Tax Bill Makes Major Changes To Deferred Compensation Rules

In early October, Congress passed the American Jobs Creation Act of 2004 (Bill). President Bush is expected to sign it shortly. The Bill includes a number of tax breaks and is primarily directed toward ending export subsidies that were declared illegal in 2002 and that caused the European Union to impose tariffs on certain imports from the U.S.

In addition, the Bill includes provisions affecting deferred compensation that have been described as a “sea change” by senior government officials. Prior to enactment of the Bill, there was substantial flexibility in designing deferred compensation plans and the IRS had a miserable record when it attempted to litigate cases involving deferred compensation; the taxpayer almost always won. The IRS attempted to tighten the deferred compensation rules by way of regulations it issued in 1978, but Congress overrode those regulations. The Bill includes the first changes in decades to the tax rules regarding deferred compensation.

Specifically, unless a number of detailed requirements set forth in new Section 409A of the Internal Revenue Code are satisfied, employees will be taxed currently on deferred compensation rather than when they actually receive the compensation. In addition, interest penalties and IRS excise taxes could also apply. Finally, employers will be required to withhold income and trust fund taxes. Thus, there is a big incentive to comply with the rules, some of which include the following:

Initial Deferral Elections. Many practitioners read current case law as providing substantial flexibility as to when employees may make deferral elections. The Bill requires that employees make deferral elections in the taxable year preceding the year in which the compensation is earned (ie, the year in which the services are provided). Two basic exceptions apply: First, newly eligible participants may make a deferral election within 30 days of becoming eligible to participate in the plan. Second, an election to defer performance-based compensation (eg, annual or long-term bonuses) that is based on services performed over at least a 12-month period and that meets certain other criteria can be made up to 6 months before the end of such period.

Secondary Deferral Elections. Many practitioners take the position that so-called “secondary elections” that defer the timing of payments or change the form of distribution from that previously elected are permissible as long as they are made in the taxable year before amounts otherwise become payable under a deferred compensation plan. The Bill substantially restricts such elections. First, those elections may not take effect until 12 months after they are made. Second, they must be made at least 12 months before the date of the first scheduled payment. Third, they must defer payments for a minimum of 5 years. In addition, the acceleration of any payment will be permitted only as provided in IRS regulations, and Treasury officials have indicated this will be only in very limited circumstances.

Distributions. Current law supports significant flexibility as to when distributions of deferred compensation may be permitted. The Bill would limit the timing of distributions to the following six circumstances: separation from service; disability; death; the occurrence of a specified time or a fixed schedule specified at the time of deferral; an unforeseeable emergency; and (pursuant to IRS regulations) a change of ownership or effective control or a sale of a substantial portion of the assets of the employer. Discretionary acceleration of distributions and “haircut” provisions (ie, provisions that allow early withdrawal of deferred compensation subject to a penalty, eg, 10%) are prohibited. In addition, the Bill includes restrictive definitions of “disability” and “unforeseeable emergency.” Finally, additional restrictions apply to distributions to certain “key employees” of publicly-traded companies.

Penalties. If a plan fails to comply with the requirements imposed by the Bill, all compensation previously deferred under the plan plus earnings ' both for the current taxable year and all preceding taxable years (except taxable years not subject to the provisions of new Section 409A based on the effective date, discussed below) ' are included in the gross incomes of the employees affected by the failure for the taxable year(s) in which the failure occurs (or, when the compensation vests, if later). In addition, the income tax is increased by i) interest at the underpayment rate plus one percent on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year(s) in which it was first deferred (or when the compensation vested, if later), and ii) an additional excise tax of 20%.

Trusts. If the employer maintains an offshore trust to fund deferred compensation, the compensation is taxed at the time the amounts are set aside in the trust (or, if later, when the compensation vests). If a plan provides that assets of a trust will become restricted to the provision of benefits under the plan in connection with a change in the employer's financial condition (eg, the creation or funding of a “rabbi” trust at that time), the assets set aside are taxable if the deferred compensation relating to the assets is vested. In addition, the income tax imposed is increased by the interest and tax penalties described above.

Plans Affected. The Bill's definition of “non-qualified deferred compensation plan” is broad, covering essentially all plans that provide for the deferral of compensation and are not tax-qualified (eg, 401(k) plans). Of particular note, the Bill effectively will eliminate “stock appreciation rights” (SARs) where the grantee has the right to choose when to exercise the SARs, because under the Bill SARs will be taxable when they vest. Employers planning to switch from stock options to SARs as a result of the forthcoming accounting treatment under FAS 123 will now have to reconsider. However, SARs that were granted on or prior to Dec. 31, 2004 should not be affected as long as the plan under which the SARs are granted is not materially modified after Oct. 3, 2004 (see discussion of the effective date of the Bill below). Options and other awards taxed pursuant to Section 83 of the Internal Revenue Code generally will not be affected by the Bill as long as they are granted at fair market value and do not contain a deferral feature other than the right to exercise the option or other award in the future.

