New Law Changes Deferred Compensation Rules
By: JOHN H. MERKLE
November 2004
Congress recently passed, and President Bush has now signed, the American Jobs Creation Act of 2004. Among other things, the Act significantly changes the rules relating to nonqualified deferred compensation. With limited exceptions, the new rules apply to any kind of arrangement providing for the deferral of taxable income, and will generally apply to amounts deferred after December 31, 2004.
Under the new law, every deferred compensation arrangement must meet certain distribution, acceleration-of-benefits, and election requirements. If the arrangement does not satisfy such requirements, the compensation that is earned and deferred must be included in income for the first tax year that the arrangement fails to meet the requirements to the extent it is not subject to a substantial risk of forfeiture and was not previously included in gross income. In addition, a 20% penalty tax is imposed and interest is assessed on the underpayment at the underpayment rate plus one percentage point.
Under the new law, an arrangement may not permit distributions earlier than:
- Separation from service,
- Death,
- Disability,
- A specified time or under a fixed schedule,
- A “change in control” (as defined in regulations), or
- An occurrence of an “unforeseeable emergency” (as defined in regulations).
In addition, a key employee of a public corporation generally may not receive a distribution earlier than six months after separation from service. So-called “haircut provisions” (which allow an immediate distribution in exchange for a forfeiture of a portion of the benefit) are prohibited. The new law also generally prohibits the acceleration of benefit payments.
The new law generally requires that deferral elections be made in the tax year preceding the year in which the services are performed, or within 30 days of the individual becoming eligible for plan participation. If the award is performance-based, the deferral election must be made no later than six months before the end of the performance period. An election of the form and timing of the benefit payment, if permitted, must be made at the same time. An arrangement cannot permit a subsequent election to delay payment or change the form of payment, unless the new election:
- Does not take effect for at least 12 months after it is made, and
- Delays payment for an additional five years.
In addition, if distributions were scheduled to begin on a specified date or according to a fixed schedule, the new election must be made at least 12 months before the date of the first scheduled payment.
The new rules prohibit the use of offshore trusts for the funding of deferred compensation. Additionally, the new rules prohibit the conversion of a trust that is subject to the claims of general creditors into a trust that is not subject to the claims of general creditors. The new rules also prohibit the payment of deferred compensation triggered by a deterioration in the financial health of the employer. Income deferrals will be reported to the IRS annually.
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The Internal Revenue Service will soon issue guidance regarding the application of and transition to the new rules. When that guidance is issued, we will be in a better position to advise you about any changes that may be needed to your nonqualified deferred compensation arrangements. In the meantime, you should identify those arrangements that could be affected by the new rules.