| Overview. Changes to the tax rules governing nonqualified deferred compensation, which are included in the American Jobs Creation Act of 2004 (the Act), will require many employers to act quickly to modify the deferred arrangements they maintain for executives. The new legislation applies to amounts deferred after December 31, 2004.
Under the Act, nonqualified arrangements must comply with new restrictions on deferral elections, distributions, and funding arrangements. If an arrangement fails to comply, any participant covered by the non-complying feature will be required to include in income the amount deferred when first deferred when such amount becomes non-forfeitable. That participant must also pay a penalty tax equal to 20% of the amount included in income plus interest on the amount of tax underpaid as a result of the failure at the statutory underpayment rate plus one percent.
Plans Affected. The new restrictions apply to all deferred compensation arrangements involving employees, directors, and independent contractors who defer compensation to a period of time after the year in which it was earned. Covered arrangements include programs maintained by public and private companies, tax-exempt organizations, and in some cases, governmental employers. There are explicit exceptions for tax-qualified retirement plans, tax-sheltered annuities, Section 457(b) plans maintained by governmental and tax-exempt employers, governmental excess benefit plans, and certain “welfare” plans such as vacation, sick leave, and death benefit plans. Specific plans covered by the new legislation are as follows:
- Elective deferred compensation programs,
- Bonus deferral arrangements,
- Supplemental Executive Retirement Plans (SERPs),
- Section 457(f) plans maintained by tax-exempt and governmental employers,
- Certain severance plans,
- Executive employment and severance pay arrangements,
- Restricted Stock programs,
- Phantom Stock plans, and
- Stock Appreciation Rights (SAR) plans.
The Conference Committee report on the Act states an intent to exempt from application of the new rules incentive stock options (ISOs), employee stock purchase plans, and non-qualified stock options granted at not less than fair market value (if granted under an arrangement that does not include a deferral feature other than allowing for future exercise).
The Penicle Group 1 November, 2004
Deferred Compensation and Taxation
American Jobs Creation Act of 2004
Restrictions. The new restrictions, described below, primarily affect the timing of deferral elections and when deferred compensation may be paid.
• Deferral Elections. Initial elections to defer compensation generally must be made before the beginning of the taxable year in which the compensation is earned, or within thirty days after initial eligibility to participate. Such deferrals only are effective with respect to services performed after the election is made. An exception for compensation based on performance over a period of twelve months or more allows deferral elections to be made as late as six months before the end of the performance period.
In general, the timing and form of payment must be specified when the initial deferral is made. Subsequent elections to defer the timing of payment or change in its form are permitted if: (1) they may not take effect for at least twelve months; (2) elections deferring payments initially scheduled to be made at a specified time or according to a fixed schedule are made least twelve months in advance of the first scheduled payment date; and (3) except for elections relating to distributions on account of death, disability, or unforeseeable emergency, the re-deferral is for at least five years.
• Distribution Restrictions. To preserve tax deferral, the new law prohibits deferred compensation arrangements from making distributions earlier than certain times or events. These include death, disability, a fixed date (or pursuant to a fixed schedule) specified in the plan, separation from service (or six months after separation from service in the case of key employees of a publicly-traded company), or an unforeseeable emergency. Distributions following a “change of control” would only be permitted to the extent permitted by regulations.
The prohibition against distributing deferred compensation before one of the above mentioned events would affect a variety of current plan designs. For example, no longer can a participant be permitted to change from an election to receive installment payments to a lump sum payment. Additionally, plan termination alone will no longer be a permissible distribution event…a fact that employers should consider when designing a new deferred compensation plan.
The new law also could be interpreted to preclude a section 457(f) plan participant from taking an early distribution to pay the tax due on benefits as they vest. However, the Conference Committee report indicates an intention to allow tax distributions equal in amount to the amount of withholding that would be required if the employer paid the participant compensation in the amount required to be included in income.
• Funding Restrictions. The new law also restricts the kinds of rabbi trusts that can be used to “fund” nonqualified plans by taxing vesting participants with assets held in those trusts. Offshore trusts will be barred, except where the assets held in trust relate to services performed in the jurisdiction where the trust is held. Trust provisions accelerating funding as a result of a change in the employer’s financial health also will be prohibited.
Compliance. To minimize negative consequences for individuals affected by the new legislation, employers should identify the deferral arrangements they maintain with employees, directors, and independent contractors that may be affected. Consideration should be given to what changes can be made to preserve the current tax deferral advantages. Since there will be protection for pre-2005 deferrals, an employer might eliminate future deferrals under its current arrangements as of December 31, 2004, and establish new programs for post-2004 deferrals.
The law requires Treasury to issue guidance within sixty days of its enactment, allowing individuals a limited period of time to terminate participation in deferral arrangements or to cancel deferral elections.
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