Tuesday, July 8, 2008

IRC 409A - www.orrick.com

Legislation and Lawsuits Concerning Deferred-Compensation Plans
From www.orrick.com

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004, which significantly changes the federal tax rules that govern “nonqualified deferred compensation plans.” The new law, codified in section 409A of the Internal Revenue Code (“IRC 409A”), prescribes how and when compensation can be deferred.

In addition, IRC 409A provides detailed rules concerning how and when previously deferred compensation can be paid out. Earlier this year, the Treasury Department and the IRS confirmed that IRC 409A applies both to certain equity-based compensation arrangements and to traditional deferred-compensation plans. For example, a nonstatutory stock option may have to comply with IRC 409A if it includes a deferral feature other than the right to purchase stock in the future at a defined price.

Similarly, a restricted stock grant that allows for an election to defer receipt of the underlying shares (e.g., conversion into a restricted stock unit) may also be subject to IRC 409A. To the extent these equity-based arrangements are deemed a “nonqualified deferred compensation plan,” IRC 409A could limit the circumstances under which the nonstatutory stock option can be exercised, in addition to restricting when the exercised/vested shares could be delivered.

Employers have until the end of 2005 to make plan design changes, bring plans into compliance or terminate non-complying plan, provided they operate in “good faith” compliance with IRC 409A during 2005. The statute imposes substantial tax consequences for noncompliance, including immediate taxation, a 20% tax penalty, and interest.

In the coming months, employers should determine what “nonqualified deferred compensation plans” they maintain, keeping in mind IRC 409A’s broad definition of the term. Employers should then review their plans to determine whether and to what extent they must be amended, suspended, or terminated. DEPARTING EMPLOYEES CONTINUE TO CHALLENGE FORFEITURE PROVISIONS Courts and arbitration panels continue to struggle with the legality of deferred-compensation plans, specifically the provisions requiring forfeiture by departing employees of unvested stock or options.

Since the decision in Truelove v. Northeast Capital and Advisory, 95 N.Y.2d 220 (2000), most New York practitioners have accepted the legality of such forfeiture provisions because the deferred payments, whether in stock or options, are not “wages” under the New York Labor Law. Truelove, however, did not resolve the legality of forfeiture provisions in plans where the shares or options are awarded based primarily or exclusively on individual performance.

In Marsh v. Prudential Securities, 1 N.Y.3d 146 (2003), the New York Court of Appeals affirmatively held that a plan under which employees could choose to use deferred wages to purchase shares of a stock index fund was “for their benefit” and thus not an illegal deduction from wages, despite the presence of a forfeiture clause triggered by the employee’s voluntary departure. The Third Circuit, applying New York law, recently reached a similar conclusion in a decision construing the same plan. See Schunkewitz v. Prudential Securities, 2004 WL 896660 (3d Cir. 2004).

In Marsh, the Court of Appeals rejected the suggestion that a per se rule bars any forfeiture provision under New York law. Rather, it called for an examination of the plan in its entirety, giving due weight to:
· the type of employees who participate and the nature of the benefit conferred;
· the manner in which the plan functions;
· the immediate benefits and potential rewards of participation compared to the risk of loss;
· the purposes of the forfeiture provision;
· the clarity of the notice that forfeiture was possible; and
· the voluntariness of the employee’s decision to participate.

Based on that analysis, one court recently dismissed the claims of a class of financial consultants who voluntarily participated in a plan in which they received discounted, unvested stock, obtained substantial tax benefits, received dividends and had voting rights with regard to the unvested stock.

Upadhyaya v. Citigroup, MDL-1354 (D. Mass. June 30, 2004) (unpublished decision) (applying New York law). The court also noted that the forfeiture provision would be permissible even where the plan does not exist solely for the benefit of the participants, so long as it had a significant benefit for the participants.

Despite these positive caselaw developments, employees continue to mount challenges to these types of plans, particularly where the voluntariness of the contribution can be questioned or where they can contend that New York law does not apply. See, e.g., Rosen v. Smith Barney, L10440-99 (N.J. Superior Ct., Essex Co. July 7, 2004) (forfeiture provisions of voluntary deferred-compensation plan violated New Jersey wage law as illegal restrictive covenant).

1 comment:

Anonymous said...

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