BUSINESS WATCH

New Legislation for Deferred Compensation Plans

By Amy Erlbacher-Anderson

 

On October 11, 2004, Congress passed the American Jobs Creation Act of 2004, making sweeping changes to certain benefit plans. The Act gives the Internal Revenue Service the authority to expand or limit a number of its provisions. Although the IRS has issued initial guidance, many provisions of the Act remain unclear and will continue to do so until further guidance is issued. The following is a brief summary of the changes made by the Act. 

 

Application of the Act

 The Act 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 unless the plan is materially modified after October 3, 2004. Plan amendments for the Act are due on December 31, 2005. 

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, supplemental executive retirement plans, phantom stock, restricted stock, bonus and incentive deferral arrangements, and severance plans appear to be covered by the Act. IRS guidance has exempted certain stock appreciation rights. 

 

Changes to Current Practices

Deferral Elections – 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” comp-ensation. No subsequent election to delay timing or change the form of payment allowed unless it will not take effect for 12 months, defers the payment for at least 5 years after a distribution would have been made, and is made at least 12 months before the first payment date. 

 

Distributions – time and form of payment must be set by the plan or elected by the participant at the time of deferral and can only occur upon death, disability, separation from service (plus 6 months for key employees of a public company), a specified time or under a fixed schedule, employer change in control, and an unforeseeable emergency. Accelerated distributions are forbidden, including changing a form of benefit from installments to a lump sum. IRS exceptions include distributing under a domestic relations order, withholding for employment taxes, and distributing a small account balance. 

 

Reporting and Withholding – deferrals must be reported in the year of the deferral and deferrals included in income in the year of taxation on Form W-2 and federal income tax withheld.

 

Funding - the use of offshore trusts and trusts that are not funded until the employer’s financial stability changes are forbidden. 

 

Penalties – amounts deferred after 2004 are included in income and subject to interest (5% currently) and a 20% penalty. 

 

If you sponsor a plan covered by the new rules, you should become familiar with the Act and later IRS guidance as soon as possible and begin identifying affected plans to ensure that you are complying with the new rules. 

 

 

 

 

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