Reporting and Withholding. Under the Bill, employers are required to report on Form W-2 for the year in which nonqualified deferred compensation is taxable, as well as for the year in which compensation is deferred even if the amount is not currently includable in income for that taxable year. Employers also are required to withhold applicable federal income tax. Because no amounts actually will be paid to employees at the time a plan “fails” the new Section 409A requirements and causes immediate taxation, in that event the withholding would have to come from another source of payments to the employee (eg, salary).

Effective Date. The Bill applies to amounts deferred after Dec. 31, 2004 and also applies to earnings on deferred compensation to the same extent as the deferred compensation itself. Amounts deferred in taxable years prior to Jan. 1, 2005, and, presumably, earnings on such amounts, are not subject to the new rules except to the extent the plan under which the deferral was made is materially modified after Oct. 3, 2004. The Bill also provides a transition rule pursuant to which the IRS is directed to issue guidance providing a limited period in which a plan adopted prior to Dec. 31, 2004 may be amended to terminate the plan, cancel outstanding deferral elections with regard to amounts to be deferred after Dec. 31, 2004, or conform the plan to the requirements of new Section 409A of the Internal Revenue Code.

Treasury Guidance. The Treasury Department has indicated informally that it will provide interim guidance first, including a sample “band-aid” plan amendment, to be followed by full substantive guidance. Moreover, full compliance of plan documents is not likely to be required before the end of 2005.

Compliance 'Roadmap'

The legislation will require many employers to substantially change the way their deferred compensation plans operate. Pending guidance from the Treasury, employers should take the following steps to comply with existing law and to prepare for compliance with the new legislation:

• Existing law and the existing plan document should be followed for amounts that are deferred on or before Dec. 31, 2004.
• Employers should solicit deferral elections before the end of 2004 for salary payable in 2005 and bonuses that will be earned in 2005 but paid in 2006.
• Until guidance addresses how the “performance-based” compensation exception to the deferral election timing rule will operate, employers should satisfy the general deferral election timing rule. That is, employers should not assume that they will be able to solicit deferrals in the middle of a bonus performance period (up to 6 months before the end of the performance period), but rather should solicit deferrals before the end of 2004 for bonuses to be earned in 2005.
• Employers should begin to inventory plans that are affected by the Bill, such as deferred compensation plans, SERPs, and plans providing for stock appreciation rights, phantom units, or other types of awards not clearly subject to Section 83 of the Internal Revenue Code.
• In general, no steps should be taken to modify existing plans (or to adopt new plans) until Treasury guidance is issued.

In early October, Congress passed the American Jobs Creation Act of 2004 (Bill). President Bush is expected to sign it shortly. The Bill includes a number of tax breaks and is primarily directed toward ending export subsidies that were declared illegal in 2002 and that caused the European Union to impose tariffs on certain imports from the U.S.

In addition, the Bill includes provisions affecting deferred compensation that have been described as a “sea change” by senior government officials. Prior to enactment of the Bill, there was substantial flexibility in designing deferred compensation plans and the IRS had a miserable record when it attempted to litigate cases involving deferred compensation; the taxpayer almost always won. The IRS attempted to tighten the deferred compensation rules by way of regulations it issued in 1978, but Congress overrode those regulations. The Bill includes the first changes in decades to the tax rules regarding deferred compensation.

Specifically, unless a number of detailed requirements set forth in new Section 409A of the Internal Revenue Code are satisfied, employees will be taxed currently on deferred compensation rather than when they actually receive the compensation. In addition, interest penalties and IRS excise taxes could also apply. Finally, employers will be required to withhold income and trust fund taxes. Thus, there is a big incentive to comply with the rules, some of which include the following:

Initial Deferral Elections. Many practitioners read current case law as providing substantial flexibility as to when employees may make deferral elections. The Bill requires that employees make deferral elections in the taxable year preceding the year in which the compensation is earned (ie, the year in which the services are provided). Two basic exceptions apply: First, newly eligible participants may make a deferral election within 30 days of becoming eligible to participate in the plan. Second, an election to defer performance-based compensation (eg, annual or long-term bonuses) that is based on services performed over at least a 12-month period and that meets certain other criteria can be made up to 6 months before the end of such period.

Secondary Deferral Elections. Many practitioners take the position that so-called “secondary elections” that defer the timing of payments or change the form of distribution from that previously elected are permissible as long as they are made in the taxable year before amounts otherwise become payable under a deferred compensation plan. The Bill substantially restricts such elections. First, those elections may not take effect until 12 months after they are made. Second, they must be made at least 12 months before the date of the first scheduled payment. Third, they must defer payments for a minimum of 5 years. In addition, the acceleration of any payment will be permitted only as provided in IRS regulations, and Treasury officials have indicated this will be only in very limited circumstances.

