American Jobs Creation Act of 2004 – The Amending of Nonqualified Deferred Compensation Plans May Be Required

By Shannon L. Bollin, CPA

Congress has enacted sweeping changes to the tax treatment of nonqualified deferred compensation. The American Jobs Creation Act of 2004, one of the largest tax bills to come along since 1986, gives businesses a host of tax benefits. The new deferred compensation treatment, however, is not one of them. To the contrary, the new law imposes new restrictions and limitations on the timing of an individual's election to defer the receipt of compensation and when nonqualified deferred compensation may be distributed.

Noncompliance with the new rules may trigger the immediate taxation of deferred compensation -- often a disastrous consequence since the compensation has not yet been paid out. The new rules also impose substantial penalties on individuals whose deferred compensation fails to comply with the new restrictions. Prompt action is required to limit this impact.

The first step in coping with the new law is to identify the types of compensation that may be subject to the new restrictions and limitations. Nonqualified deferred compensation generally includes all compensation other than direct salary, contributions to qualified retirement plans, and most sick and vacation pay plans. Nonqualified plans typically are part of a compensation package designed to provide executive and middle management employees with special incentives in excess of those allowed under the qualified plan rules. They frequently include equity incentive plans that provide for grants of deferred stock units, restricted stock units, stock appreciation rights and/or discounted stock options. In addition, executive employment and consulting agreements may come under the jurisdiction of the new rules.

The following is a summary of the new requirements for nonqualified deferred compensation under the American Jobs Creation Act of 2004:

Limitation on Distribution

Compensation deferred under the plan must not be distributed earlier than:

1)       the date of the participant's separation from service (or in the case of a specified employee, six months after the date of the employee's separation from service);

2)       the date the participant becomes disabled;

3)       death;

4)       a time specified in the plan at the time of the deferral election;

5)       the time of a change in the ownership or effective control of the employer or in the ownership of a substantial portion of the assets of the employer (to the extent provided by the IRS); or

6)       the occurrence of an unforeseeable emergency.

Specified Employees. Distributions to a specified employee relating to the employee's separation from service cannot be made until six months after the specified employee's separation from service (or if earlier, the specified employee's death). A specified employee is an employee of any corporation with publicly traded stock who is an officer of the corporation having annual compensation in excess of $130,000, is a five-percent owner of the corporation, or is a one percent owner of the corporation and has annual compensation in excess of $150,000.

Unforeseeable Emergencies. Distributions upon the occurrence of an unforeseeable emergency are allowed. An unforeseeable emergency is a severe financial hardship to the participant resulting from an illness or accident of the participant, the participant's spouse or a dependent of the participant; a loss of the participant's property due to casualty; or other similar extraordinary and unforeseeable circumstances beyond the control of the participant.

Election Timing Requirements to Defer Compensation

Initial Deferral elections generally are to be made during the taxable year preceding the year in which these services are performed (i.e., for 2005 on or before December 31, 2004). New participants may make initial election within 30 days of the participation date for the first year of participation. In the case of any performance-based compensation based on services performed over a period of at least 12 months, such election may be made no later than 6 months before the end of the period.

Distribution Change Elections

Elections to delay a previously scheduled payment or change the form of a distribution (a "change election"): 1) may not be effective for at least 12 months from the date of the change election; 2) must delay the initial payment under the change election by at least 5 years (except in the case of death, disability or unforeseeable emergency), and 3) the plan must require that a change election related to a distribution, scheduled originally to happen under the plan at a specified time or pursuant to a fixed schedule, must be made not less than 12 months prior to the date of the first scheduled payment.

After an employer identifies the nonqualified deferred compensation arrangements within its business, employers should take action to modify such plans to conform to the new law or to discontinue future deferrals under such arrangements. While the planning process should begin immediately, however, amending existing arrangements must be done cautiously. Congress has directed the IRS to issue guidance by the end of December on how best to make amendments and it is wise to remain flexible until those additional rules are issued.

In the meantime, employers will need to pay close attention to recordkeeping requirements to ensure that pre-2005 and post-2004 deferrals can be accounted for separately. In addition, employers with 401(k) excess arrangements will need to examine those plans very carefully to ensure that such arrangements conform to new timing restrictions on the deferral of bonuses.

While considerable uncertainty remains as to the application of new law to existing deferred compensation arrangements, it also is clear that changes to plans will need to be made soon. The full force of these new rules is scheduled to take effect on January 1, 2005. All employers and employees operating under nonqualified deferred compensation arrangements will be affected.

Please contact Shannon Bollin at 508-880-4955 if you have any specific questions concerning how the new rules apply to you or what specific steps you should be taking to protect your tax exposure to these changes.

The above discussion is designed to provide readers with current information associated with Federal Income tax issues. It is not designed or intended to provide legal or tax advice and should not be relied upon to do so.