Congress recently approved the American Jobs Creation Act of 2004 (H.R. 4520), which includes provisions that impose significant new restrictions on deferred compensation. If these restrictions are not satisfied, deferred compensation amounts are taxable when vested and subject to tax penalties. President Bush is expected to sign the Act, but as of October 19th has not done so. This Update highlights the Act's key changes to deferred compensation requirements and offers practical guidance.

What Types of Plans Are Covered by the New Deferred Compensation Legislation?

• Plans That Provide for Deferral of Compensation Are Covered—Including Plans for Employees, Directors and Independent Contractors. The Act broadly defines the term "nonqualified deferred compensation plan" to include any plan that provides for the deferral of compensation, including elective deferral arrangements, nonqualified pension plans, excess plans and supplemental executive retirement plans, whether in a formal plan or pursuant to an individual agreement. Because covered deferred compensation arrangements are not limited to arrangements between an employer and employee, these new requirements also apply to director and independent contractor programs.

• Vested Deferrals Are Not Affected Immediately, Unless Plans Are Materially Modified. The Act applies to compensation deferred on or after January 1, 2005. The legislative history states that compensation is considered deferred before January 1, 2005 only if the amount is earned and vested before such date. The Act also applies to compensation deferred under a plan if the plan is materially modified after October 3, 2004. According to the legislative history, if a deferred compensation plan is modified to accelerate vesting after October 3, 2004, this change will be considered a material amendment that accelerates the effectiveness of the Act for the modified plan.
• Certain Types of Retirement and Benefit Plans Are Specifically Excluded. The Act specifically excludes certain types of pension and welfare plans, including tax-qualified retirement, tax-deferred annuity, SEP, SIMPLE and section 457(b) plans; and bona fide vacation leave, sick leave, compensatory time, disability pay and death benefit plans.

When Does Deferred Compensation Become Taxable Under the Act?

• Deferred Compensation Is Taxed as It Vests, Unless It Meets the Act's Requirements. Under the Act, all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently included in the participant's income unless (1) such amounts are subject to a substantial risk of forfeiture and (2) the plan satisfies the design and administration requirements of the Act.

What Constitutes a Substantial Risk of Forfeiture? The IRS guidance will specify what constitutes a substantial risk of forfeiture. The legislative history states that Congress intends substantial risks of forfeiture to be disregarded in cases in which they are illusory, used to manipulate the timing of income inclusion or used in a manner inconsistent with the purposes of the provision.

When Must an Initial Deferral Election Be Made? Both the time and form of distributions must be specified at the time of initial deferral.

• Initial Deferral Election Must Be Made Before Year Services Are Performed. Initial deferral elections must be made before the beginning of the taxable year in which the services giving rise to the compensation are performed, or at such other time specified by the IRS guidance.

• New Participants Must Make Initial Deferral Election Within 30 Days. Newly eligible participants may be given 30 days following their initial eligibility in which to make their initial deferral election.
• For Performance-Based Compensation, Initial Deferral Election Must Be Made at Least Six Months Before Performance Period Ends. In the case of performance-based compensation related to services performed over a period of at least 12 months, the initial deferral election must be made no later than six months before the end of the performance period. We expect that the IRS will define "performance-based compensation" to include compensation to the extent that an amount is (1) variable and contingent on the satisfaction of pre-established organizational or individual performance criteria and (2) not readily ascertainable at the time of the election. Performance-based compensation may also be required to meet certain requirements similar to those under Code Section 162(m)'s $1 million limit on deductible compensation, such as that the performance criteria be established in writing no later than 90 days after the commencement of the performance period.

May a Participant Change a Previous Distribution Election? The Act permits a participant to change a previous distribution election to delay the timing or change the form of payment of deferred compensation only if the election meets the following conditions:

• it does not take effect until at least 12 months after the date of the election;

• it provides an additional deferral for a period of at least five years from the date such payment would otherwise have been made (including for a subsequent distribution upon separation from service within such period, but not distributions on death, disability or unforeseeable emergency); and
• if related to a payment at a specified time or made pursuant to a fixed schedule, it is made at least 12 months prior to the date of the first scheduled payment.