Distributions. Current law supports significant flexibility as to when distributions of deferred compensation may be permitted. The Bill would limit the timing of distributions to the following six circumstances: separation from service; disability; death; the occurrence of a specified time or a fixed schedule specified at the time of deferral; an unforeseeable emergency; and (pursuant to IRS regulations) a change of ownership or effective control or a sale of a substantial portion of the assets of the employer. Discretionary acceleration of distributions and “haircut” provisions (ie, provisions that allow early withdrawal of deferred compensation subject to a penalty, eg, 10%) are prohibited. In addition, the Bill includes restrictive definitions of “disability” and “unforeseeable emergency.” Finally, additional restrictions apply to distributions to certain “key employees” of publicly-traded companies.

Penalties. If a plan fails to comply with the requirements imposed by the Bill, all compensation previously deferred under the plan plus earnings ' both for the current taxable year and all preceding taxable years (except taxable years not subject to the provisions of new Section 409A based on the effective date, discussed below) ' are included in the gross incomes of the employees affected by the failure for the taxable year(s) in which the failure occurs (or, when the compensation vests, if later). In addition, the income tax is increased by i) interest at the underpayment rate plus one percent on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year(s) in which it was first deferred (or when the compensation vested, if later), and ii) an additional excise tax of 20%.

Trusts. If the employer maintains an offshore trust to fund deferred compensation, the compensation is taxed at the time the amounts are set aside in the trust (or, if later, when the compensation vests). If a plan provides that assets of a trust will become restricted to the provision of benefits under the plan in connection with a change in the employer's financial condition (eg, the creation or funding of a “rabbi” trust at that time), the assets set aside are taxable if the deferred compensation relating to the assets is vested. In addition, the income tax imposed is increased by the interest and tax penalties described above.

Plans Affected. The Bill's definition of “non-qualified deferred compensation plan” is broad, covering essentially all plans that provide for the deferral of compensation and are not tax-qualified (eg, 401(k) plans). Of particular note, the Bill effectively will eliminate “stock appreciation rights” (SARs) where the grantee has the right to choose when to exercise the SARs, because under the Bill SARs will be taxable when they vest. Employers planning to switch from stock options to SARs as a result of the forthcoming accounting treatment under FAS 123 will now have to reconsider. However, SARs that were granted on or prior to Dec. 31, 2004 should not be affected as long as the plan under which the SARs are granted is not materially modified after Oct. 3, 2004 (see discussion of the effective date of the Bill below). Options and other awards taxed pursuant to Section 83 of the Internal Revenue Code generally will not be affected by the Bill as long as they are granted at fair market value and do not contain a deferral feature other than the right to exercise the option or other award in the future.

Reporting and Withholding. Under the Bill, employers are required to report on Form W-2 for the year in which nonqualified deferred compensation is taxable, as well as for the year in which compensation is deferred even if the amount is not currently includable in income for that taxable year. Employers also are required to withhold applicable federal income tax. Because no amounts actually will be paid to employees at the time a plan “fails” the new Section 409A requirements and causes immediate taxation, in that event the withholding would have to come from another source of payments to the employee (eg, salary).

Effective Date. The Bill applies to amounts deferred after Dec. 31, 2004 and also applies to earnings on deferred compensation to the same extent as the deferred compensation itself. Amounts deferred in taxable years prior to Jan. 1, 2005, and, presumably, earnings on such amounts, are not subject to the new rules except to the extent the plan under which the deferral was made is materially modified after Oct. 3, 2004. The Bill also provides a transition rule pursuant to which the IRS is directed to issue guidance providing a limited period in which a plan adopted prior to Dec. 31, 2004 may be amended to terminate the plan, cancel outstanding deferral elections with regard to amounts to be deferred after Dec. 31, 2004, or conform the plan to the requirements of new Section 409A of the Internal Revenue Code.

Treasury Guidance. The Treasury Department has indicated informally that it will provide interim guidance first, including a sample “band-aid” plan amendment, to be followed by full substantive guidance. Moreover, full compliance of plan documents is not likely to be required before the end of 2005.

Compliance 'Roadmap'

The legislation will require many employers to substantially change the way their deferred compensation plans operate. Pending guidance from the Treasury, employers should take the following steps to comply with existing law and to prepare for compliance with the new legislation:

• Existing law and the existing plan document should be followed for amounts that are deferred on or before Dec. 31, 2004.
• Employers should solicit deferral elections before the end of 2004 for salary payable in 2005 and bonuses that will be earned in 2005 but paid in 2006.
• Until guidance addresses how the “performance-based” compensation exception to the deferral election timing rule will operate, employers should satisfy the general deferral election timing rule. That is, employers should not assume that they will be able to solicit deferrals in the middle of a bonus performance period (up to 6 months before the end of the performance period), but rather should solicit deferrals before the end of 2004 for bonuses to be earned in 2005.
• Employers should begin to inventory plans that are affected by the Bill, such as deferred compensation plans, SERPs, and plans providing for stock appreciation rights, phantom units, or other types of awards not clearly subject to Section 83 of the Internal Revenue Code.
• In general, no steps should be taken to modify existing plans (or to adopt new plans) until Treasury guidance is issued.