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Nonqualified Deferred Compensation Plans: New Rules under the AJCA More plans, more rules, more taxes. This is the best way to describe the new world of nonqualified deferred compensation (NQDC) plans after the American Jobs Creation Act of 2004 (AJCA). AJCA Section 885 enacts new Sec. 409A and dramatically changes the operation of many NQDC plans and, as discussed below under Effective Date, applies to amounts deferred in tax years beginning after 2004. Notice 2005-1 provides initial guidance under Sec. 409A. Also, several helpful examples and guidelines appeared in the AJCA Conference Report (CR); see Conf. Rept No. 108-755, 108th Cong., 2d Sess. (2004). Additional IRS guidance expected later this year will probably be consistent with the examples in the CR. Any such guidance should be considered before taking action.
More Taxes Perhaps the most significant aspect of the new rules is the tax liability that plan participants will incur if the rules are not followed. It is hard to imagine that an employer or individuals covered under a plan would chance noncompliance with the new distribution, funding and election rules, as it would trigger inclusion of the entire cumulative post-2004 deferred compensation in income (plus any investment earnings) at regular rates. An additional 20% penalty would apply to the deferred compensation. A third component relates to interest. The taxpayer has to pay interest on the income taxes that would have been paid had the deferred compensation been reported as income as services were performed in each prior year. The interest is calculated using the underpayment rate, plus one percentage point. Current taxation can be avoided for noncompliance if any of the deferred compensation amounts are subject to a substantial risk of forfeiture; such amounts will not be taxed. It is only a matter of time, though, until they are taxed. Taxation occurs as soon as there is no longer a substantial forfeiture risk. Under the new rules, rights to compensation are subject to a substantial risk of forfeiture if they are conditioned on the future performance of substantial services by any individual, or the occurrence of a condition related to a purpose of the compensation (e.g., the attainment of a prescribed level of earnings or equity value). Thus, significant risk of forfeiture refers to whether amounts are vested.
More Plans AJCA Section 885 very broadly defines an NQDC plan to include any plan that provides for the deferral of compensation, except for the following:
A plan or arrangement not listed above is subject to the new rules. Under new Sec. 409A(d)(3), the term plan includes any agreement or arrangement, even if it includes only one person. Nothing in the AJCA suggests that the new rules apply only to written agreements. The agreements substance, rather than its name or degree of formality, is what matters. Also, the rules are not limited to arrangements between an employer and an employee. Thus, arrangements involving independent contractors and directors are also covered. The types of plans that also may be treated as NQDC plans include supplemental executive retirement plans, employment agreements that include a retirement benefit, phantom stock, stock appreciation rights (SARs), discounted stock options and Sec. 401(k) mirror plans. Given the all-inclusive definition of an NQDC plan, it will be a significant challenge to ensure that all of an employers plans are properly identified. Notice 2005-1, Q&A-4(iv), provides that, pending further guidance, nondiscount SARs granted under a plan in effect before Oct. 4, 2004 are not subject to Sec. 409A, if the SAR does not allow any compensation deferral other than the participants exercise right. Q&A-4(iv) also provides conditions under which SARs granted by publicly held companies are not subject to Sec. 409A. In addition, under Q&A-19(d) and (a), severance plans collectively bargained or that cover no key employees are not required to comply with Sec. 409A in 2005, as long as such plans are amended before 2006.
More Rules Prior law did not contain specific, detailed rules governing NQDC plans. General tax principles (e.g., the constructive-receipt doctrine) applied instead. The new rules primary theme aims to put a significant distance between the time an individual elects to defer compensation and when he or she receives payouts. In fact, the new rules can best be described as hurry up and wait: hurry up and make deferral elections before it is too late; wait for distributions until the AJCA says sufficient time has passed to receive them. The new rules can be divided into three broad categoriesdistributions, elections and funding.
Distributions Under the new rules, no distribution can be made until one of the following occurs:
Planning opportunity: The greatest opportunity for individuals to direct the timing of distributions will be to select a specific distribution date. The date must be chosen at the time of the deferral election. Planning opportunity: There is a risk that a specific date selected will ultimately be undesirable (e.g., a year in which individual tax rates are high). However, one way to lessen this effect is to select multiple payout dates.
Change in ownership/control: Distributions on a change in the ownership or effective control of a corporation, or in the ownership of a substantial portion of the corporations assets, may be made only to the extent provided in Treasury guidance. Notice 2005-1, Q&A-11 through -14, address changes in ownership or control, or ownership of assets. Unforeseeable emergency: According to new Sec. 409A(a)(2)(B)(ii)(I), an unforeseeable emergency means a severe financial hardship to the participant resulting from:
Under new Sec. 409A(a)(2)(B)(ii)(II), a distribution must be limited to the amount necessary to satisfy the emergency, plus reasonably anticipated taxes resulting from the distribution. Distributions may not be allowed to the extent that the hardship may be relieved through reimbursement or compensation by insurance or otherwise, or by liquidation of the participants assets (to the extent such liquidation would not cause a severe financial hardship). Separation from service: For distributions made on separation from service, a special rule applies to specified employees. A specified employee must wait for six months after separating from service to receive a distribution. All other employees may receive a distribution immediately after separation. Under new Sec. 409A(a)(2)(B)(i), determining whether an individual is a specified employee is a two-step pro-cess. The individual must: 1. Be an employee of a publicly traded corporation and 2. Fit into one of the following categories:
Disability: Disability is defined under new Sec. 409A(a)(2)(C) as a medically determinable physical or mental impairment, expected to result in death or to last for a continuous period of not less than 12 months. If this definition is met, then the individual must meet one of the following two additional criteria:
To reinforce the concept that distributions cannot be made earlier unless one of the six circumstances discussed above applies, new Sec. 409A(a)(3) specifically states that a plan cannot permit acceleration of the time of payment, except as provided in the regulations. However, payment acceleration is permissible under some circumstances, as indicated by several helpful CR examples.
