Tucked away in the voluminous American Jobs Creation Act of 2004, which was signed into law on October 22, 2004, is a provision changing the taxation of nonqualified deferred compensation. Nonqualified deferred compensation arrangements allow employees to defer the payment and income taxation of certain compensation. If the requirements of the new law are not satisfied, however, the deferred compensation is includable in the participant's taxable income before it is paid. In addition, interest (at the IRS underpayment rate, plus 1%) and a penalty of 20% on the taxable amount are added to the individual's income tax liability. Since early and punitive taxation defeats the purpose of these plans, all nonqualified deferred compensation plans and programs should be reviewed to make sure that they comply with the new rules.
The new law applies to any plan or program that provides deferred compensation other than a tax-qualified retirement plan, vacation, sick leave, disability pay or death benefits program and certain other arrangements. Rather, the rules apply to elective salary deferral arrangements; severance; phantom stock plans; discounted stock options; so-called 457(f) plans for governmental entities and non-profit organizations; annual bonuses paid more than 2-1/2 months after year-end; split-dollar agreements; and other supplemental executive retirement plans. The new law also applies to stock appreciation rights and restricted stock.
Limitations on Distributions
Under the new rules, distributions from nonqualified deferred compensation plans are permitted only at certain times to preserve income tax deferral. These are:
- Separation from service;
- A time specified by the plan;
- Change of control of the employer;
- The participant's disability; or
- The occurrence of an unforeseeable emergency.
Payments for unforeseeable emergencies are allowed only in the case of severe financial hardship to the participant. Distributions to pay for non-emergencies such as the payment of the tuition for participants' children can trigger accelerated income taxes, interest and penalties under the new rules unless the plan is carefully designed.
Timing Elections to Defer Compensation
Participants' elections to defer compensation and its taxation must now generally be made before the close of the prior taxable year in which the compensation is earned. A special 30-day rule applies to newly eligible participants. Otherwise, elections to defer compensation can trigger punitive taxation.
There is a special rule for "performance-based" compensation which is pay that is contingent on pre-determined targets for services performed over the course of 12 months. The election to defer performance-based compensation may be made no later than 6 months before the end of the service period.
No Accelerated Payments
The early payment of deferred compensation is a special target of the new legislation. For example, switching from installment payments to a lump sum can trigger punitive taxation. Accelerated payments that are allowed, however, may occur only for reasons beyond the control of the participant, such as for divorce settlements and the payment of the employee's share of employment taxes.
Subsequent Changes in Distribution Elections
Under the new rules, a deferred compensation plan is also restricted in allowing participants to delay payments otherwise scheduled. The following, however, illustrate permissible elections:
- An election to delay payments can be made without punitive taxation only if the delay in payment is for at least 12 months after the date on which the election is made.
- If the election to delay payment relates to the separation of service, the employer's change of control, or a specified time, the first payment must be deferred for at least 5 years from the date it would have otherwise been made.
- Finally, an election to delay a payment scheduled under the plan must be made at least 12 months before the first scheduled payment.
If the plan restricts employer assets to payment of deferred compensation upon a change in the employer's financial health, then the asset restriction triggers penalty taxation. For example, if the employer's shaky financial health triggers the funding of a rabbi trust, the amount funded is subject to penalty taxation.
Offshore Trusts Impermissible
The transfer of assets to offshore trusts to fund the deferred compensation programs of workers in the U.S. will also trigger punitive taxation.
Effective Date and Limited Transaction Period
The new rules apply to amounts deferred after 2004, including any earnings on those amounts. Amounts deferred before 2005 (and the earnings thereon) are not subject to the new law unless the plan is materially modified after October 3, 2004.
The IRS will be issuing guidance before the end of 2004 regarding this new legislation. This guidance will provide a limited period during which a deferred compensation plan adopted before 2005 may be amended to conform to the new rules and avoid penalty taxation.
What Should Employers Do Now?
It is important the employers take the following steps now:
- Make a list of deferred compensation plans and practices that may be subject to the new laws.
- Do not make any changes to any plans without contacting counsel.
- Make plan participants aware of the new law and possible need to amend arrangements to avoid adverse taxation.
- Consider the timing of 2004 bonuses deferred and earned in 2005.
- Consider the timing of elections to defer compensation paid in 2005.
- Review any rabbi trusts that require funding upon the change of an employer's financial health.
- Contact counsel to devise a strategy for avoiding penalty taxation.
As a result of these new rules, your company's nonqualified deferred compensation plans and election procedures should be reviewed immediately and discussed with counsel.