New Rules (And Pitfalls) For Non-Qualified Tax Deferred Compensation Plans

The recently enacted American Jobs Creation Act of 2004 has made substantial changes to the tax rules governing non-qualified deferred compensation plans.

These provisions (added as Section 409A to the Internal Revenue Code) permit the deferral of taxation only if the deferred compensation meets certain requirements governing when deferrals may be elected; when distributions may be elected and made; and when payments may be accelerated.

Penalty For Failure To Comply

If an arrangement fails to meet the new requirements, then all compensation deferred for the tax year and for all preceding years will become taxable as soon as it is not subject to a “substantial risk of forfeiture.”

In addition, the following penalties will be assessed: (1) a 20 percent penalty tax on all of the compensation, plus (2) interest on any taxes on compensation that was vested in any previous year.

There is no corresponding penalty on the employer. However, in order to help the Internal Revenue Service to police compliance with the new rules, employers will now be required to report annual amounts deferred, even if not currently taxable.

Requirements Of The New Law

Generally, the new law requires that elective deferrals of salary be elected before the start of the year in which the salary will be earned, and

deferrals of bonuses be elected within the time permitted by the IRS. (Currently, for bonus periods of at least one year, the election deadline is no later than six months before the end of the bonus period.)

The law also specifies that payments may only be made in certain circumstances, and it requires that the payment date or events either be specified in the plan or be elected by the participant before the deferral is made. The following payment choices may be offered under the new law:

• Payment upon termination of employment,

• Payment upon death or disability,

• Payment at a time specified in the plan or by the participant’s election before the deferral period begins,

• Payment upon an unforeseeable financial emergency, or

• Payment upon a change in control (of a corporation employer).

The same rules apply to specifying the method of distribution – such as a choice between a lump sum and installments.

The law does permit limited changes in the date or event for a distribution and in the method of distribution. However, generally any changes must be elected at least a year in advance of their effective date (and, in the case of payments scheduled to begin on a certain date, at least a year before that date).

Furthermore, any changes must defer payment (or the start of payments) by at least five additional years.

Finally, the new law generally forbids the acceleration of any payment, except to the extent permitted by the IRS in future guidance. In such guidance issued so far, the IRS has permitted acceleration only in very limited circumstances.

Application Of The New Law

The new law applies to all amounts deferred under any new plans created after Oct. 3, 2004. For plans that were in existence on that date, the new law exempts only deferred compensation that is actually earned and vested before Jan. 1 of this year. Thus, under existing plans unvested amounts and future deferrals will be subject to the new rules, as well as all amounts under any new plan.

The new law also applies to deferred compensation paid to non-employee service providers, including outside directors, consultants and other independent contractors and members of scientific advisory boards or other types of advisory boards.

In addition, it applies to deferred compensation paid by partnerships and other types of non-corporate employers to their partners or members. However, a profits interest in a partnership or a limited liability company is not subject to the new law, and a capital interest that is either vested (and taxed) when granted or is taxed when it subsequently becomes vested is also not subject to the new law.

The new law applies to all non-qualified deferred compensation arrangements, whether incorporated into a plan for multiple participants or contained in an agreement for a single person.

It also applies to some arrangements that you may not think of as deferred compensation plans. For example, in addition to traditional elective deferral plans and supplemental executive retirement plans (SERPs), the IRS has announced that the new law applies to several types of equity plans.

According to the IRS’s recent guidance, the following types of equity plans are covered by the new law:

• All stock options that are granted at below fair market value;

• All stock appreciation rights (SARs), except (1) SARs granted by publicly traded employers, and (2) SARs which remain unvested until the occurrence of a payment event (such as an IPO or the sale of the employer) and which then immediately pay out the resulting compensation; and

• All phantom stock plans.

The IRS is also considering adding to this list of covered types of equity compensation all non-qualified stock options if the employer has any right or obligation to repurchase the shares. This would primarily affect closely held employers.

Certain types of compensation and benefits are exempt from the new law, including all:

• types of tax-qualified retirement plans;

• non-pension benefits, except for severance benefits;

• compensation and benefits that become taxable upon vesting;

• bonuses paid within 2-1ݚ months after the end of the bonus period;

• other compensation paid within 2-1ݚ months after the end of the tax year in which the compensation vests; and

• Incentive Stock Options and all options under an Employee Stock Purchase Plan.

Transition Period For Compliance

The IRS has now issued preliminary guidance that gives employers until the end of 2005 in order to either amend their existing plans to comply with the new rules, or terminate them without incurring the new penalty tax and interest.

Nevertheless, any plan that is in existence during 2005 must either be operated in accordance with the new rules – and amended by the end of the year – or terminated (and the benefits paid out) by the end of the year. Under this transition relief, a plan may be amended with respect to some participants and terminated as to other participants.