When May a Participant Receive Deferred Compensation Distributions? Deferred compensation distributions are permitted only upon:

• separation from service (six months after separation from service for certain key employees of publicly traded companies as described below);

• disability;
• death;
• a specified time (or pursuant to a fixed schedule) elected at the date of deferral;
• a change in ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, to the extent provided in the IRS guidance directed to be issued within 90 days after the Act's enactment; or
• an unforeseeable emergency.

The Act contains a special definition for "disability" and a stringent "unforeseeable emergency" definition.

• No Distributions to Key Employees of Public Companies Because of Separation From Service Until Six Months After Such Separation From Service. Payments to "key employees" (as generally defined under the top-heavy rules of Code Section 416(i) and including up to 50 officers) of a publicly traded company due to a separation from service may not be made until six months after the individual's separation from service.

• Haircut Withdrawal and Other Acceleration Provisions Prohibited. The Act prohibits acceleration of the time or schedule of any payment under the plan (such as from an annuity to a lump sum), except as specifically provided by the IRS guidance. This prohibits the use of so-called "haircut provisions," which allow participants to access their deferred compensation accounts by incurring a penalty (typically 10% of the amount withdrawn). The legislative history suggests the IRS guidance may provide limited exceptions for accelerated distribution, such as for court-approved settlements incident to a divorce, tax withholdings or automatic distributions of account balances of less than $10,000 upon separation from service of a non-key employee.

How Does the Act Affect a Company's Ability to Set Aside Assets to Fund Deferred Compensation Benefits?

Funding Requirements for Most Rabbi Trusts Not Affected. The Act would not affect most traditional U.S.-based rabbi trusts but would regulate the funding of deferred compensation in the following situations:

• Transfer of Assets to Offshore Rabbi Trusts May Trigger Taxation. In general, assets set aside (directly or indirectly) in an offshore trust for the purpose of paying nonqualified deferred compensation will be treated as property transferred under Code Section 83 and therefore generally taxable to the extent vested at the time set aside or transferred outside the United States whether or not the assets are available to satisfy claims of creditors.

• Plans With Financial Distress Triggers May Trigger Taxation. A transfer of property also occurs under Code Section 83 if the plan provides that upon a change in the employer's financial health, assets will be restricted to the payment of benefits, or will occur on the date on which assets are so restricted. According to the legislative history, this provision applies in the case of a plan that provides that upon a change in financial health, assets will be transferred to a rabbi trust.

New Rules Impose Severe Tax Penalties for Violating New Deferred Compensation Requirements and Impose Additional Withholding and Reporting Requirements.

• All Deferred Compensation Included in Gross Income, Unless Subject to Substantial Risk of Forfeiture. If the deferred compensation requirements are violated with respect to the design or administration of a deferred compensation arrangement, the new rules impose severe tax consequences on participants with respect to whom the failure relates—all compensation deferred that is not subject to a substantial risk of forfeiture is included in gross income.

• Must Also Pay Interest and Additional Tax Penalty. Interest at the underpayment rate plus 1% is imposed on the underpayments that would have occurred had the amounts been included in income for the taxable year in which they were first deferred or, if later, the first taxable year in which such amounts were no longer subject to a substantial risk of forfeiture. An additional tax in an amount equal to 20% of the compensation included in gross income also applies.
• Increased Withholding and Reporting Requirements. The Act establishes increased withholding requirements for nonqualified deferred compensation and other supplemental wages in excess of $1 million and additional generally applicable Form W-2 (or Form 1099-MISC) reporting requirements for all amounts deferred under a nonqualified deferred compensation plan. The Act allows the IRS to establish minimum reporting thresholds.

Additional Information

This Update is only intended to provide a brief summary of certain aspects of the Act that relate to deferred compensation. Click here for the conference report.