendments will not be required and that amendments, when made by a later prescribed date, will be permitted to relate back to deferrals made for 2005. Accordingly, until guidance is issued by the Secretary of the Treasury, employers should not proceed actually to amend their deferred compensation plans and arrangements.
   
   
6. Plan for 2004 Open-Enrollment Period. Employers typically enroll and re-enroll participants in deferred compensation plans toward year-end (often during the months of November and December). In light of the Act, deferral election forms and plan communications materials will need to be revised to be consistent with plan amendments or new plans that may be adopted in 2005 following guidance from Treasury.

   2004 Earned Bonuses. If an employer in the past has permitted bonus deferrals to be made after completion of part or even all of the relevant service period, such employer should await further guidance from Treasury as to whether this approach will be permitted under transitional relief with respect to bonuses earned in 2004 that will be payable in 2005. For example, while the Act would require a deferral election for a calendar year 2004 bonus to have been made by December 31, 2003 (or perhaps June 30, 2004, if it is considered “performance-based”), transitional relief might allow for a later, one-time election. Thus, employers that in the past have permitted bonus deferrals to be made at or near the end of the service period may be able to permit such elections to be made with respect to 2004 earned bonuses that will be payable in 2005 on the basis of a reasonable expectation that transitional relief from Treasury will permit such elections. If Treasury guidance does not provide such relief, the bonuses then would become taxable when paid.

   2005 Earned Bonuses. It is also advisable to request elections by December 31, 2004 for deferrals of bonuses to be earned in 2005, even if the Act might allow such elections to be delayed until as late as June 30, 2005, because the bonus is considered performance-based compensation. Until the contours of performance-based compensation are set out in guidance from Treasury, the safer course is to assume that a 2005 bonus would not qualify as performance-based compensation and thus require the election to be made by the end of 2004.

7. Consider Effect of New Rules in M&A Transactions. Various forms of deferred compensation plans (as broadly defined by the Act to include RSUs, SARs and options with below-fair market value exercise prices) are the subject of negotiated treatment in mergers and acquisitions. Deferred amounts often are accelerated as to vesting and exercisability or converted as to form. In light of the risk of losing the grandfathered status of a deferred compensation plan or arrangement through a material modification, care should be taken in the negotiation of M&A documents that will have any of these effects.
   
   
8. Consider Effect of New Rules on Plans of Hedge Funds. The deferred compensation plans and arrangements of hedge funds typically are established as fee deferral agreements between the offshore hedge fund and its investment manager. It is not clear how the Act’s deferred compensation provisions apply to such entity-to-entity agreements. However, certain distribution triggers commonly found in such fee deferral agreements (for example, dissolution of the hedge fund or a change in applicable tax law) may not be permitted by the Act, and they clearly are not permitted if payment of the deferred amount is triggered by departure of an employee of the investment manager. Further guidance from Treasury is needed.
   
   
9. Establish Necessary Tax Reporting Systems. he Act requires that starting with 2005, deferred amounts are to be reported on an individual’s Form W-2 or Form 1099 for the year of deferral, even if the amounts are not currently includible in income for that taxable year.
   
   
10. Await Further Treasury Guidance. By December 22, 2004, the Secretary of the Treasury is required to issue guidance providing a limited period during which a plan or arrangement adopted before December 31, 2004 may be amended (i) to permit a participant to terminate participation or cancel a deferral election with respect to post-2004 amounts so long as such amounts are included in income as earned (or, if later, vested) and (ii) to conform to the requirements of the Act with regard to post-2004 deferrals. By January 22, 2005, guidance on changes in ownership or control is expected.
    
    
11. Contact Your Howard Rice Attorney. This Alert necessarily does not specifically address the details of your deferred compensation plans and arrangements. Please contact Gary P. Kaplan (415.434.1600, gpkaplan@howardrice.com) or your usual Howard Rice attorney to discuss the specific application of the Act to such plans and arrangements.

* * *

Related Groups:

• Corporate & Securities
• Labor & Employment
• Tax Strategies & Planning

Click here to unsubscribe from these Alerts.

http://www.howardrice.com/

Copyright © 2005 Howard Rice Nemerovski Canady Falk & Rabkin PC, Three Embarcadero Center, Seventh Floor, San Francisco, CA 94111.
Permission is granted to make and redistribute, without charge, copies of this entire document provided that such copies are complete and unaltered and identify Howard Rice as the author. All other rights reserved.