United States: American Jobs Creation Act Of 2004 Changes The Tax Rules Applicable To Nonqualified Deferred Compensation Plans

Sweeping changes in the tax rules governing nearly all nonqualified deferred compensation arrangements are included in the American Jobs Creation Act of 2004, which has been passed by Congress and is expected to be signed into law by President Bush. Employers will need to consider and react to the new rules before the end of 2004.

Nonqualified deferred compensation arrangements include salary and bonus deferral plans, supplemental retirement plans and plans that make up for benefits limited by tax-qualified plan rules. These arrangements have been drafted under generally favorable case law and limited IRS guidance. As a result, most existing deferral arrangements provide considerable flexibility and discretion in the timing and structuring of deferral elections and benefit distributions, and how benefits are secured. This flexibility will be substantially limited by the new law, which imposes detailed statutory requirements that these arrangements must satisfy in order to defer taxation and avoid penalties. Failure to meet these requirements will cause the affected participants not only to pay tax on the deferred compensation, but also to pay an additional 20% tax plus interest. The new rules apply to most deferrals beginning after December 31, 2004, and to existing deferrals made under plans that are materially modified after October 3, 2004.

This article briefly discusses the new rules and describes some immediate practice implications.

The new law applies to all plans that defer compensation other than most tax-qualified retirement arrangements, certain deferred compensation plans for governmental and other tax-exempt entities, or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. Deferral plans may include an arrangement for a single individual (e.g., an employment agreement) and may include arrangements for non-employees. The new rules also apply to a wide variety of equity compensation awards, such as restricted stock units, performance units and stock appreciation rights. The conference report indicates, however, that most stock options, including incentive stock options and I.R.C. section 423 options, are not intended to be covered.

Elections to defer compensation must generally be made prior to the commencement of the relevant taxable year and must specify the time and form of the distributions. New participants have up to 30 days to make deferral elections with respect to future services. In the case of performance-based compensation that covers a performance period of at least 12 months, the deferral election must be made at least six months prior to the end of the performance period. Thus, in the case of a calendar-year performance bonus, the deferral election must be made by June 30 of that year. "Performance-based compensation" will be defined by applying some of the principles that are used to determine performance-based compensation that is exempt from the $1 million cap on certain executive pay.

Deferrals may be distributed to participants no earlier than: separation from service; a specified time or pursuant to a fixed schedule imposed by the plan or elected when the compensation is deferred; death; disability; the occurrence of an unforeseeable emergency (but only to the extent of the financial hardship); or, pursuant to regulations, a change in ownership or control (which is expected to be defined more narrowly than under I.R.C. section 280G). Thus, "haircut" provisions that allowed participants to take early distributions subject to a substantial reduction in benefits are prohibited. A specified "time" does not include a specified event, such as enrollment of a child in college. In the case of officers of publicly-traded companies who earn more than $130,000 per year, among others, distributions triggered by a separation from service must be delayed at least six months. Once made, a deferral election may be further deferred, but only if the new election does not take effect for at least 12 months, is made at least 12 months before the due date of the first payment under the original deferral and extends the original deferral by at least five years. As a result, "roll-over" provisions, which permitted deferrals for relatively short periods that could subsequently be renewed, will be severely restricted.

Except as provided by regulation, the plan must prohibit accelerated distributions. The conference report indicates that changes in the form of distributions that accelerate payments are not permitted, subject to limited exceptions, such as elections between actuarially equivalent forms of life annuity payments. Regulations may permit the acceleration of payments needed to comply with federal conflict of interest requirements or a court-approved divorce settlement; to pay employment taxes on deferrals; or to distribute de minimis account balances.

The application of the new rules to defined benefit arrangements such as SERPs is not specifically addressed, although it is clear that such arrangements are intended to be covered. The IRS is expected to issue regulations explaining how to determine the amounts deferred and how to make elections pertaining to distributions under such plans.

The new legislation also limits the ability to secure compensation deferrals, although not as drastically as some earlier proposals. A traditional domestic-based rabbi trust will continue to be permitted. Except in limited circumstances, however, the use of foreign rabbi trusts to secure deferrals will result in immediate taxation. In addition, deferrals will be taxed if the plan provides that assets will be set aside to pay plan benefits upon a change in the employer’s financial health (to be defined by regulations) or, if later, when assets are so restricted, even if, in either case, the assets are subject to the claims of general creditors. The conference report makes clear, however, that security arrangements that take effect without regard to changes in the financial health of the employer or upon the occurrence of events other than changes in financial health, such as a change in control, do not present problems.

