New Rules on Executive Compensation
By Beverly White and Robert L. Pash
Financial institutions in New Jersey and across the country need to pay careful attention to new rules and regulations on executive compensation programs. There is, to be sure, still great opportunity to use deferred compensation and other nonqualified retirement plans to help retain and attract quality executives.
Given the plethora of regulations themselves, as well as the corporate governance environment in general, it makes good business sense for institutions to carefully review their existing plans as well as to very carefully structure new programs.
Financial institutions have long used deferred compensation and other nonqualified, supplemental retirement plans to help retain and attract quality executives who generate maximum shareholder value. These benefits have often been instituted to provide retirement planning parity for executives.
Because of limitations on what many executives can contribute to and receive from qualified retirement plans, such as pensions and 401(k)s, many executives will receive a lower percentage of their salary at retirement from qualified plans than will other employees. Deferred compensation contributions, as well as other nonqualified plans, help to bridge this gap.
Executive compensation has been a topic of intense discussion in the halls of Congress for the past few years. Corporate malfeasance at Enron, WorldCom, Adelphia and Global Crossing placed pressure on Congress to legislate reform and rein in executive compensation abuses. After much industry involvement, on Oct. 22, 2004, President Bush signed the American Jobs Creation Act, which added Section 409A to the Internal Revenue Code.
Viewed as sweeping non-qualified plan deferred compensation reform, Section 409A finally codified what some believed were much-needed rules. However, like much of the legislation that emanates from Congress, the legislation has broad-reaching implications.
In a nutshell, the legislation makes it harder for executives and others who are entitled to deferred compensation to take an early payout, or to change elections with respect to the time and form of payment of deferrals after amounts are initially deferred. In addition, payments under deferred compensation plans subject to the legislation can be made only upon the occurrence of one of six specified events, which include, among other things, departure from the company, death, disability or a change in control.
If the company is publicly traded, certain executives generally may not receive a distribution for six months after their “separation from service” (other than due to death or disability). For these purposes, an executive who terminates employment but continues as a “consultant” may not be considered “separated from service” if the hours worked and pay received exceed a certain percentage of such individual’s prior hours and pay. The opportunity to accelerate deferred compensation and pay it at any time other than the time originally specified in the plan or related documents will no longer be permitted except in very limited circumstances. Failure to comply with these new rules may cause an executive or other plan participant who is subject to such failure to include the amount deferred in income, to pay interest from the time of the initial deferral and a 20 percent penalty on the includible amount.
FEWER QUESTIONS REMAIN
In late December 2004, the U.S. Treasury Department issued Notice 2005-1 under Section 409A that clarified some basic questions and established a compliance deadline of Dec. 31, 2005. Despite this guidance, many questions were left unanswered. The Treasury Department issued a second round of promised guidance this past October in the form of proposed regulations. The proposed regulations built upon the foundation laid in December.
So what does Section 409A encompass? Basically, Notice 2005-1 provides that any agreement, method or arrangement, including one that applies to only one person, which provides for the deferral of compensation, is a “plan” for purposes of Section 409A. A deferral of income occurs where 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, pursuant to the terms of the arrangement, is payable to the service provider in a later year.
Plans subject to Section 409A include salary and fee deferral plans, supplemental retirement plans (SERP), bonus deferral plans, stock options and stock appreciation rights issued at less than fair market value (SARs), mirror 401(k) deferral plans, excess benefit plans, restricted stock units and severance pay plans, including severance payment arrangements found in most executive employment agreements and/or change in control agreements that pay more than two times annual compensation, as defined in the proposed regulations (but not in excess of $420,000 for 2006, as indexed).
Specifically excluded from Section 409A are bona fide vacation and sick leave plans, disability and death benefit plans, annual bonus or compensation received within two-and-a-half months after the taxable year in which services were performed, qualified plans, stock options or SARs issued at fair market value, section 423 employee stock plans and tax-deferred annuities. Section 409A is initially effective with respect to amounts deferred after Dec. 31, 2004 and amounts deferred before Dec. 31, 2004 that are not both earned and vested prior to Jan. 1, 2005. Amounts that are both earned and vested prior to Jan. 1, 2005 will not be subject to the legislation unless there is a material modification to the plan after Oct. 3, 2004 (the date the legislation was released from the Conference Committee).
If a plan is materially modified after Oct. 3, 2004, amounts that might not otherwise be subject to Section 409A will become subject to its provisions. Notice 2005-1 indicates that amending a plan to bring it into compliance with the legislation will not be considered a material modification; however, any changes that enhance a benefit under a plan will be considered a material modification.
TRANSITIONAL RELIEF EXTENDED
Treasury understands that most non-qualified deferred compensation plans will be affected in some way by the new legislation. As such, and considering that proposed regulations were not issued until October 2005, the Treasury has imposed an unusually long transition period for banks and companies to bring their plans in compliance.
In general, as long as the non-qualified deferred compensation plan is operated in good faith compliance with Section 409A, amendments are required to be adopted on or before Dec. 31, 2006 to conform to Section 409A.
Treasury extended the compliance deadline to Dec. 31, 2006 for document compliance, changes in payment elections or conditions (provided that the election changes do not apply to amounts otherwise payable in 2006 or cause payments to be made in 2006), revision of “mirrored elections” based on qualified plan elections and substitutions of non-discounted options or SARs for discounted options or SARs.
Treasury did not extend transitional relief for making initial elections to defer 2006 compensation or for the cancellation of previous deferral elections and termination of plan participation or for the termination and distribution of a grandfathered plan, which relief ends at Dec. 31, 2005.
With this second round of guidance issued, now is the time to review existing arrangements to determine what, if any, action needs to be taken. The key to compliance is through a thorough review of all of your “plans.” Although the penalties of noncompliance fall exclusively on the “service provider”, e.g. the executives and directors who participate in such arrangements, the company has a keen interest in making certain that the arrangements it entered into with its executives and directors ultimately satisfy the intended purpose.
In fact, when evaluating what changes need to be made to their executive compensation and benefits programs as a result of the new regulations, financial institutions might want to see this as an opportunity to make sure their plans are as effective as they can be. They may wish to gauge what competitors are doing, or likely doing, in order to institute refinements or other changes in their plans. By doing so, they will ensure that the plans are not only compliant, but provide quality “golden handcuffs” that make sure the institution is able to keep its best and brightest, and not lose them to competitors.
Beverly White (firstname.lastname@example.org) is an attorney with Luse Gorman Pomerenk & Schick P.C. Robert L. Pash (email@example.com) is an executive benefits consultant with The Todd Organization.