A new section of the Internal Revenue Code, enacted last year to regulate deferred compensation plans, will significantly impact M&A by increasing the cost of acquiring a public or private company if due diligence on these plans is not performed before an acquisition agreement is signed. The new rules for deferred compensation plans were established by Section 409A of the code. Their scope is extremely broad and the subject of deferred compensation is not well understood by lawyers who don’t regularly practice under the ERISA laws covering pensions and other benefits. But potential buyers could encounter a number of hidden costs ranging from tax withholding obligations to gross-up payments to executives, making it critical for dealmakers to understand Section 409A and its implications before entering into transactions. Deferred compensation under Section 409A is broadly defined to include any deferral of compensation from the year in which the related services are performed to a subsequent year, unless specific exclusions to that generalization are applicable. The term “plan” is also broadly defined to include any agreement, method, or arrangement with a single employee, independent contractor, director, or partner of the service recipient. Based on this definition, a clause in an employment agreement with a single individual could constitute a “plan.” Except for benefits under a plan that were deferred and vested prior to Jan. 1, 2005 and the earnings produced by those plans (i.e., grandfathered amounts), the following generally constitute deferred compensation under Section 409A: * Deferrals of salary, bonus, director’s fees, or other compensation which is not paid within two and a half months after the end of the fiscal year in which the payment is earned; * Discounted nonqualified stock options; * Most stock appreciation rights; * Phantom stock plans and restricted stock units that provide total or partial deferral of compensation; * Certain severance plans and agreements; and * Certain supplemental executive retirement plans While not replacing previous deferred compensation principles, the new rules impose additional requirements that must be met for an executive or other service provider to be able to defer the date when the compensation must be recognized for federal income tax purposes. These include: * Strict rules for determining when the initial deferral elections can be made; * Limits on participants’ ability to change the timing or form of their benefits; * Prohibition on distributions except as a result of certain specified events, such as separation from the employer company, death, or a “change-in-control event”; * Prohibition on accelerated distributions before the original, specified payment date; * Requirements to delay distributions to “key employees” of publicly traded companies; and * Prohibition of certain funding practices, such as off-shore rabbi trusts or similar trusts to hold assets If an employer does not comply with the new rules, harsh consequences will follow. Generally, a participant is immediately taxed on the value of his or her deferred compensation once the benefit is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20% excise tax on the amount that is included in his or her income, as well as a significant interest penalty. Although the excise tax is imposed on individuals, employers will have withholding responsibilities. Section 409A also requires employers to report amounts deferred into a nonqualified deferred compensation plan on the individual’s W-2 or 1099 for the year in which the deferral occurs. Additionally, any compensation or penalties triggered by failing to comply with Section 409A must be reported on the individual’s W-2 or 1099 and taxes must be withheld for employees. Completing due diligence with respect to Section 409A compliance before signing an acquisition agreement is important for a potential buyer because the buyer often may lack an adequate remedy for breaches of representations and warranties that are not discovered until after closing. Although a complete due diligence checklist is beyond the scope of this article, these are critical due diligence issues for potential buyers to consider, such as: * Determining whether any compensation plan, agreement, method, or arrangement would qualify as a “nonqualified deferred compensation plan” under Section 409A; * Determining whether any amounts deferred under a nonqualified deferred compensation plan are subject to Section 409A or are “grandfathered”; * Determining whether a plan with “grandfathered” amounts meets all of the qualification requirements of Section 409A; * Determining, if the plan does not meet one or more of the qualification requirements, whether the target company has satisfied all of its tax withholding obligations, and whether the employee will be entitled to a gross-up payment or other indemnity rights from the target; * Examining any amendments to the plan after Dec. 31, 2004 and determining whether any constituted a material modification of what would otherwise be a grandfathered account; * Checking severance provisions included in employment agreements and other severance arrangements, including those not publicly filed; * Taking a close look at any discounted stock options that were not 100% vested on Dec. 31, 2004, bearing in mind that discounted stock options vesting in 2005 and later would be immediately taxable and subject to an excise tax on the date of vesting; and * Determining whether the plan can be amended or terminated and the deferred compensation paid out prior to deal closing, bearing in mind that the consent of participants may be required to avoid a breach of their contractual rights under the plan. There is a transition period ending Dec. 31, 2005 that allows plan sponsors to terminate nonqualified deferred compensation plans without violating Section 409A if all deferred amounts are included in income in the taxable year in which the termination occurs. Section 409A raises a number of questions that will impact buyers and sellers in mergers and acquisitions. The potential hidden costs to a buyer include liability for the target company’s failure to satisfy its tax withholding obligations with respect to deferred amounts, possible breach of contract claims for amendments or terminations of benefits where consent of the employee was not obtained, and gross-up payments to executives of the target if excise taxes are imposed under Section 409A. A number of important questions still don’t have definitive answers. For any transactions during 2005, it will be important to take into account the most recent IRS guidance available and for deal counsel to work closely with the employee benefits lawyers to identify the risks of noncompliance with Section 409A and to properly incorporate them in the acquisition agreement. John Partigan is a Partner in the Washington, D.C., office of Nixon Peabody LLP and Chair of the firm’s national Securities Practice Group. (c) 2005 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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