United States: Significant Changes To Deferred Compensation Are Made By the American Jobs Creation Act

Sweeping new provisions in the American Jobs Creation Act of 2004 will fundamentally change the taxation of deferred compensation arrangements as well as many equity and phantom equity grants not traditionally considered deferred compensation. The Act will have a significant impact on the design of new plans, and existing plans should be reviewed to insure that they comply with the Act.

Timing. Under the Act, at the first time a deferred compensation arrangement does not meet the strict guidelines described below, amounts deferred for the current taxable year and for preceding taxable years (to the extent not subject to a substantial risk of forfeiture and not previously included in income) are subject to the regular income tax plus an additional 20% tax and an interest charge.

Stock Options/SARS and Other Arrangements. Even relatively standard equity compensation grants are potentially covered by the Act. The legislative history to the Act suggests that nonqualified options granted at a discount are subject to the new rules. Many existing restricted stock unit plans, stock appreciation rights and phantom stock awards are also covered by the Act.

Important questions about the scope of the new legislation include:

• Whether standard restricted stock awards are subject to the Act.
• Whether "change-in-control" agreements and severance agreements that provide payment only on a future event (e.g., a sale of the employer or a termination of employment) are deferred compensation arrangements covered by the Act.

The legislative history to the Act indicates that the new rules are not applicable to incentive stock options or to employee stock purchase plans.

Overview

One of the fundamental principles underlying the taxation of compensation is that an unfunded and unsecured promise to pay money in the future is not generally taxable to a cash method service provider (such as an individual) until the service provider receives payment. Over time, rules have developed concerning when promises that are funded and/or secured are taxable. The Act rewrites these rules in many respects.

General Rule. Under the Act, compensation that has been deferred (including incentive and equity compensation) under a "non-qualified deferred compensation plan" must meet strict guidelines or else the compensation will be included in income currently and subject to (i) an additional 20% tax for the year of inclusion and (ii) interest on the amount of the underpayment of the taxes that would have been payable if the compensation had been included in income when deferred (the interest rate is the interest rate applied to underpayments of tax, plus 1%). An exception to current taxation is provided for compensation that is subject to a substantial risk of forfeiture if the service provider fails to continue to provide services.

"Non-Qualified Deferred Compensation Plan." The Act defines any arrangement involving the deferral of compensation as a "non-qualified deferred compensation plan." Accordingly, a single agreement with one employee (for example, a grant of a non-qualified stock option at a discount) may be treated as a "non-qualified deferred compensation plan." The Act applies to compensation paid to both employees and independent contractors, including directors.

Specifically excluded from the definition of "non-qualified deferred compensation plans" are bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans, as well as qualified retirement plans, tax-deferred annuities, simplified employee pensions, SIMPLEs, and governmental eligible deferred compensation plans.

Plan Requirements. In order to avoid current taxation, "non-qualified deferred compensation plans" must meet the following requirements.

• Under the plan, deferred compensation must not be distributed earlier than (i) on death, (ii) on disability, (iii) on separation from service (to the extent provided in future regulations), (iv) at a specified time or on a fixed schedule provided in the plan at the date of deferral (but not on an event), (v) on an unforeseeable emergency, or (vi) to the extent provided in future regulations, on a change in control of the payor. Key employees of public companies — generally, officers having annual compensation greater than $130,000 (and limited to 50 employees) and certain shareholders — generally cannot receive distributions earlier than six months after the date of separation from service.
• The plan must prohibit acceleration of payments, except as provided in future regulations.
• An election by a service provider to defer compensation must be made in the taxable year prior to the year in which the services are performed. In the case of the first taxable year in which the participant is eligible to participate, an election may be made within 30 days after the service provider becomes eligible, but only with respect to services performed after the election. If the deferred compensation plan is a performance-based plan based on services performed over a period of at least 12 months, the election to defer may be made no later than six months before the end of the performance period.
• The plan must provide that an election to further defer or change the form of a payment cannot take effect until at least 12 months after the election is made. If an employee elects to further defer a payment (other than payments due to death, disability, or emergency), the new payment date must be at least five years after the original payment date. If an employee intends to further defer a payment which is scheduled to be made at a specified time under the plan, the employee must make the election at least 12 months before the original payment date.

Offshore Trusts. Deferred compensation held in an offshore trust (or other arrangement determined by the Treasury) will be immediately taxable to the service provider under most circumstances.

Effective Date. The provisions are generally effective for amounts deferred in taxable years beginning after December 31, 2004. In order for an amount to be treated as deferred in a prior period, it must be earned and vested in the prior period. The requirement that amounts be earned and vested in a prior period could cause existing unvested arrangements (e.g., existing unvested nonqualified options granted at a discount) to become subject to the Act after December 31, 2004.

Amounts deferred in taxable years beginning before January 1, 2005 will be subject to the Act if the plan under which the deferral is made is materially modified after October 3, 2004. The Act provides that the Secretary of the Treasury is to issue guidance within 60 days permitting a limited period within which to bring deferred compensation plans into compliance. Plans should not be modified until that guidance is issued.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.