By: John J. Eagan
The American Jobs Creation Act of 2004 (the “Act”) includes sweeping changes to the tax treatment of nonqualified deferred compensation plans. The changes are so significant that we recommend an immediate review of your nonqualified deferred compensation plans in order to determine whether your plans need to be amended to comply with the Act. The following is a synopsis, in question and answer format, of the key provisions of the Act.
What plans are subject to the Act?
The Act applies to any “nonqualified deferred compensation plan,” which means any plan that provides for the deferral of compensation other than (a) certain types of qualified retirement plans; (b) employee benefit plans relating to vacation leave, sick leave, compensation time, disability pay, and death benefits; (c) Code Section 457(b) plans; and (d) incentive stock option plans (under Code Section 422), employee stock purchase plans (under Code Section 423), and grants of options (subject to Code Section 83) where the option exercise price is equal to the fair market value of the stock at the time of grant and there is no deferral feature other than the ability to exercise the option in the future. The Act applies to traditional salary and bonus deferral plans, as well as equity-based compensation plans (such as phantom stock plans, stock appreciation rights, performance units and restricted stock units) and nonqualified supplemental retirement plans. The scope of the Act includes arrangements covering only one person, such as employment or consulting agreements, as well as certain fringe benefit programs, but it is not clear how the Act applies to less traditional arrangements such as severance and certain death benefit payments.
How does the Act apply to nonqualified deferred compensation plans?
The Act requires nonqualified deferred compensation plans to contain provisions that identify the benefit distribution date, prohibit the acceleration of benefits, and limit the time period to make deferral elections. While the Act does not prohibit “rabbi trusts,” it does foreclose the use of offshore trusts. If the plan does not follow or operate in accordance with the new rules, all compensation deferred (subject to the effective date and special rules described below) will be taxable as soon as the deferred amounts are no longer subject to a substantial risk of forfeiture. Assuming the plan does not otherwise contain vesting or forfeiture provisions, the failure to comply with the new law eliminates the deferral benefit and causes what would otherwise have been deferred income to become current income, together with interest and a 20% additional tax.
What is the effective date of the changes under the Act?
The Act applies to amounts deferred after December 31, 2004. While there are special rules for existing plans (discussed below), post-December 31, 2004 deferrals, even if made under an existing plan, are subject to the new law. One planning option is to “freeze” the benefits under an existing plan and adopt a new plan that complies with the Act for post-December 31, 2004 deferrals.
Is transitional relief available for existing plans?
There are a number of special rules for existing plans. First, if an existing plan is materially modified after October 3, 2004, the Act applies to amounts deferred (plus earnings) before January 1, 2005 as well as new deferrals. This means that existing plans should not be amended without careful analysis of the new law. Absent a material modification, the Act does not apply to pre-January 1, 2005 deferrals. Second, the IRS is required to issue guidance within 60 days after enactment of the law, which is October 22, 2004, providing for a period during which an existing plan can be amended to allow a participant to terminate participation in an existing plan (and include amounts in income) and/or to allow an existing plan to be amended to comply with the Act. This means that you should consider waiting until the IRS releases the guidance before amending any existing plan. However, new deferrals (i.e., post-December 31, 2004 deferrals) will be subject to the Act. Third, the IRS is required to issue guidance within 90 days after enactment regarding what constitutes a change in ownership/change in control, which is an issue associated with the timing of distributions.
Given the new Act applies to post-December 31, 2004 deferrals, how soon do we need to review our plans?
The Act clearly creates a “timing crunch” given the effective date. The problem is that the Act is effective for deferrals made after December 31, 2004, but the IRS is not required to issue guidance with respect to existing plans until late December 2004. We recommend that you make no revisions to an existing plan until the guidance is issued. Since the Act applies to deferrals made after December 31, 2004, you may want to suspend new deferrals until the guidance is issued when we can help you evaluate whether or not to “freeze” an existing plan or adopt a new plan for post-December 31, 2004 deferrals.
What are the principal plan design features now required for a nonqualified deferred compensation plan?
Distributions. Compensation deferred under a plan cannot be distributed earlier than (i) separation from service (as determined by the IRS), (ii) disability, (iii) death, (iv) a specified time or pursuant to a fixed schedule specified in the plan where such time/schedule is made at the date of the deferral, (v) a change in ownership/control (as determined by the IRS), or (vi) an unforeseeable emergency.
Acceleration of Benefits. A plan cannot accelerate the time or schedule of benefits (except as specified by the IRS).
Elections. A deferral election must be made before the beginning of the tax year (or, for first-time participants, within 30 days after a participant becomes eligible to participate in the plan). In the case of “performance-based compensation” (such as stock appreciation rights) where services are expected to be performed over a period of at least 12 months, a deferral election must be made within six months after the beginning of the period when the services are performed.
Changes in the time and form of a distribution (i.e., a “delay” or “redeferral” election) are allowed only in limited cases. First, the redeferral election must not take effect for at least 12 months. Second, in the case of distributions involving a separation of service, a specified time (or fixed schedule) or change in ownership/control, the first payment under the redeferral election must not start for at least five years from the date the distribution would (but for the redeferral election) have commenced. Third, a redeferral election involving a specified time (or fixed schedule) distribution must be made at least 12 months before the date the first distribution would (but for the redeferral election) have commenced.
Funding. A plan cannot allow for assets to be placed in an offshore trust for the purpose of paying the deferred compensation. In addition, the Act prohibits provisions that allow for the earmarking of assets to be used for paying deferred compensation in connection with a change in an employer’s financial health.