New Tax Law Requires Review of Deferred Compensation Arrangements Before End of Year

The American Jobs Creation Act signed by President Bush on October 22 makes major changes to the rules governing "nonqualified deferred compensation plans." In general, a "nonqualified deferred compensation plan" is any plan, arrangement, or agreement (including an employment contract) that provides for the deferral of compensation, except for (i) a qualified retirement plan or (ii) a vacation, sick leave, compensatory time, disability pay, or death benefit plan. The new law covers many arrangements that employers have typically not considered deferred compensation plans.

Overview of the New Law.

The new law imposes strict limitations on the timing of deferral elections, the ability to change elected forms of payment, the timing and manner of permitted payments, and the funding of deferred compensation. Each of these requirements is discussed below.

If an arrangement fails to satisfy the new law, individuals affected by the failure will be liable for:

• income tax on amounts deferred under the arrangement,
• interest during part or all of the deferral period, and
• an additional tax equal to 20% of the amount included in income.

Under the new tax law, employers have additional reporting requirements with respect to nonqualified deferred compensation. In addition, the employer may be subject to penalties if it does not withhold income taxes at the appropriate time and in the appropriate amounts.

Effective Date.

The new law applies to compensation deferred after December 31, 2004, as well as compensation deferred before December 31 that becomes vested after that date. In general, amounts deferred and vested before January 1, 2005, remain subject to prior law. However, if an existing plan is materially changed after October 3, 2004, the new law will apply to amounts deferred under the plan before January 1, 2005. The addition of any benefit, right, or feature to a plan (such as acceleration of vesting) is considered a material change, making pre-2005 deferrals under the plan subject to the new law.

Anticipated IRS Regulations.

Congress has directed the IRS to issue guidance in the form of regulations not later than December 21, 2004. As part of these regulations, the IRS has been directed to provide for a transitional period after December 31, 2004, during which (i) plans may be amended retroactively to comply with the new law and (ii) participants may terminate participation in the plan or cancel outstanding elections relating to amounts deferred after December 31, 2004.

Recommended Actions.

In light of the new law, every employer or other provider of nonqualified deferred compensation should take the following steps:

1. Identify All Plans Subject to the New Law

In addition to covering traditional nonqualified deferred compensation plans, the new law covers arrangements that employers traditionally have not considered to be deferred compensation plans. For example, stock appreciation rights, phantom stock, and restricted stock units are subject to the new law. In addition, employment contracts, severance and change in control agreements, and incentive compensation programs may create arrangements covered by the new law. It also appears that discounted stock options (i.e., options with an exercise value less than the fair market value of the underlying stock on the date of grant) are also subject to the new law.

2. Evaluate Each Covered Plan's Election Provisions

In general, an election to defer compensation must be made before the beginning of the year in which the compensation is earned. For example, an election to defer 2005 compensation must generally be made before the end of 2004. There are special rules for performance-based compensation and an employee's first year of eligibility under an arrangement.

At the time of the deferral election, an employee must also designate the time and form in which the deferred compensation will be distributed, unless the plan contains mandatory provisions relating to the timing and form of distributions. Once a deferral election is made, the elected distribution cannot be accelerated, and any later election to defer elected distribution must satisfy the following:

• it cannot take effect until 12 months after it is made;
• if the election relates to a payment made for a reason other than death, disability, or an unforeseeable emergency, it must defer previously elected payments for a period of at least five years from the previously elected distribution date; and
• any election to defer amounts payable at a specified time or pursuant to a fixed schedule must be made at least 12 months before the first scheduled payment under the original election.
  

3. Review Each Covered Plan's Distribution Provisions

The new law takes away much of the flexibility available under current law regarding the timing and manner of deferred compensation payments. Under the new law, distributions from a nonqualified deferred compensation plan are permitted only upon the occurrence of one of the following events:

• separation from service (six months after separation from service in the case of key employees of a public company),
• disability,
• death,
• a specified time (such as age 65) or pursuant to a fixed schedule,
• the occurrence of an unforeseeable emergency,
• or a change in control.

In addition, except as permitted by IRS regulations, a plan may not allow for the acceleration of distributions. Many plans provide, for example, that all deferred amounts will be distributed upon the employer's termination of the plan. The IRS has indicated informally that the new law prohibits such a provision.

4. Examine Funding Arrangements

Under the new law, certain funding arrangements can lead to immediate taxation and penalties. The new law imposes immediate taxation and penalties if either (i) a plan requires that assets be restricted to the payment of deferred compensation under the plan, if the employer's financial health changes, or (ii), regardless of plan language, assets are restricted to the payment of deferred compensation as a result of a change in the employer's financial health. This rule applies even if the restricted assets are subject to claims of the employer's general creditors.

In addition, the new law generally imposes immediate taxation and penalties if assets set aside for the payment of deferred compensation are located outside of the United States. The purpose of this rule is to prevent the use of foreign trusts to avoid corporate creditors. The language of the new law goes far beyond this purpose, however.

In connection with the new funding prohibitions, employers should review plan documents, trust agreements, and funding practices, whether formal or informal.

5. What Should Be Done Before December 31, 2004

Before 2005, employers should review all plans, agreements, and other arrangements involving the deferral of compensation (whether elective or not) to determine whether any of its arrangements is covered by the new law. Employers should review election forms and other communications materials relating to any arrangements that may be covered. Any elections to defer 2005 compensation, with the exception of compensation under certain performance plans, must be made before the end of 2004. Employers should inform employees that these elections will be subject to the new law. Because of the special impact of the new law on stock appreciation rights, phantom stock, and restricted stock units, we generally recommend that employers not issue post-2004 grants until the arrangements have been changed have been changed to comply with the new law.

In light of the IRS's recent assurance that retroactive amendments will be permitted next year and the uncertainty of many aspects of the new law pending the issuance of IRS regulations, in many circumstances, the employer may decide to delay plan amendments until after the IRS issues regulations. Any such decision should be carefully considered based on the advice of your legal and tax counsel.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.

Ice Miller is a full-service law firm with offices in Chicago, Indianapolis and Washington, D.C.  The employee benefits professionals of Ice Miller provide legal and consulting services regarding retirement, executive compensation and health and welfare benefits to public and private employers, financial institutions, insurance companies and other types of benefit service providers.
 
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