1. Don’t Bite the Hand That Feeds You! New Compliance Requirements for Deferred Compensation Programs By Kristi Cook, JD For: 1-800-433-1828

2. ALSO…Please Don’t Shoot the Messenger!  Law passed at end of 2004 as part of American Jobs Creation Act of 2004 – IRS issued a Notice 2005-1 that provided some guidelines – But, regulations not issued until the end of September, 2005  Created a new Section 409A which establishes new requirements for deferred compensation arrangements

3. Surprise…Surprise!!!  Effective for all compensation deferred after December 31, 2004  Until 12/31/05, employers were permitted to terminate ongoing arrangements provided that all assets were distributed by 12/31/05  Must operate in “good faith” compliance with new requirements until programs are amended to conform to new requirements  Have until 12/31/06 to amend current programs to conform to new requirements

4. What is §409A?  A new section added to the federal income tax code establishing requirements for all deferred compensation arrangements – There are certain exemptions available under §409A – But any arrangement not exempted must satisfy the requirements of §409A

5. New §409A Regulations  Impose new rules on all deferred compensation arrangements  Impose annual 20% excise tax on employee on arrangements that fail to meet requirements – Plus 1% over “underpayment interest rate – BUT, employer must report properly  PLUS amounts are taxable when no longer subject to substantial risk of forfeiture – NOT when received by the employee

6. What Arrangements are Affected?  Affects any plan, arrangement or agreement (whether written or not) between an employee and employer that defers compensation into a future year – Exception for qualified retirement plans and certain bona fide welfare plans. – However, most severance pay programs, accumulated leave programs, early retirement incentive programs and split dollar insurance plans are affected by these new regulations

7. What is Deferred Compensation?  A plan provides deferred compensation if – the employee has a legally binding right to compensation – that is not received during the current tax year and – is payable to (or on behalf of) the employee in a later year

8. Statutory Exemptions from §409A  Short Term Deferrals  Qualified Plan Contributions  Separation Pay Safe Harbor  Bona Fide Welfare Plans

9. Short Term Deferrals  Any amounts paid to the employee within 2½ months of the end of the year in which the benefit is no longer subject to a “substantial risk of forfeiture” – For most K-12 employers, the year of severance is the applicable year  Plan should require payment within the 2½ month period – Amounts paid after 2 ½ month period may be exempted if due to unforeseeable administrative issues or solvency problems if paid as soon as practicable

10. What is a Substantial Risk of Forfeiture?  Entitlement to the compensation is – conditioned on the performance of substantial future services or – the occurrence of a condition related to the purpose of the compensation, and – the possibility of forfeiture is substantial  Specifically rejects “noncompete” arrangements, “rolling risks of forfeiture,” post employment consulting agreements – Also extending deferrals of salary unless related to a “material” increase in compensation

11. Qualified Plans  Amounts paid into qualified plans are excluded from definition of “deferred compensation”  Applies to contributions into 401(a), 403(b), 401(k) and 457(b) programs  Health reimbursement and medical reimbursement accounts are also excepted

12. Separation Pay Exceptions  Three types of separation payments are excluded from deferred compensation, including payments for – Certain involuntary terminations of employment – Certain “window” programs – Certain payments under collectively bargained plans

13. Involuntary Separations and Window Programs  Excluded if: – Payments do not exceed the lesser of 2X the employee’s compensation or 2X the 401(a)(17) limit on compensation; and – Payments are not made later than December 31 of the second calendar year following the year of separation from service  “Window” period cannot exceed 12 months

14. Collectively Bargained Plans  Window plans and involuntary termination plans that are collectively bargained through arms length negotiations are not subject to the limits on the amount of the benefit or on the duration of the payouts.  NO exception for programs that provide benefits for voluntary terminations or are offered under “windows” that are open for more than 12 months

15. Bona Fide Welfare Plans  Programs structured as “wage replacements” for – Vacation leave – Sick leave – Compensatory time, – Disability pay, or – Death benefit plan  Severance pay plans are NOT excluded as bona fide welfare plans  Sabbatical leave plans are not exempted

16. Review of §409A Coverage  Any arrangement that defers compensation to a future year unless there is a substantial risk of forfeiture  Exemptions for: – Short term deferrals – Qualified plan contributions – Separation Pay “Safe Harbors,” and – Bona fide welfare plans

17. What Should You Do Now?  Examine all compensation arrangements – Individual employment contracts, collective bargaining agreements, Act 93 agreements and similar agreements  Determine if compensation earned in the current year is payable in a future year – If yes, are any exemptions available to exclude the benefit from 409A?  Can the benefit be restructured to avoid inclusion under 409A? – If yes, open contracts and restructure – If not?

18. What Does 409A Require?  Establishes requirements for written documentation, valid deferral elections, timing of distributions and tax reporting – Plan must be evidenced in writing – Must report in year of deferrals AND in year of payments Different reporting codes

19. “Deferral Elections”  Deferrals may be “elective” or “nonelective”  Elective deferrals occur when employee voluntarily elects to defer compensation into a future year  Nonelective deferrals occur if the payment for the benefit is based on contractual obligations or similar binding agreement – Accumulated leave payments, ERIPs, severance pay, etc.

20. Elective Deferral Elections  Elections must include the amount of the deferral, the form of payment to be received and the timing of the distributions  Elections must be completed in year preceding year in which the services are provided to the employer – In initial year, election must occur within 30 days of eligibility  Elections are irrevocable – Unforeseeable emergency withdrawals are permitted

21. Nonelective Deferrals  This type of compensation is considered earned in the year in which the employee has a legally binding right to the compensation – Generally, the year in which benefits first become payable to employee – Treated as an “initial year” election

22. Distribution Restrictions  Arrangement must limit distributions to the occurrence of one of the following events: – Severance from service – Disability – Death – Specified time or fixed schedule – Unforeseeable emergencies  Cannot accelerate distributions

23. Can Employees Change Previous Distribution Elections?  Distribution elections may be changed by employees provided that the change occurs at least 12 months prior to the date the distribution would otherwise have occurred, AND  Payment must be deferred for at least another 5 years  NOTE: this does not defer taxation on the distribution to employee

24. Employer Tax Reporting  Employers must report all deferrals in the years when made and when no longer subject to forfeiture – All deferrals plus earnings in Box 12 on Form W2 using Code Y – Amounts includable in income are reported in Box 12 with Code Z  Reporting requirements applicable to 2006 tax year

25. Best Solutions for §409A Issues  Short Terms Deferral Exemption – Pay all benefits within 2½ months of end of year in which severance from service occurred Requirement for timing of payment should be included in written arrangement  Qualified Plan Exemption – Structure deferred compensation around employer 403(b) contributions 6 year payout limitation –Year of severance from service plus the next 5 years

26. Strategies?  Try to avoid application of §409A – Review all current compensation arrangements – Identify any that defer compensation after 12/31/2004, plus ALL §457(f) plans Most split dollar plans Many “traditional” benefits –Severance benefits –ERIs –Retirement bonuses –Accumulated leave programs

27. Strategies…continued  Determine if any exemptions apply – Short term deferral for accumulated leave type benefits – Contributions into 403(b) plans to replace benefits Restructure to avoid 409A – Window plans Remember 12 month limitation More helpful for CBA ERIPs

28. More Strategies  Remember the issue when crafting future compensation programs  Try to keep it simple – Complicated arrangements lead to missed payments – Acceleration of taxes, excise tax and reporting problems

29. Questions? Thank You