New Tax Act Has Major Effects on Nonqualified Deferred Compensation Plans
Corporate & Finance Alert
November 19, 2004
The American Jobs Creation Act of 2004 (the “Act”) contains important provisions dealing with nonqualified deferred compensation plans. These provisions reduce the flexibility available to boards of directors, Compensation Committees, and executives in designing and administering these plans. Generally, the Act’s provisions apply to amounts deferred after December 31, 2004 and earnings thereon. For amounts deferred prior to January 1, 2005, the Act’s provisions apply to plans that are materially modified after October 3, 2004. An amount is treated as deferred prior to January 1, 2005 if it is earned and vested prior to that date. Thus, a bonus earned and vested prior to January 1, 2005 is grandfathered, and an executive can make a deferral election for the bonus free of the Act’s requirements even if the bonus is paid in 2005. If a bonus plan requires that an executive be employed on the date of payment, and the corporation pays a bonus for 2004 service in 2005, it is likely that deferral of the bonus is subject to the Act’s requirements.
The Act provides that all amounts deferred for a taxable year and all preceding taxable years are includible in an executive’s gross income to the extent that these amounts are (a) not subject to a substantial risk of forfeiture; (b) not previously included in gross income; and (c) if at any time during the taxable year the plan document does not contain the provisions required by the Act for distributions, acceleration of benefits, and deferral elections. Substantial risk of forfeiture means that the right to the deferred compensation is conditioned on the future performance of substantial services, or satisfaction of a condition related to the services, such as performance goals or financial targets. In addition, income inclusion occurs when the plan is not operated in accordance with the Act’s provisions.
Income inclusion means not only that the deferred compensation is subject to income tax, but also two other payments. First, interest is imposed on the underpayment of tax that would have occurred had the deferred compensation been included in income for the taxable year in which it was first deferred, or, if later, the first taxable year in which it is not subject to a substantial risk of forfeiture. The interest rate is the underpayment rate plus one percentage point. The underpayment rate is the federal short term rate plus three percentage points. Thus, the additional interest charge is the federal short term rate plus four percentage points. Second, the Act imposes a penalty of twenty percent of compensation that is included in gross income.
Under the Act’s distribution requirements, the plan must provide that amounts deferred cannot be distributed earlier than:
- A participant’s separation from service, with a special rule for “specified employees;”
- The date of a participant’s disability;
- The date of a participants death;
- A time specified, or a fixed schedule under the plan, at the date of the deferral;
- To the extent provided by IRS regulations, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation’s assets; or
- The occurrence of an unforeseeable emergency.
If a plan permits distribution for any event other than the foregoing events, income inclusion occurs. Thus, if the plan allows a participant to elect distribution at any time subject to a ten percent forfeiture of the amount distributed, income inclusion occurs. In addition, a distribution in the discretion of the plan administrator, such as the Compensation Committee, results in income inclusion.
For “specified employees,” distribution cannot be made before the earlier of six months after the date of the employee’s separation from service, or the date of the employee’s death. A specified employee is a key employee of a publicly traded corporation under the top-heavy rules for qualified retirement plans. Key employees are officers having annual compensation greater than $135,000 (as adjusted for inflation) and limited to fifty employees; five percent owners; and one percent owners having annual compensation greater than $150,000. Since the qualified retirement plans of most publicly traded corporations are unlikely to be top-heavy, most plan administrators do not determine who are the corporation’s key employees. Accordingly, corporations may wish to impose a universal six-month waiting period to address this requirement.
For a distribution at a specified time or on a fixed schedule, amounts payable on the occurrence of an event do not qualify. For example, amounts payable once an executive reaches a specified age, such as sixty-two or seventy, are amounts payable at a specified time. Amounts payable when an executive purchases a principal residence, or when an executive’s child enters college, are amounts payable on the occurrence of an event. In addition, 401(k) wraparound arrangements in which deferrals to a nonqualified plan are transferred to a 401(k) plan may be amounts payable on the occurrence of an event.
Acceleration of Benefits
The Act generally prohibits the acceleration of benefits. A plan cannot permit acceleration of the time or schedule of any payment, except as provided by IRS regulations. Thus, changes in the form of distribution that accelerate payments, such as a change from installment payments to a lump sum, result in income inclusion. Many corporations will have to amend their plans to eliminate acceleration provisions.
