TAX BREAK

The Times, They Are A-Changin’ – The New Deferred Compensation Rules By Amy Erlbacher-Anderson

 

Last fall, Congress passed the American Jobs Creation Act of 2004, instituting sweeping changes to certain nonqualified benefit plans. Under the Act, the Internal Revenue Service was given the authority to expand, define, or limit a number of its provisions. On December 20, 2004, the IRS issued its first guidance in the form of Notice 2005-1, but made it clear that additional guidance would be issued throughout 2005. 

 

The Act and the Notice, while providing an immense amount of information, do not answer many of the questions that have been raised by the changes made by the Act. Since a definitive description of the new rules is not possible before more guidance is provided, the following is simply a “highlight” of the changes.

 

 Application of the Act

 

The Act created a new section of the Internal Revenue Code – Code section 409A – and it applies to all amounts deferred to a nonqualified deferred compensation plan on or after January 1, 2005. Amounts previously deferred to a plan that are earned and vested are not subject to the Act (or “grandfathered”) unless the plan is materially modified after October 3, 2004. All affected plans must be amended to comply with the Act on or before December 31, 2005. Until then, a plan must be operated in good-faith compliance with the new rules. 

 

 To translate: 

 

 A “deferral of compensation” occurs when a person has a legally binding right to compensation that will be paid in the future, has not been actually or constructively received, and is subject to a substantial risk of forfeiture. A non-compete clause is no longer considered a substantial risk of forfeitures. “Rolling” forfeitures or forfeitures elected by the participant are deemed also  not to qualify as substantial risks of forfeitures under the new rules. 

 

A “nonqualified deferred compensation plan” includes all arrangements that allow participants to elect or automatically defer compensation except qualified plans and vacation, sick leave, disability, or death benefit plans. Traditional deferred compensation plans, discounted stock options and stock appreciation rights, supplemental retirement benefit plans, phantom stock, bonus and incentive deferral arrangements, and certain severance plans appear to be covered by the Act. 

 

The IRS has exempted certain nonstatutory stock options and stock appreciation rights, but strict rules must be met to avoid the new rules. In addition, deferred compensation that will be paid within 2½ months of the end of the taxable year in which the compensation vests has also been exempted from the new rules. 

 

 A “material modification” of an existing plan occurs when a benefit or right is added to the plan or a right that existed on October 3, 2004 is enhanced. Amendments made to comply with the new rules or to terminate or freeze the plan will generally not be considered a material modification. 

 

Changes to Current Practices

 

Deferral Elections – now required before the beginning of the taxable year in which services are performed, with an exception for new participants and a deferral of “performance-based” or bonus compensation. Elections for bonus compensation must generally now be made at least 6 months before the end of the performance period. Under certain circumstances, deferral elections related to services performed during 2004 and 2005 may be made as late as March 15, 2005. 

 

 

Continued

 

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