American Jobs Creation Act of 2004 May Adversely Impact Your Nonqualified Deferred Compensation Plans
In response to actual and perceived abuses, Congress has enacted sweeping changes to deferred compensation plans. The American Jobs Creation Act of 2004 (the Act) adds Section 409A to the Internal Revenue Code, which will have a significant impact on the design and operation of such plans. Section 409A is effective January 1, 2005, and affects all employers, whether public, private or tax-exempt.
Arrangements Covered by 409A
Section 409A applies to any plan, agreement, or arrangement with employees, directors or independent contractors that provides for the deferral of compensation, including:
- traditional elective deferral plans
- equity-based compensation arrangements such as stock appreciation rights, restricted stock and phantom stock
- supplemental executive retirement benefits (SERPs)
- plans that cover only one person, such as employment agreements and severance agreements
- nonqualified stock options having a below-market exercise price
The following are excluded from the rules of 409A:
- tax-qualified retirement plans, such as 401(k), 403(b) and 457(b) plans
- vacation or sick leave, compensatory time, disability pay, or death benefit plans
- statutory stock options (ISOs) and employee stock purchase plans (ESPPs)
- stock options with an exercise price that equals or exceeds the fair market value of the underlying stock on the date of the grant, if such arrangement does not include a deferral feature
- annual bonuses or other annual compensation amounts paid within two-and-one-half months after the close of the tax year in which the services were performed
- deferred compensation that is earned and vested before January 1, 2005 (unless plan or agreement is materially modified after October 3, 2004)
Requirements for Deferral of Compensation
Amounts deferred under a nonqualified deferred compensation plan or arrangement will be includable in an employee’s gross income unless (a) the amounts are subject to a substantial risk of forfeiture, or (b) the plan or arrangement satisfies certain requirements.
For purposes of the Act, “substantial risk of forfeiture” means that a participant’s right to compensation is conditioned on the participant’s future performance of substantial services. A “substantial risk of forfeiture” contained in a plan will be disregarded if it is used to manipulate the timing of the inclusion of income or if it is illusory.
If the plan does not provide for a “substantial risk of forfeiture,” it must satisfy the following requirements:
- Restrictions on distributions – The plan must provide that compensation deferred under the plan cannot be distributed earlier than (a) the participant’s termination of employment, death or disability (as defined in the Act), (b) a time specified, or a schedule fixed, under the plan as of the date of the deferral of the compensation, (c) a change in control of the employer or (d) the occurrence of an unforeseen financial emergency. The distribution to a key employee of a publicly traded corporation must be delayed until six months following separation from service. “Haircut” provisions allowing a participant to voluntarily take a withdrawal at any time subject to a small penalty are no longer permitted.
- No acceleration of benefits – The plan may not permit the acceleration of the time or schedule of payments under the plan, except as provided in forthcoming IRS regulations. Acceleration of payments to participants in the event of deterioration of the employer’s financial condition is prohibited.
- Election requirements – The plan must provide that initial deferral elections generally must be made prior to the year in which the services are performed. However, newly eligible participants may elect deferrals within 30 days of becoming a participant. Performance-based deferrals (i.e., variable and contingent on the satisfaction of pre-established criteria and not readily ascertainable at the time of election) must be made not later than six months before the end of the performance period.
Subsequent elections to further defer distributions are permitted but cannot be effective until at least 12 months after the election is made and must defer receipt of the deferred compensation for at least five years (except in the case of death, disability, or unforeseen emergency). If payments to be made at a specified time or under a fixed schedule are to be delayed, no election is permitted within the 12 month period prior to the date of the initial payment.
- Use of Rabbi trusts – Rabbi trusts may still be used, but use of offshore Rabbi trusts is prohibited. Also prohibited are Rabbi trusts that are convertible into secular trusts.
Penalties for Failure to Comply With the New Rules
Failure to comply with the new rules may result in substantial penalties for employees covered by these plans. Covered employees may be liable for (1) income taxes on all amounts deferred in the current and prior years, (2) interest on the tax from the date the amount was first deferred or vested, and (3) additional penalties equal to 20 percent of the deferred amounts included in the employee’s income.
The new rules are effective for amounts deferred or amounts which become vested in tax years beginning after December 31, 2004. Amounts deferred under a plan during tax years beginning prior to December 31, 2004, are subject to the new rules if the plan is materially modified after October 3, 2004.
The IRS is directed to issue guidance prior to December 22, 2004, providing a limited period of time during which current plans can be amended to conform to the new requirements and participants can terminate participation in the plan or modify or cancel outstanding deferral elections.
Employers should identify and review their compensation plans and agreements and determine which have deferral features that may be subject to the new rules. No “material” modifications to existing plans should be made without carefully considering the effects of the new rules. Additional guidance from the Internal Revenue Service is expected mid-December 2004. Once this guidance is received, employers should decide whether to make changes to their existing plans or agreements or “freeze” them and adopt new plans or agreements that are designed to comply with the new rules. Holland & Knight attorneys are closely monitoring this area of the law and will send out alerts following the issuance of additional guidance by the Internal Revenue Service.