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President Bush signed the American Jobs Creation Act of 2004 (AJCA) into law on October 22, 2004, which makes significant changes to the tax rules applicable to nonqualified deferred compensation plans (NQDC). The AJCA adds a new Section, 409A (Inclusion in Gross Income of Deferred Compensation under Nonqualified Deferred Compensation Plans), to the Internal Revenue Code of 1986, as amended (the Code). Code Section 409A becomes effective on January 1, 2005. On December 20, 2004, the Internal Revenue Service (IRS) issued Notice 2005-1 as its first interim guidance on Code Section 409A deferred compensation provisions of the American Jobs Creation Act of 2004.
"Nonqualified deferred compensation plan" is defined as any arrangement (including individual or group plan) under which the employee has a legally binding right to earned compensation that he or she has not actually or constructively received and that is payable at a later date. Section 409A of the Code provides that deferred amounts under a nonqualified deferred compensation plan would be taxed immediately, unless either:
1. The deferred amounts are subject to a substantial risk of forfeiture; or
2. New requirements are met.
Substantial risk of forfeiture is defined as requiring a person's right to compensation be conditioned upon the future performance of substantial services.
This law is analogous to the tax world's Sarbanes-Oxley, with strict new rules for deferred compensation. The new rules governed by Section 409A will have an effect on a broad range of compensation arrangements including deferred salaries and bonuses, supplemental executive retirement plans (SERP), certain stock option plans, stock appreciation rights (SAR), restricted stock units (RSU), performance shares/units, and phantom stock plans. All covered deferral plans will need to follow new rules regarding the timing of elective deferrals and permissible distribution events.
This article focuses on the implications of the new rule for equity compensation plans other than other types of deferral compensation plans such as elective salary deferral plans or deferred plans for sales representatives and other independent contractors. In addition, this article is intended to address the implications of the rules related to constructive receipt only under Code Section 409A, rather than the rules related to funding of NQDC plan through offshore trusts and financial health triggers.
GENERAL PARAMETERS OF THE RULE AND THE GUIDANCE
Code Section 409A depicts that the documents governing the nonqualified deferred compensation arrangements must contain language that incorporates the requirement for:
1. Time of deferral (i.e., timing restrictions); and
2. Time and form of distribution (i.e., distribution restrictions).
With the timing restrictions, …