United States: Nonqualified Deferred Compensation Provisions Added to The International Tax Bill

Charles Grassley, Chairman of the Senate Finance Committee, has added amendments to the Jumpstart Our Business Strength Act (S. 1637) that would adversely change longstanding tax rules used by corporations to provide non-qualified deferred compensation to their employees. S. 1637 is an international tax bill primarily intended to address rulings by the World Trade Organization regarding foreign sales corporations and extra-territorial income. The amendments generally follow the nonqualified deferred compensation provisions previously included in last year’s National Employee Savings and Trust Equity Guarantee Act (NESTEG) pension bill with some important exceptions. If enacted, the amendments would be effective for amounts deferred after December 31, 2004. It appears that the Senate will debate S. 1637 by early summer.

Key Provisions Retained from NESTEG

Election, Distribution and Investment Restrictions

A nonqualified deferred compensation plan would be required to include the following election, distribution and investment restrictions in order to defer income taxation:

  • Deferred amounts cannot be distributed before the earlier of death, disability, a time specified in the contract, separation from service (or six months after separation from service in the case of key employees), change of control (to the extent permitted by regulation and, in the case of Section 16 insiders, one year after change of control), or an unforseeable emergency.
  • Initial elections to defer benefits must be made before the beginning of the taxable year that the compensation is earned (except as provided otherwise by Treasury) or within thirty days after initial eligibility to participate (but only with respect to subsequent services).
  • A second election to defer either the timing or form of payment would be allowed only if such election is made at least 12 months in advance of the scheduled payment date and the deferral is for at least five years. No additional elections to defer would be allowed.
  • Investment options under the non-qualified deferred compensation plan must be "comparable to" those provided under the employer’s tax-qualified retirement plan with the fewest investment options. The Treasury Department would be directed to promulgate permissible investment options if the employer does not sponsor a tax-qualified retirement plan.
  • non-qualified deferred compensation plan would be required to preclude accelerated benefit payments to participants. Therefore, traditional "haircut" clauses providing accelerated payment subject to a financial penalty and secondary elections made a year in advance to accelerate payments would trigger immediate taxation.

For purposes of the proposed amendments, a nonqualified deferred compensation plan includes any arrangement covering one or more persons that defers the payment of compensation other than a tax-qualified retirement plan, a Section 457(b) eligible deferred compensation plan or a bona fide disability, sick pay, compensatory time, vacation or death benefit plan.

Failure to include these restrictions in the plan document or to follow these restrictions in operation would result in immediate taxation of all deferred amounts in the year of violation unless the benefits are subject to a substantial risk of forfeiture. Interest at the IRS underpayment rate generally would also be assessed on the underpayment that would have occurred if the compensation had not be subject to a deferral election. In addition, a ten percent tax would be assessed on the amount of compensation to be included in income under the proposed amendments.

Funding Rules

Setting aside or transferring assets to informally fund nonqualified deferred compensation benefits that are not subject to a substantial risk of forfeiture under the circumstances described below would be treated as a taxable transfer of property under Section 83 of the Internal Revenue Code. There is no proposed outright ban on rabbi trusts.

  • Restricting assets under any funding arrangement in form or operation for the purpose of paying benefits under a nonqualified deferred compensation plan in connection with change in the employer’s financial health would trigger immediate taxation.
  • Transfers to offshore trusts or other funding vehicles in which assets would be held outside of the United States would trigger immediate tax under this provision. An exception would be provided if substantially all of the services to which the deferred compensation relates are provided in a foreign jurisdiction.

The Treasury Department would be directed to issue regulations exempting offshore funding arrangements that are not abusive, defining changes in financial condition subject to the provision and disregarding substantial risk of forfeitures to the extent necessary to carry out the purposes of the legislation. If a funding arrangement triggers this provision, affected participants would also be assessed interest and a ten percent tax in essentially the same manner as described above for violation of the distribution, investment and election restrictions. In addition, increases in the value of the assets would be treated as separate taxable property transfers.

Prohibition on Deferring Stock Option and Restricted Stock Gains

Gains attributable to the exercise of stock options, the vesting of restricted stock (absent a Section 83(b) election) and other forms of equity compensation would not be allowed to be deferred by exchanging such rights for a future payment of company stock. The proposed amendments would require the present value of the deferred payment right to be included in income for the taxable year of the deferral. If enacted, this provision would create difficulties for public companies using restricted stock units and deferred stock units for their directors and executives to meet stock ownership guidelines.

Tax Reporting

Employee deferrals under a nonqualified deferred compensation plan would be subject to reporting on IRS Form W-2. The IRS would be allowed to exempt amounts below a stated minimum amount.

Important Changes from NESTEG

Golden Parachute Treatment

The proposed amendments under S. 1637 would treat nonqualified deferred compensation benefits paid to Section 16 insiders within one year of a change of control as an "excess parachute payment" subject to the twenty percent excise tax under Section 4999 of the Internal Revenue Code. Amounts subject to the golden parachute tax under this provision would be taken into account in determining the disqualified individual’s "parachute payments" and "excess parachute payments."

No Repeal of Section 132 of the 1978 Revenue Act

NESTEG proposed amendments to repeal Section 132 of the Revenue Act of 1978, which limits the Treasury Department to the legal authorities in effect on February 1, 1978, when determining the tax consequences of non-qualified deferred compensation plans. If enacted, this provision would have authorized the Treasury Department to issue new guidance regarding fundamental constructive receipt and economic benefit tax principles. S. 1637 does not include a repeal of the Revenue Act of 1978.

Terminating Participation in Nonqualified Deferred Compensation Plan

The proposed amendments under S.1637 would require the Treasury to issue guidance giving participants in nonqualified deferred compensation plans established on or before December 31, 2004 a limited period of time in which to terminate participation or cancel an outstanding deferral election with regard to amounts earned after December 31, 2004, if such amounts are included in income as earned.

No Inference Rule

S 1637 would not prevent benefits under a nonqualified deferred compensation plan from being taxable at an earlier time under any other provision of the Internal Revenue Code. Amounts taxable under these amendments would not be subject to tax again under another provision of the Internal Revenue Code.

Related Provisions Not Included in S. 1637

The proposed nonqualified deferred compensation amendments do not provide for any changes to company-owned life insurance. S.1637 also does not include a permanent moratorium with respect to the collection of FICA and FUTA taxes on incentive stock options and employee stock purchase plans.

Effective Date

As noted above, the proposed amendments to the Internal Revenue Code would be effective for amounts deferred (or exchanges in the case of stock option or restricted stock deferrals) in taxable years beginning after 2004. S 1637 clarifies that earnings on deferred compensation will be subject to these amendments only to the extent the underlying deferred compensation is subject to these amendments; thus, to the extent deferred compensation is grandfathered, earnings on such amounts also will be grandfathered.

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.

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