A little-known provision of the American Jobs Creation Act of 2004 may have a devastating impact on employees who have deferred compensation that would be otherwise currently payable.
Affected are nonqualified plans, which include any deferred compensation plan other than a traditional pension, profit sharing or 401(k). Also included are arrangements that involve a single employee.
Often, employees and employers agree that compensation, either regular salary or bonuses, will be deferred until a later date, usually agreed upon in advance or sometimes at the discretion of the employer. Typically, the amounts deferred are invested in a mutual fund in the name of the employer, and earnings or losses are reflected in the account balance.
Sometimes, the employer retains use of the funds and credits the account at some assumed rate, such as prime plus 1 percent.
Until paid out, deferred accounts are subject to the claims of the employer’s creditors. Taxwise, it has never been possible to avoid taxation unless the funds are subject to the claims of the employer’s creditors. Some employees have insisted that the accounts be maintained by an escrow agent to avoid being subject to a change in management (sometimes called a “rabbi trust,” as a rabbi who feared incurring the displeasure of his congregation sought the first ruling by the IRS).
But even with a rabbi trust, the funds must be subject to the claims of the employer’s creditors. Rabbi trusts continue to be permissible under the new law.
Some executives have used even more aggressive means to protect their deferred compensation accounts by moving the accounts offshore. Others, as reported in connection with the accounting fraud scandals of recent years, have included provisions calling for an immediate payout if the employer’s financial condition begins to deteriorate.
Neither of these provisions is permissible now.
The new law substantially revises and clarifies requirements for an employee to defer taxation on compensation. If the rules for tax deferral are initially satisfied and material changes are later made in the arrangement, the compensation initially deferred (together with any earnings on it) becomes immediately taxable. In addition, there is a penalty of 20 percent of the amount of deferred compensation, together with interest on the amounts deferred from the time of deferral.
In general, the new restrictions can be divided into three categories — restrictions on distributions, restrictions on acceleration of benefits and restrictions on elections.
The distribution rules are satisfied if deferred compensation can only be distributed after these particular events.
- Separation from service
- Disability
- Death
- A prearranged time or schedule
- A change in ownership
- The occurrence of an unforeseen emergency
The acceleration of benefits rule requires that the plan not permit acceleration of the time or schedule of any payment, with limited exceptions. But, the account of a terminated participant containing less than $10,000 may be distributed immediately.
The elections requirement generally requires that compensation for services performed during a year may be deferred only if the election is made at the end of the preceding taxable year. There are exceptions for the first year of participation and performance-based compensation covering a period of at least 12 months. A change in the timing of an otherwise elected distribution may be made under limited circumstances.
In general, the new rules are effective for amounts deferred in the year 2005 and later. Deferred compensation plans created prior to the date of enactment of the new law (Oct. 3, 2004) are generally grandfathered.
Nedom A. Haley is a partner at Gambrell & Stolz, LLP. His areas of practice are federal taxation, municipal finance and employee benefits. Reach him at (404) 221-6505 or [email protected].
