Spotlight on deferred compensation.

On Oct. 22, President Bush signed into law the American Jobs Creation Act of 2004, which makes sweeping changes in deferred-compensation law. Written in an effort to curb the kinds of abuses recorded in the actions of Enron Corp. executives, the new law makes changes to nonqualified deferred compensation in three areas--Elections to Defer, Distributions and Inclusion in Income--and sets requirements in each area. The law also requires the Department of the Treasury to issue guidance within 60 days of enactment.

The law applies to all arrangements that provide for the deferral of compensation after calendar year 2004. Generally, the only exceptions to this rule are qualified plans such as 401(k) plans, bona fide vacation leave plans, sick leave, compensatory time, disability pay or death benefit plans. The forthcoming guidance is also expected to exempt statutory stock options, such as incentive stock options (ISOs) and employee stock purchase plans (ESPPs), as well as bonuses that are paid out within 2-1/2 months after the end of the bonus period.

Under the new law, if a deferred compensation plan does not comply, deferred amounts will be includable in income and will be subject to a penalty of interest at the underpayment rate plus 1 percent, and an additional 20 percent tax penalty. Because the penalties for non-compliance are severe, some companies may have to radically change their plans to meet the following requirements:

First, the law requires that any decision to defer compensation must be made in the taxable year prior to the deferral. The only exception to this rule deals with newly eligible employees.

Second, the distribution restrictions in the law provide that deferred compensation cannot be distributed any earlier than one of six specified events:

(1) separation from service (six months after separation from service for key employees of publicly traded companies); (2) disability (as narrowly defined in the statute); (3) death; (4) a specified time (or fixed schedule) specified under the arrangement as of the date of deferral, but not an event; (5) a change in the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation (to the extent provided by the Treasury); or (6) the occurrence of an unforeseeable emergency (as narrowly defined in the statute).

The Concern over SARS

While transition guidance is expected from the Treasury Department before December 21, it is important to note that several popular vehicles for receiving deferred compensation may be noncompliant under the new law, including stock appreciation rights (SARs), certain severance plans and discounted stock option plans if the exercise price is less than the fair market value of the stock at the date of grant.

There is great concern about the noncompliant status of SARs, and it appears that the Treasury Department will allow for a modification of SAR plans to bring them into compliance. The plan would have to be modified to provide that a SAR holder can exercise the SAR at any time, but the appreciation would not be paid out until a specific date or at the time of a permitted distribution event.

This type of modification would give the executive the ability to control the timing of the measurement of the appreciation, but would arguably comply with the new law because the appreciation would not be payable until one of the recognized distributable events occurs.

Though sweeping changes to plans could be required, the Treasury Department has signaled that it intends to offer employers a grace period in which to bring their plans into compliance with the new law. However, at a minimum, companies should begin to:

(1) examine all benefit plans to determine whether they will be affected by the change in the law; (2) identify which provisions of those plans may be affected; (3) identify areas that may be affected by transition rules; (4) develop a plan-modification strategy; (5) obtain board approvals, if necessary; (6) assess and revise employee communications, including deferral election materials; (7) obtain elections for 2005 deferrals by the end of 2004; (8) coordinate plan changes with third-party administrators.

FEI will continue to monitor developments in this area and will provide comment to the Treasury Department as warranted.

Bob Shepler ([e-mail]) is FEI's Director of Federal Affairs.

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