For an initial deferral election, the plan must provide that a participant can elect to defer compensation for services performed during a taxable year either not later than the close of the preceding taxable year, or at any other time provided by IRS regulations. In addition, the time and form of distribution must be specified at the time of the initial deferral election. For performance-based compensation based on services performed over a period of at least twelve months, the executive must make the initial deferral election no later than six months before the end of the service period. Performance-based compensation means amounts that are variable and contingent on satisfying preestablished performance goals, and not readily ascertainable at the time of the deferral election. Thus, the exception for performance-based compensation allows the executive to make a later election to defer annual bonuses, and bonuses for a multiyear performance period.
A plan can permit a subsequent election to change the time or form of distribution only if the plan contains the following requirements:
- The election cannot take effect until at least twelve months after the date on which it is made;
- For an election for a payment made other than by reason of disability, unforeseeable emergency, or death, such as on separation from service, change in control, or at a specified time, the first payment for which the subsequent election applies must be deferred for at least five years from the date on which the payment would otherwise have been made. For example, if an executive changes the form of distribution from a lump sum to installment payments, the executive cannot receive the first installment until five years after the lump sum would have been paid; and
- Any election for a payment made at a specified time or under a fixed schedule cannot be made less than twelve months before the date of the first scheduled payment.
Under the Act’s effective date rules, subsequent deferral elections for amounts deferred before January 1, 2005 under a plan that is not materially modified after October 3, 2004 are not subject to the Act.
Employer Financial Health Funding Triggers
The Act provides that a taxable transfer of property occurs for compensation deferred under a nonqualified deferred compensation plan as of the earlier of:
- The date on which the plan first provides that assets will become restricted to providing benefits if there is a change in the employer’s financial health; or
- The date on which the assets are so restricted, regardless of whether the assets are available to satisfy the claims of the employer’s general creditors.
Thus, an amount subject to a financial health funding trigger is treated as restricted and part of a taxable transfer regardless of whether the assets are available to satisfy the claims of the employer’s general creditors. For example, if a plan provides for the funding of a rabbi trust on a change in the employer’s financial health, income inclusion occurs regardless of the whether the trust is ever funded.
For purposes of the effective date rules, the addition of any benefit, right, or feature is a material modification. Thus, accelerating vesting is a material modification. The exercise or elimination of an existing benefit, right, or feature is not a material modification. Thus, elimination of a provision allowing a participant to withdraw an amount subject to a ten percent forfeiture, or eliminating the grant of discretion to the Compensation Committee to make a distribution, should not be a material modification. Prior to eliminating any benefit, the employer should determine whether the contemplated elimination would run afoul of any plan provision or common law contract rule prohibiting reduction or elimination of any benefit accrued under the plan.
The Act covers a broad range of deferred compensation arrangements. The Act’s broad definition of nonqualified deferred compensation plans covers salary and bonus deferral plans, supplemental executive retirement plans, stock options, stock appreciation rights, phantom stock, restricted stock plans, and severance plans. The Act applies to plans that cover directors, employees, and independent contractors, and plans that cover only one person. The Act does not apply to nonqualified stock options with an exercise price that is not less than the fair market value of the stock on the date of the option’s grant, as long as the arrangement’s only deferral feature is the right to exercise the option in the future. Thus, the Act applies to discounted nonqualified options. Finally, the Act does not apply incentive stock options and employee stock purchase plans governed by Internal Revenue Code Section 423.
The Act provides that the Treasury Department shall issue transition relief guidance within sixty days after the Act’s enactment, which is by December 21, 2004. The guidance will provide a period of time during which a plan adopted before December 31, 2004 may be amended (a) to provide that a participant can terminate participation in the plan, or cancel outstanding elections for amounts deferred before December 31, 2004; and (b) to comply with the Act’s provisions. Treasury must provide a reasonable time after the issuance of regulations for employers to amend plans to satisfy the Act’s provisions. The IRS has stated that it will be liberal in providing transition relief. The Act also provides that within ninety days after the Act’s enactment, which is by January 20, 2005, the Treasury Department shall issue guidance on the definition of the change in ownership or effective control.
Considerations for Employers
Since the IRS has stated that it will be liberal in providing transition relief, the prudent approach is to wait for the IRS to issue its guidance prior to changing deferral elections and amending plans. Furthermore, employers should not amend plans without considering whether the amendment will cause the plan to be materially modified and lose its grandfather status. Accordingly, employers may wish to freeze existing plans, and create new plans for post-2004 deferrals so as to avoid an inadvertent material modification. Pending the issuance of IRS guidance, employers should create a list of the plans subject to the Act, and review the plans for the provisions affected by the Act.
If you have any questions on these items or other tax issues, please contact Steven H. Sholk, Esq. of our Corporate Practice Group at 973-596-4639 or send him an e-mail message at firstname.lastname@example.org.