Nonqualified Deferred Compensation Plans

October 15, 2004

by

Patricia K. Keesler

Benefits Law Group

 

The House and Senate have both passed the American Jobs Creation Act of 2004 (H.R. 4520) a bill including provisions that will dramatically affect nonqualified deferred compensation plans. The President is expected to sign the bill in November of 2004. The provisions are effective for amounts deferred in taxable years beginning after December 31, 2004. Amounts deferred before December 31, 2004 are subject to the new provisions if the plan was materially modified after October 3, 2003. The legislation directs the Secretary of the Treasury to provide a limited period of time when participants can terminate plan participation with regard to amounts earned after December 31, 2004, if such amounts are includible in income  as they are earned.

 

The new law will apply to any plan that provides for the deferral of compensation, other than a qualified plan, a bona fide vacation leave, sick leave, compensatory time, disability, or death benefit plan.  It does not apply to 403(b) plans, SEPS, SIMPLE plans, section 415(m) governmental excess plans or eligible 457(b) plans. However section 457(f) plans, 401(a) ÓmirrorÓ plans, restricted and phantom stock plans are included. The provision does not generally apply to stock options granted at fair market value.

 

If the provisions of the new law are not satisfied, the participant will have income tax consequences on the amount deferred, plus interest at the underpayment rate plus one percentage point. This amount will be subject to a 20 percent additional tax.

 

Under the new law, distributions from a nonqualified deferred compensation plan may be made only upon the following events: (1) separation from service (6 month wait for distributions to key employees of publicly-held companies); (2) specified time or pursuant to a fixed schedule, but not the occurrence of an event; (3) change in control of the company; (4) unforeseeable emergency; (5) disability.

 

A nonqualified deferred compensation plan may not permit acceleration of distributions unless specifically permitted in regulations to be issued by the Secretary of the Treasury. This restriction will eliminate the so-called Òhaircut provisionsÓ found in many plans that allow participants to receive distributions by agreeing to reduce the amounts previously deferred.

 

As under current law, the new law requires that any election made by a participant to defer compensation for service during a taxable year,  be made no later than the close of the preceding taxable year. There are specific rules regulating deferrals of performance-based compensation.   In general, a deferral election for a performance-based incentive that is based on service over a 12-month period must be made at least 6 months before the end of the measuring period.

 

The time and form of distribution must be specified at the time of the initial deferral. The plan may allow changes in the time and form of distribution only if all of the following are met: (1)  the change is not effective for at least 12 months after the election is made, (2)  the additional deferral is for at least 5 years from the date the payment would have begun and (3) the election is made at least 12 months before the initial payment would have been due. 

 

In general amounts set aside in foreign and ÒspringingÓ rabbi trusts to fund the nonqualified plans will be considered funded and thus taxable in the first year the amounts in the trust are not subject to a substantial risk of forfeiture. Both are also subject to the 20% additional tax.

 

Amounts deferred under a nonqualified deferred compensation plan are required to be reported on the individualÕs Form W-2 or 1099 for the year deferred.

 

All nonqualified deferred compensation arrangements and any communications materials or prospectuses relating to them should be reviewed prior to the end of 2004 to ensure that deferrals made in 2005 will meet the requirements.  Tax consequences can be severe for noncompliance. Employers should also review executive agreements and severance pay plans for provisions that may be covered by the new legislation and  be prepared to either amend their plans with respect to deferrals made after 2004 or freeze their old plans and establish new plans under the new rules. 


Return to the Legislative Updates page.