The American Jobs Creation Act of 2004 (the “2004 Act”), enacted Oct. 22, 2004, imposes new statutory requirements for nonqualified deferred compensation plans. These new rules became effective the first of this year, even for plans established or adopted prior to such date.
If you are an employer and have a nonqualified deferred compensation plan in place, or if you are a participant in such a plan, it is important that the terms of the plan be reviewed to ensure compliance. In many cases, amendments to the plan will be necessary for it to comply with the act. Failure to conform a plan to the new rules can result in substantial adverse tax consequences to the participants.
A nonqualified deferred compensation plan is defined by the act to include any plan that provides for the deferral of compensation, other than (1) a “qualified employer plan,” and (2) any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. A “plan” includes an agreement or arrangement, including an agreement or arrangement that includes only one person.
Examples of nonqualified deferred compensation plans include salary and bonus deferral plans, supplemental executive retirement plans (SERPs), certain nonqualified stock options, rabbi trusts, stock appreciation rights, phantom stock plans and any employment agreement that contains provisions that defer compensation.
If a current plan does not comply with the new requirements, all amounts deferred under the plan after Jan. 1, 2005, will be currently includible in the gross income of the participant. In addition, interest is imposed on the tax underpayments that would have occurred had the compensation been includible in income when first deferred, and, to make matters worse, the amount required to be included in income is subject to a 20 percent additional tax.
The act imposes requirements that affect three basic areas — distributions, acceleration of benefits and elections to defer.
The plan must provide that compensation deferred under the plan may not be distributed earlier than:
* Separation from service
* The date the participant becomes disabled
* Death
* A time (or pursuant to a fixed schedule) specified in the plan at the date of the deferral of such compensation
* The occurrence of an unforeseeable emergency
* To the extent to be provided by the Treasury secretary, a change of ownership or effective control of the corporation
Acceleration of benefits. A plan may not permit the acceleration of the time or schedule of any payment under the plan, except as may be provided in regulations to be issued by the Secretary of the Treasury.
Elections to defer. A plan must provide that compensation for services performed during a taxable year may be deferred at the participant’s election only if the election to defer is made no later than the close of the preceding taxable year. There are, however, exceptions to the foregoing rule in the case of the first year of participation and for performance-based compensation.
Due to the substantial changes made by the 2004 act, it is likely that many existing nonqualified deferred compensation plans will need to be amended, frozen or terminated.
Accordingly, every nonqualified deferred compensation plan should be reviewed as soon as possible to determine what changes, if any, are necessary to conform the plan to the new rules.
Thomas J. Ubbing is a partner with Brouse McDowell. Reach him at (216) 830-6830 or [email protected].