Fortunately, if a plan fails to comply with the new rules, only the individuals to whom the failure applies are subject to the consequences.
Elections As noted above, the new law contains certain hurry up rules; new Sec. 409A(a)(4) addresses how soon an individual has to elect to defer compensation under an NQDC plan. There is a general rule, with two exceptions; see Exhibit 1. Notice 2005-1, Q&A-21, provides yet another exception for 2005: a plan in existence before 2005 can allow a participant to make a deferral election until March 15, 2005. The election must be restricted to amounts not yet paid or payable, as of the date of the election.
Both the time and form of distributions (e.g., a lump-sum payment versus an annuity) must be specified at the time of the initial deferral. An individuals circumstances often change after making the initial deferral election; while the new rules permit individuals to change an initial election, there are strict parameters for such subsequent elections. For example, one cannot elect to accelerate the timing of a distribution. It is possible, however, to elect to delay the timing of a distribution or to change the form of payment (e.g., from a lump-sum distribution to annuity payments). The rules on subsequent elections are somewhat complex, largely because there are different rules for different types of distribution events. Exhibit 2 presents the various rules. Planning point: When an individuals circumstances change, he or she should make a new election as soon as possible, because it will have to be ignored by the plan for the first 12 months.
Funding The third major area addressed by the AJCA is funding. The rules take aim at two specific areas: (1) off-shore trusts and (2) funding triggered on a change in the employers financial health. Off-shore trusts: If assets are set aside in a trust or other arrangement under an NQDC plan and located outside the U.S., the assets are treated as property transferred in connection with performing services. This will result in immediate taxation of the deferred compensation to plan participants at ordinary income tax rates, plus the additional 20% penalty, as well as interest. This would occur even if the assets were available to satisfy general creditors claims. If a trust or arrangement initially has no assets outside the U.S., but later transfers them outside the U.S., participants will be taxed at the transfer date. Assets can be located outside the U.S. without triggering taxation if substantially all of the services to which the nonqualified deferred compensation relates are performed in the foreign jurisdiction in which the assets are located. Employers financial health: The new rules do not permit a plan to trigger a restriction of assets for paying NQDC plan benefits when an employers financial health changes. If such a trigger occurs, the assets are treated as property transferred in connection with performing services. Like the off-shore trusts described above, this would result in immediate taxation of the deferred compensation to plan participants at ordinary income tax rates, plus the additional 20% penalty, as well as interest. Moreover, the transfer of property is deemed to occur if the plan simply contains a provision to restrict assets, even if none were actually restricted. Of course, an actual asset restriction is also treated as a property transfer.
Reporting Requirements The new rules require annual reporting to the IRS of deferred amounts on an individuals Form W-2 (or Form 1099, for a nonemployee) for the year deferred, even if the amount is not currently includible in income for that tax year. In Ann. 2004-96, the IRS indicated that deferral amounts under an NQDC plan should be reported in box 12 of 2005 Form W-2, using a new code (Code YDeferrals under a section 409A nonqualified deferred compensation plan).
The new rules are effective for amounts deferred in tax years beginning after 2004. An amount is deemed deferred before 2005, if it is earned and vested before that year. Thus, amounts not vested as of Dec. 31, 2004 will be subject to the new rules. Amounts deferred in tax years beginning before 2005 are subject to the new rules if the plan under which the deferral is made is materially modified after Oct. 3, 2004.
Transition Guidance Notice 2005-1, Q&A-16 through -23, provide transition guidance, which gives both plan sponsors and participants time to make important decisions. Plan sponsors have until Dec. 31, 2005 to amend plans to comply with the AJCA; plan participants have until the same date to opt out of plans. The plan may allow the participant to stop participating in the plan, or simply cancel a deferral election, for amounts deferred after 2004. The sponsor may distribute to the participant the amounts affected by the participants decision at any time during 2005 (or, if later, during the year in which the amount is earned and vested); the amounts are taxed at that time. Additional transition rules allow participants to revise payment elections until Dec. 31, 2005. In addition, sponsors who no longer wish to provide an NQDC benefit may stop participant deferrals, or terminate a plan and distribute benefits by Dec. 31, 2005.
Conclusion The AJCA added many NQDC plan rules, with significant tax penalties for noncompliance. The IRS has indicated that it will continue to issue guidance during 2005. Such guidance, coupled with Notice 2005-1, should be very helpful in operating plans to comply with the new rules. From Eddie Adkins, Washington, DC |
