As part of the American Jobs Creation Act of 2004 (the “Act”) signed into law on October 22, 2004, major changes were made regarding the taxation and administration of nonqualified deferred compensation plan benefits. In February 2003, the Joint House and Senate Committee on Taxation, in its investigation of Enron, reported that Enron executives had deferred millions of dollars in federal income taxes through the abusive use of nonqualified deferred compensation plans. Several of the recommendations of the Joint Committee were incorporated into the Act in order to curtail perceived abuses in the utilization of nonqualified deferred compensation plans.
The Act Adds Section 409(A) to the Internal Revenue Code (“Code”)
In general, Section 409(A) of the Code:
- Adopts a broad definition of nonqualified deferred compensation plans.
- Provides that, unless certain requirements are met, all amounts (past and present) deferred under a nonqualified deferred compensation plan will be immediately included in a plan participant’s gross income.
- Imposes a 20% nondeductible tax penalty as well as an interest charge for all compensation deferred under the plan, not just in the current year, if the plan does not meet the requirements of Section 409(A) of the Code. The deferred compensation will also be subject to regular income tax.
- Is effective for amounts deferred after December 31, 2004, provided that a material modification to a plan after October 3, 2004 will cause all deferrals under such plans to be subject to the new rules.
Nonqualified Deferred Compensation Plans Covered (and Not Covered) by the Act
Section 409(A) of the Code defines a nonqualified deferred compensation plan to include any plan or arrangement that provides for the deferral of compensation other than a qualified retirement plan. Common types of plans and arrangements that are covered by this new law beyond a traditional nonqualified deferred compensation plan include:
- phantom stock awards;
- severance pay plans;
- stock appreciation rights (SARs);
- supplemental executive retirement plans (SERPs);
- elective salary deferral plans;
- bonus deferral plans; and
- discounted stock options.
In addition to the plans described above, individual agreements which allow for the deferral of compensation, such as an employment agreement, may constitute nonqualified deferred compensation plans which are subject to the new rules. It should be noted that the new rules apply not only to employer/employee arrangements but also to agreements with independent contractors and non-employee directors.
The following plans are not covered by the new rules:
- qualified plans including 401(k) plans and cash balance plans;
- SIMPLE plans;
- 457(b) plans;
- disability pay plans;
- sick leave arrangements;
- vacation leave arrangements;
- compensatory time arrangements;
- bonuses or annual compensation paid within 2 months after close of the taxable year in which the services were provided;
- stock options granted at fair market value if the arrangement does not include a deferral feature;
- incentive stock options; and
- employee stock purchase plans.
What Must Be Done In Order for Continued Tax Deferral for Nonqualified Deferred Compensation Plans?
In order to qualify the deferred compensation under a nonqualified deferred compensation plan for deferral of taxation, the plan must do the following:
- permit distributions of plan benefits only upon the following events: separation from service, disability, death, the date specified at the time of deferral, change in control of the company and the occurrence of an unforeseeable emergency;
- prohibit accelerated payment of deferred compensation with or without a penalty; and
- in general, require initial deferral decisions to be made no later than the close of the taxable year preceding the taxable year during which compensation is earned.
The time and form of distribution generally must be specified at the time of initial deferral. There are exceptions to this rule.
Key employees of publicly traded corporations are not permitted to receive a plan distribution earlier than six months after the end of employment.
Tax Reporting Requirements
The Act requires that all amounts deferred must be reported on Form W-2 or 1099 for the year of deferral, even if the amount is not included in the participant’s income for that year. In order to comply with the reporting requirements, the deferred amount will be reported twice, once in the year of deferral and again in the year paid. Some commentators believe that these new reporting requirements will allow the IRS to identify companies with nonqualified deferred compensation plans for tax audit purposes.
Severe Consequences For Not Following the New Rules
In the event that a nonqualified deferred compensation plan fails to satisfy the new requirements either in form or in operation, all current and prior years deferred amounts will be included in the participant’s gross income for federal and state tax purposes and the deferred amounts will be subject to a 20% nondeductible tax penalty plus interest.
What Should be Done Now?
The IRS will issue regulations which should help interpret provisions of Section 409(A) of the Code in the near future. Also, some commentators have mentioned that written guidance will be issued regarding these new rules prior to December 31, 2004. Regardless of new regulations or additional written guidance, we recommend that you do the following at this time:
- Identify all plans and arrangements subject to the new rules. We recommend that you review all of your plan documents and individual arrangements which may be subject to the new rules under Section 409(A) of the Code. Any arrangement that involves deferring compensation to a date later than the date on which services were rendered should be identified.
- Identify plan provisions affected by the new rules. You should identify specific provisions which may need to be repealed or amended. However, you should not amend an existing nonqualified deferred compensation plan to comply with the new rules without consulting with a professional knowledgeable in the new rules.
- Communicate to plan participants the new rules and their potential impact.
- Determine how the new rules may impact your overall compensation strategy.
For an existing nonqualified deferred compensation plan, you may need to either amend such plan to comply with the new rules or adopt a new plan going forward which complies with the new rules.
We would be pleased to help you review your nonqualified deferred compensation plans and recommend a proper course of action. You may contact a member of Berry Moorman’s Estate Planning and Business Planning Groups in order to assist you in these matters.