As part of the American Jobs Creation Act of 2004 (H.R. 4520), Congress has made far-reaching changes to the rules governing deferred compensation arrangements. The legislation, which we understand is likely to be signed by the President, will affect virtually every existing nonqualified deferred compensation arrangement. Because the new rules are generally effective for amounts deferred after December 31, 2004, employers must respond quickly to the new rules.
Definition of Nonqualified Deferred Compensation: The term "nonqualified deferred compensation" is defined very broadly under the new rules to include any arrangement that provides for the deferral of compensation (other than qualified retirement plans, bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans). As a result, the new rules will potentially cover a broad range of programs, including:
- Stock appreciation rights (SARs)
- Phantom stock
- Severance payments (payable in a later taxable year)
- Discounted stock options (presumably with a discount substantially below FMV)
- Employment agreements (containing deferred compensation/retirement benefits)
- Restricted stock units
- Window benefits (e.g., Social Security bridge payments)
The new rules are not limited to arrangements between an employer and an employee. Accordingly, arrangements with independent contractors (e.g., deferred directors’ or consulting fees) will also be affected.
Revisions to the Constructive Receipt Doctrine: Amounts deferred under a nonqualified deferred compensation plan for the current taxable year (and all preceding taxable years) will now be includible in gross income to the extent not subject to a substantial risk of forfeiture unless each of the following requirements are satisfied:
Distribution Limitations - A plan may only allow for distributions upon the occurrence of six specific events, including:
- Separation from service;
- At a specified time (or pursuant to a fixed schedule) specified under the plan at the date of deferral;
- Upon a change in the ownership or effective control; or
- Upon the occurrence of an unforeseeable emergency.
For certain key employees of publicly traded companies, the distribution of deferred compensation by reason of a separation of service may not be made for six months following the date of such separation. Additionally, with respect to distributions at a specified time, amounts must become payable as of a specified date (e.g., at age 65) and a payment on the occurrence of an event (e.g., a child entering college) will not comply with this requirement.
Prohibition Against Acceleration - A plan may no longer permit the acceleration of the time originally specified for payment. As a result, "haircut" provisions that allow a participant to accelerate the distribution of their deferred compensation if they forfeit a certain percentage (e.g., 10%) will also no longer be permitted.
Deferral Elections - Plans must now provide that the election to defer compensation will have to be made in the preceding taxable year. However, with respect to participants who first become eligible to participate in the plan, the initial election may be made within 30 days after the date the employee becomes eligible.
A special rule will also apply to "performance-based compensation." In the case of performance-based compensation based on services performed over a period of at least twelve months, an election may be permitted to be made no later than six months before the end of the service period.
Substantial Penalty Provisions: If a plan fails to meet the new requirements or is not operated in compliance with such rules, the employee must recognize income with respect to current and prior deferrals to the extent not subject to a substantial risk of forfeiture. In addition, the employee must pay (i) interest (at the underpayment rate plus one percentage point) measured from the date of deferral, plus (ii) a 20 percent additional tax. These penalty provisions only apply with respect to those participants for whom the requirements are not satisfied.
Funding Restrictions: While the use of U.S.-based rabbi trusts continues to be permitted, the new rules provide that a taxable transfer will occur under Section 83 of the Code if any such assets are located outside of the United States or are subsequently transferred outside of the United States. Any subsequent increases in the value of such property will also be treated as a taxable transfer.
Effective Date Provisions: The new rules generally apply to amounts "deferred" in taxable years beginning after December 31, 2004. Earnings on amounts deferred before the effective date are subject to the new rules to the extent the underlying deferrals are subject to the rules. However, in order to prevent employers from "stuffing" their existing plans prior to the effective date, amounts deferred prior to January 1, 2005, will be subject to the new rules if the arrangement is materially modified after October 3, 2004. For this purpose, a material modification will include any additional benefit, right or feature (e.g., acceleration of vesting). As a result, employers should proceed cautiously before making any changes to their deferred compensation arrangements after October 3, 2004.
For purposes of the effective date provisions, the Conference Report indicates that an amount will be considered "deferred" before January 1, 2005, to the extent the amount is earned and vested before such date. Accordingly, deferrals with respect to compensation that vests subsequent to December 31, 2004, will be subject to the new rules notwithstanding the fact that the deferral election was made prior to the effective date.
What Employers Should Do: As of the date of this Tax Advisory, it appears very likely that the President will sign this legislation. Within 60 days of its enactment, Treasury is required to issue guidance providing a limited period of time during which nonqualified deferred compensation plans adopted prior December 31, 2004 may be amended (without violating the new rules). In the meantime, employers must establish a prudent course of action to evaluate the impact of this new legislation on existing arrangements.
- Inventory Existing Arrangements - In light of the broad scope of the term "nonqualified deferred compensation," employers must act quickly to identify and inventory existing arrangements. The new rules can be expected to cover practically every deferred compensation arrangement, whether created under a formal plan document or individual employment agreement.
- Establish a Course of Action - In evaluating and establishing one or more potential courses of action, an employer will likely conclude that one remedy will not suit all of its arrangements, particularly if the deferred compensation provisions are contained in existing individual employment agreements. Accordingly, employers may find it desirable to evaluate the transition rules promulgated by Treasury before making a final decision. Employers with mature plans should also evaluate whether it is advisable to "freeze" existing plans and establish new plans for future deferrals. The benefit of this approach is that it would significantly reduce the risk that the plan will be inadvertently "materially modified" in the future, thereby subjecting participants to significant interest and penalty obligations. To this end, an Employer will also need to consider whether and under what circumstances it may be willing to reimburse the employee for such interest and penalties.
- Employee Communication and Consent - Educating employees on the impact of the new rules will be critical in light of the limitations on the acceleration of deferrals as well as the interest and 20% penalty provisions contained in the new rules. Employers would be well advised to modify existing election forms and other participant communications to ensure proper disclosure. It is also important to remember that many, if not most, nonqualified deferred compensation arrangements require participant consent before they are modified in a manner that negatively affects a participant's benefits. Accordingly, employers will likely find that employee education and communication will be essential during this time of transition.
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