New Corporate Tax Law Requires Review of All Executive Benefit Plans Before End of Year

The House and Senate recently approved the American Jobs Creation Act, which includes tax reform legislation that will require review and possible changes to virtually all nonqualified deferred compensation plans before the end of this year. President Bush is expected to sign the legislation in the very near future.

The new law applies to compensation deferred after December 31, 2004. If a plan is materially modified after October 3, 2004, the law also affects amounts deferred under the plan prior to January 1, 2005. The addition of any benefit, right, or feature is considered a material modification for purposes of the law.

Although the Conference Committee Report provided guidance regarding the new law and its impact, many questions remain unanswered. Congress has directed the IRS to issue guidance not later than 60 days after the President signs the law to further explain the new rules and their application. Thus, this guidance should be provided before the end of the year.

If a plan does not satisfy the requirements of the new law, all individuals covered by the plan will be subject to taxation and penalties. Consequences for a covered executive include:

• current income tax inclusion on the deferred amounts,
• interest at the underpayment rate retroactive to the date of the original deferral (or, if later, that date on which the deferred compensation was no longer subject to a substantial risk of forfeiture), and
• an additional tax equal to 20% of the amount included in income.

In light of the new law, every employer that provides nonqualified deferred compensation for one or more of its employees should do the following:

1. Consider the Plans and Arrangements Affected By Legislation

The new law applies to compensation arrangements that some employers have not traditionally considered to be a deferred compensation plan, such as supplemental executive retirement plans (SERPs), stock appreciation rights plans, phantom stock plans, excess benefit plans, and individual arrangements providing for the deferral of compensation. Employers should review all executive compensation arrangements to determine which plans are subject to the legislation. "Nonqualified deferred compensation plan" is broadly defined as any plan or arrangement that provides for the deferral of compensation, excluding "qualified" plans. Stock options are not considered deferred compensation.

2. Review Plan's Distribution and Acceleration Options

Employers should review each plan's distribution and form of payment options to ensure compliance with the new law. Under the new law, distributions from a nonqualified deferred compensation plan may be allowed only upon:

• separation from service,
• death,
• a specified time (such as age 65) or pursuant to a fixed schedule,
• change in control of the corporation, as defined by the law,
• the occurrence of an unforeseeable emergency, as defined by the law, or
• the participant's disability, as defined by the law.

In addition, a plan may not allow for the acceleration of distributions. If a plan does not satisfy these requirements, amounts deferred under the plan will be includible in income at the time of vesting and be subject to the additional interest and penalties described above.

3. Evaluate Plan's Election Provisions

Employers should examine a plan's deferral election provisions to ensure that employees are required to make deferral elections no later than the end of the year before the compensation is earned. For example, employees must elect to defer compensation earned in 2005 by December 31, 2004. There is an exception for performance-based bonus pay based on services performed over a period of at least 12 months: these elections must be made at least six months before the end of the 12-month service period.

At the time of the deferral election, an employee must also designate the time and form in which the deferred compensation will be distributed. The new law strictly limits an employee's ability to make any later change in this election. An employee may not accelerate the timing of the elected payment. Any election to defer the elected payment must be made at least 12 months before the effective date of the change. In addition, any election related to a payment made for a reason other than death, disability, or an unforeseeable emergency must defer previously elected payments for a period of at least five years.

4. Examine Foreign Trusts and Trusts with Financial Triggers

Under the new law, certain types of trusts can lead to unintended tax consequences. The new law treats certain foreign trusts and trusts with funding triggers tied to the financial health of the employer as owned by the employees for whom compensation has been deferred. This rule means that assets set aside in such a trust will be taxable to the employee/beneficiaries of the trust. Employers should review both the plan and trust language to make sure that nothing triggers these unanticipated tax consequences.

5. Amend Plan Documents and Election Forms

Once it is determined that a plan or trust must be amended to comply with the new law, employers should arrange to amend the appropriate documents and, if necessary, have their Board of Directors or other governing body approve the changes before the end of 2004. Documents that will need to be reviewed include:

• employment contracts or other agreements providing for deferred compensation,
• plan documents,
• election forms, including election forms for compensation that would otherwise be payable in 2005 that may have already been completed,
• trust agreements, and
• communication materials sent to employees.

Although the Committee Report indicates that the Secretary of Treasury has the authority to extend the amendment period, there is no assurance that this extension will be given.

To discuss this matter with your contact in the Employee Benefits Group at Ice Miller, please use this link to access our directory of attorneys.  If you do not have a contact in the Ice Miller Employee Benefits Group, please feel free to contact  Marc Sciscoe or Jim Kemper, who prepared this article.

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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