Grace Period for Restrictions on Funding Nonqualified Deferred Compensation

The IRS has issued Notice 2006-33 to provide a transition period for bringing nonqualified deferred compensation (NQDC) plans funded with offshore trusts or funding arrangements with financial health triggers into compliance with Internal Revenue Code section 409A(b). The grace period continues until December 31, 2007 for assets that are held in a funding arrangement as of March 21, 2006.

Code section 409A(b) provides that an NQDC plan funded through an offshore trust or a funding arrangement that includes a financial health trigger is subject to the following adverse tax consequences: (1) any deposit to the fund is treated as a transfer of property subject to tax under Code section 83, i.e., it is currently included in the employee’s or other beneficiary’s income, (2) an additional income tax equal to 20 percent of the amount included in income is imposed, and (3) an interest charge is imposed.

An offshore trust is a trust or other funding arrangement for NQDC located outside the U.S., unless the services related to the NQDC were performed in the jurisdiction where the assets are held. The adverse tax consequences apply at the time the assets are set aside in the fund if it is then located offshore or at the time the assets are later transferred to a fund outside the U.S.

A funding arrangement with a financial health trigger is a rabbi trust or other funding arrangement which provides that assets will be dedicated to the funding of NQDC in connection with a change in the employer’s financial health. The adverse tax consequences apply as of the earlier of the time that the NQDC plan includes a provision stating that the assets will be restricted in this manner if there is a future change in the employer’s financial health or the date that such a restriction actually applies.

Code section 409A generally became effective for amounts deferred after December 31, 2004 or for prior deferrals materially modified after October 3, 2004. The American Jobs Creation Act of 2004, which adopted Code section 409A, did not include any special effective date for the funding rules in section 409A(b). In the Gulf Opportunity Zone Act of 2005 (GOZA), however, Congress adopted a technical correction to revise the effective date of the funding rules. Specifically, GOZA provides that the funding rules of section 409A(b) take effect on January 1, 2005. Thus, the adverse tax consequences apply as of January 1, 2005 to amounts that were set aside in an offshore fund or were subject to a financial health trigger before that date. The legislative history to GOZA directs Treasury to provide a transition period to allow sponsors of NQDC plans to make changes to their funding arrangements to avoid this harsh result.

The transition relief in Notice 2006-33 applies to assets set aside, transferred or restricted on or before March 21, 2006. These "grace period assets" will not be treated as subject to section 409A(b) if the related NQDC plan comes into compliance by December 31, 2007 with subsequent guidance issued by the IRS on the funding rules. The grace period assets that receive the benefit of the transition relief include earnings credited after March 21, 2006, but not:

• any assets held in the U.S. at any time on or after March 21, 2006, or

• any assets not subject to a financial health trigger on March 21, 2006.

For example, if amounts held in an offshore trust in 2004 were transferred into the U.S. during 2005 and were held in the U.S. on March 21, 2006, those amounts cannot be transferred outside the U.S. after March 21, 2006 to regain their status as grace period assets.

The Notice says that grace period assets will be treated as in compliance by December 31, 2007, if:

• the related NQDC plan is terminated and the assets are distributed by that date, or

• the NQDC plan is amended, the fund is liquidated, or the assets are otherwise disassociated from the plan by that date.

IRS and Treasury have requested comments regarding the Notice and all other aspects of Code section 409A(b).

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.