If in any year a deferred compensation plan, either as drafted or as operated, fails to meet the new requirements, all current and prior deferrals made under the plan will generally be taxed in that year, except to the extent the deferrals are subject to a substantial risk of forfeiture. In addition, the participant’s taxes will be increased by an amount equal to 20% of the deferrals plus an interest charge based on the period of deferral. The interest rate will be the rate the IRS charges for underpayments of tax plus one percentage point. These sanctions will be limited, however, to those participants with respect to whom the requirements are not met, subject to the effective date rules noted below.

With certain limited exceptions, employers will be required to report the amount of deferrals on Form W-2 or Form 1099, even though such amounts are not includible in income. By regulation, the IRS may exempt from reporting de minimis amounts and amounts that are not reasonably ascertainable with respect to nonaccount balance plans.

The new rules apply to amounts deferred in tax years that begin after December 31, 2004, and to prior deferrals made under plans that are materially modified after October 3, 2004. A material modification includes the addition of any benefit, right or feature, but not the exercise or removal of an existing benefit. Material modifications do not include revisions made pursuant to IRS guidance that permit a participant to terminate participation in a plan or to cancel an existing deferral election, or to conform the plan to the new requirements. According to the conference report, a prior deferral means a deferral that is both earned and vested prior to January 1, 2005. This principle could have broad application to equity compensation grants, as well as to the unvested portions of SERP benefits and defined contribution accounts that accrued prior to January 1, 2005. A prior deferral continues to be subject to old law, including, for example, rules pertaining to redeferring the original deferral, as long as a material modification is avoided.

Prior versions of the nonqualified deferred compensation legislation contained several restrictions that were not enacted in the final bill, including: severe limitations on the types of investment alternatives that could be offered to participants; penalties on certain change-in-control distributions; and a prohibition on the deferral of stock option gains. In addition, the final bill and conference report contain some revisions that reduce the impact of the new law: permitting deferral elections for certain performance-based compensation to be made as close as six months before the end of the performance period; limiting the adverse tax consequences of a failure to meet the new requirements only to the participants with respect to whom the requirements were not met, rather than affecting all participants in the plan; the exclusion of most stock options; and elimination of some retroactive effective dates.

We recommend that employers consider the following in light of the new restrictions on nonqualified deferred compensation arrangements. Unfortunately, many of the tasks are time sensitive.

1. Inventory existing deferral plans and agreements. Employers should identify all deferred compensation arrangements that may be subject to the new legislation and all related security devices. Bear in mind that the new rules apply not only to plans, but also to individual agreements, such as employment and severance agreements, and to some equity compensation arrangements.
2. Prepare for 2005 deferrals. Deferrals after 2004 must meet the requirements of the new rules. Therefore, employers will need (a) plans that comply with the new rules and (b) election forms and disclosure statements that reflect the new rules.
3. Review certain 2004 deferrals. It is possible that elections to defer 2004 bonuses, which typically would take effect in early 2005, may be considered subject to the new rules. Many such elections would be noncompliant. Hopefully, the IRS will provide prompt guidance.
4. Reconsider equity-based compensation choices. The selection of the form of equity-based compensation grants, such as stock options and stock appreciation rights, will need to take into account the new nonqualified deferred compensation rules. For example, stock appreciation rights and restricted stock units may be adversely affected by the new law, thus making stock options and restricted stock more attractive.
5. Caution before amending existing deferral arrangements. Because a material modification adopted after October 3, 2004, will cause existing deferrals made under a plan to be subject to the new rules, employers should carefully consider proposed amendments to existing deferral arrangements, including individual agreements.
6. Consider adoption of new plans. In order to make deferrals for 2005, employers will need to consider adopting new plans and "freezing" existing plans and deferrals, which may be more practical than trying to bring existing plans into compliance.
7. Look for IRS guidance. Congress has directed the IRS to publish guidance within a short period after enactment addressing certain subjects, such as the definition of change in control and the termination of existing arrangements. The IRS may issue other guidance in the near term. Employers should keep informed of these developments.

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.