The following article discussing new rules governing nonqualified deferred compensation plans will be published in the Greater Valley Forge Human Resource Association upcoming newsletter. (I serve as Legislative Chair for the association.) I am publishing the article here as well, since by the time it is published in the newsletter, it will likely need a rewrite due to soon-to-be-released IRS guidance expected in December. If you “google” the subject matter or search via Benefitslink.com, you will see that the internet has already seen a proliferation of law firm articles and publications on the topic. While there is not really anything new to report other than what most have already said about the subject, this article does contain some comments from Bill Sweetnam, Benefits Tax Counsel for the Treasury, made to practitioners at the recent ALI-ABA satellite webcast entitled “Annual Fall Employee Benefits Law and Update.”
The American Jobs Creation Act of 2004 (“AJCA”) made sweeping and dramatic changes to the tax rules relating to nonqualified deferred compensation plans. Such tax rules are the foundation for corporate executive compensation programs. The legislation adds a new section 409A to the Internal Revenue Code, which generally is effective with respect to amounts that are deferred in taxable years beginning on or after January 1, 2005. Noncompliance with the new rules once they become effective will cause all compensation deferred under a plan for the taxable year and all preceding taxable years to be included in an affected participant’s gross income (if not subject to a substantial risk of forfeiture) and subject to interest and an additional penalty tax of 20% of the compensation required to be included in income.
Amounts that are earned and vested before 2005 under a current plan are grandfathered as long as the plan is not materially modified after October 3, 2004. According to the legislative history of AJCA, a “material modification” includes the addition of a new benefits, right or feature, such as a disability benefit or death benefit, as well as acceleration of vesting, but the exercise or reduction of an existing benefit, right or feature does not constitute a “material modification.”
The rules extend to most plans or arrangements that provide for the deferral of compensation including, but not limited to:
- Excess benefit plans
- Supplemental executive retirement plans (SERPs)
- Elective deferrals of salary and/or bonuses
- Section 457(f) plans maintained by tax-exempt and governmental employers
- Stock appreciation rights (SARs)
- Discounted stock options
- Phantom stock
The following types of plans are exempt from the new rules:
- Qualified retirement plans
- Tax-deferred annuities
- Simplified employee plans
- SIMPLEs
- Section 457(b)eligible deferred compensation plans maintained by governmental and tax-exempt employers
- Bona fide vacation leave plans, sick leave, compensatory time, disability pay and death benefit plans
- Code Section 422 incentive stock option plans
- Code Section 423 employee stock purchase plans
Please note that the IRS has indicated informally that deferral provisions in employment agreements or severance plans may be subject to the new rules, and that the IRS will address these types of plans in their upcoming guidance. Also, the conference report makes it clear that plans covering non-employees (e.g. independent contractors, directors) are also covered by the new rules.
Summary of New Rules: Under the new rules, in order for a participant to avoid current taxation of deferred compensation and penalties, the deferred compensation arrangement must satisfy the following requirements:
1. Distributions must be made only upon separation from service, death, disability, change in ownership or effective control of the employer, unforeseeable emergency, or at a specified date. A participant will be considered to be disabled if either (1) the participant is disabled within the meaning of the Social Security Act, or (2) the participant is receiving income replacement benefits for a period of at least three months under an accident and health plan of the employer, by reason of a medically determinable physical or mental impairment which can be expected to result in death or last for a continuous period of at least 12 months. Payments to “key employees” of a publicly traded corporation may not be made in the first six months following the individual’s separation from service. (“Key employees” are officers earning at least $135,000 for 2005 -but not more than the first 50 officers, ranked by current year compensation-and some owners.)
2. The initial deferral election must be made prior to the beginning of the year in which the compensation is earned. However, with respect to “performance-based compensation” based on services performed over a period of at least 12 months, the election may be made no later than six months before the end of the performance period.
3. An election to delay or to change the form of payout is allowed only if:
- Such election does not become effective until at least 12 months after the election is made;
- Such election, if it relates to a distribution at a specified time, must be made not less than 12 months prior to the date of the first scheduled payment; and
- The additional deferral with respect to which the election is made must be for a period of not less than 5 years from the date such payment would otherwise have been made (except in the case of an election related to a payment on account of the participant’s disability, death, or an unforeseeable emergency.)
4. Acceleration of any payout is prohibited. Many existing plans now include provisions that permit participants to elect to receive distributions of their deferred benefits subject to a penalty (referred to as a “haircut provision”). However, the new law would preclude participants from making such an election on or after January 1, 2005. In addition, changes in the form of payment that result in an acceleration of payments, e.g. election options which permit a participant to elect a lump sum over an annuity, would not be permitted.
5. Deferred compensation may not longer be funded using offshore funding arrangements.
6. A financial health trigger that results in a plan becoming funded will result in adverse tax consequences for a participant, even though the assets of the plan are still available to satisfy claims of general creditors.
The Department of Treasury has been directed by the Congress to issue guidance within 60 days after enactment of the law. The guidance will permit employers within a limited time frame to amend plans adopted prior to December 31, 2004 (1) so as to allow individuals to terminate participation in the plan or cancel an outstanding deferral election with respect to amounts deferred after December 31, 2004 or (ii) to comply with the legislation with respect to amounts deferred after December 31, 2004.
What Should Employers Be Doing Now? There are many unanswered questions that will need to be addressed in guidance issued by the Treasury. Until guidance is issued (such guidance is expected in December of this year), employers are being advised by practitioners to be taking inventory of all plans that might be affected. At a recent ALI-ABA conference (November 10, 2004), William F. Sweetnam, Jr., Esquire, Benefits Tax Counsel for the Treasury, stated that the new law will make nonqualified plans look more and more like qualified plans in that there will now be more specific legal requirements for such plans, new document requirements and operational requirements as well. Mr. Sweetnam urged employers not to “panic”, but to be taking inventory of their plans so that when guidance is issued, employers will be ready to take action and make amendments to their plans. He offered assurances that the Treasury will provide a transition period during which employers will be allowed to be bring their nonqualified plans into compliance with the new laws, even though the new rules technically take effect on January 1, 2005.
Also, practitioners are warning that employers who might seek to amend a grandfathered plan now to allow distributions in 2004, and to terminate the plan prior to January 1, 2005 to avoid application of the new rules, might end up actually running afoul of the new rules, since such an amendment would likely result in a “material modification,” meaning that the plan would no longer qualify for the “grandfather” rule.
Please note that the IRS has issued Announcement 2004-96 advising employers about an additional code for use on the 2005 Form W-2. The new code will be used to identify annual deferrals of income under a nonqualified deferred compensation plan covered under new section 409A of the Internal Revenue Code. The deferred amounts will be reported in box 12 of Form W-2, using Code Y.
Bottom Line: All nonqualified deferred compensation plans covered by the new rules will most likely have to be amended. The features of many current plans will no longer be permitted, and many plans will have to be redesigned. Employers will have to communicate these changes to affected participants.