The American Jobs Creation Act of 2004, signed into law in October, includes changes in the federal tax laws that apply to nonqualified deferred compensation plans. The new rules will require most existing executive compensation plans, including individual agreements, to be amended.
Failure to satisfy the new requirements will result in the inclusion of deferrals in a participant’s income, except to the extent that the amounts are subject to a substantial risk of forfeiture. Interest and a 20 percent additional tax also apply.
The new law appears to cover typical deferral election plans, supplemental 401(k) and supplemental executive retirement plans, certain types of equity compensation plans and even severance plans. The Internal Revenue Service is to issue guidance on the law, including its applicability to certain types of plans, before the end of the year.
In general, the law imposes the following restrictions on covered nonqualified deferred compensation.
* Amounts deferred may not be distributed earlier than the participant’s separation from service, and in the case of “key employees” of publicly traded companies, not earlier than six months after the date of their separation from service; the participant’s disability or death; a specified time established under the plan at the date of the deferral; upon a change in control; or the occurrence of an unforeseeable emergency.
* In addition, a covered plan may not permit the acceleration of the timing of a payment under the plan. This provision eliminates so-called “haircut” provisions whereby a participant agrees to forfeit a portion of his or her benefit in exchange for an earlier payout.
* A plan must provide that initial deferral elections be made before the taxable year in which compensation is earned, or within 30 days after first becoming eligible to participate in a plan.
* A subsequent election to change the timing or form of benefit is only permitted if the election does not take effect until at least 12 months after the date it is made, and the election generally provides a deferral period of at least five years from the date the payment would otherwise have been made.
* Subject to limited exceptions, assets set aside by an employer in an offshore rabbi trust are taxable to participants when vested. In addition, an arrangement providing for funding of benefits upon a change in the employer’s financial health will cause deferrals to be taxable to participants.
The restrictions apply to deferrals earned after Dec. 31, 2004. Deferrals earned and vested before 2005 are grandfathered under prior law unless the plans under which they were made are materially modified after Oct. 3, 2004.
As noted above, the IRS is expected to issue guidance on the new law shortly. The IRS also has indicated informally that it intends to provide for meaningful transition relief so that employers can bring covered plans into compliance. We recommend that employers wait for the IRS guidance before actually amending their existing plans, but that employers begin the process now of identifying potentially affected plans and agreements.
Kathryn A. English is a lawyer with Eckert Seamans Cherin & Mellott. Reach her at www.escm.com.
