United States: Congress Passes New Rules for Nonqualified Deferred Compensation

After a long gestation period during which various proposals for new statutory rules governing nonqualified deferred compensation ("NQDC") have appeared in a number of House and Senate bills, these provisions were included in a form agreed between House and Senate Conferees in the American Jobs Creation Act of 2004 (H.R. 4520) passed by the House on October 7 and by the Senate earlier today (October 11). The President is expected to sign the measure shortly. (For a copy of the relevant statutory language from the bill, click here. For a copy of the portion of the statement of the Conference Managers discussing these new requirements, click here.

These new rules will require changes to many executive compensation plans, including individual arrangements or agreements, as well as other NQDC arrangements such as those covering non-employee agents. The definition of NQDC employed in the new legislation is a broad one, covering elective deferred compensation, non-elective arrangements such as supplemental executive retirement plans ("SERPs"), restricted stock units ("RSUs"), stock appreciation rights ("SARs"), any stock option issued with an exercise price that is less than fair market value, and other forms of compensation intended to result in the deferral of income taxation.

Failure to satisfy the new requirements either in form or in operation results in (1) the current inclusion in the individual's income of all amounts deferred in the current and prior years, (2) the individual becoming liable for interest at the tax underpayment rate plus one percent from the date the included amount was first deferred or vested, and (3) an additional tax equal to 20 percent of the amount included. Though these consequences apply only to affected participants, i.e. those "with respect to whom the failure relates", this group could easily include all plan participants in the case of a defect in the form of the plan and might, for example, be interpreted to include all similarly situated participants in the case of an operational defect. In short, the legislation provides serious tax penalties designed to ensure attention to the new requirements.

The new requirements are effective for amounts deferred in taxable years beginning after December 31, 2004. Earnings on amounts deferred are only subject to the new rules to the extent that amounts deferred are (or become) subject to these rules. Material modifications (essentially, the addition of any benefit, right or feature) to a plan after October 3, 2004, will subject amounts deferred under the plan before the general effective date to the new requirements. Accordingly, any NQDC plan changes currently under consideration need to be carefully reviewed before adoption. The legislation directs the Treasury and IRS to issue guidance within 60 days of final enactment providing, among other things, a limited transition period during which an NQDC plan adopted before December 31, 2004 may be brought into compliance with the new requirements with respect to amounts deferred after December 31, 2004.

This article is designed only to apprise you of the enactment of these changes and the October 3, 2004 "material modification" date. We will later produce a memorandum containing a detailed discussion of the new rules and their implications. At this juncture, we will simply offer the following brief summary of the principal requirements.

• Distribution Restrictions: NQDC plan distribution events must be limited to (1) separation from service, (2) disability, which is narrowly defined, (3) death, (4) as necessary to meet an "unforeseeable emergency" or (5) a specified time or pursuant to a fixed schedule specified under the plan at the date of deferral. (Distributions on specified events, such as a child attending college, are not permitted.)

• Acceleration of Payments: The time or schedule of any payment may not be accelerated, except as may be permitted in regulations (for example, to comply with conflict of interest requirements).

• Elections: Any initial deferral elections generally must be made no later the close of the year prior to the year during which the services giving rise to the compensation are performed. (Newly eligible participants may, however, elect within 30 days of eligibility with respect to future compensation; and for performance-based compensation earned over a period of at least 12 months, elections may be made up to six months before the end of the performance period.)

• Changes in Time or Form of Distribution: Subsequent elections to further defer distribution are permitted, but cannot take effect for at least 12 months and, with limited exceptions, must require that the first payment be deferred for at least five years from when it would otherwise have been made.
• Offshore Trusts: Subject to limited exceptions, assets set aside in an offshore trust, even if the trust is a "rabbi trust" subject to the claims of creditors of the employer, are treated as IRC §83 "property", taxable when vested, and subjected to rules taxing any subsequent increases in value.

Financial Health Triggers: Any arrangement that purports to restrict assets to providing NQDC benefits in connection with a change in the employer's financial health will result in taxation under rules similar to those applied to offshore trusts, whether or not the assets remain subject to the claims of the employer's creditors.

The new legislation also includes additional reporting and withholding rules applicable to NQDC.

© 2004 Sutherland Asbill & Brennan LLP. All Rights Reserved.

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