The American Jobs Creation Act of 2004 – signed into law by President Bush on October 22, 2004 – creates significant new restrictive rules governing the taxation of nonqualified deferred compensation. The new rules apply to all employers, including associations. Specifically, they apply to any deferred compensation that is not vested on December 31, 2004 and to compensation deferred prior to 2005 if the arrangement was "materially modified" after October 3, 2004 (e.g., acceleration of vesting or payment).
The new rules affect SERPs; 401(k) wrap around plans; bonus and incentive deferral plans; elective deferral arrangements; other deferred compensation subject to Section 457(f); and severance pay. The new rules do not affect eligible deferred compensation plans under Section 457(b); tax-qualified plans; Section 403(b) tax-sheltered annuities and custodial accounts; simplified employee pensions and SIMPLE plans; governmental excess plans under Section 415(m); "bona fide" vacation leave, sick leave, compensatory time, disability, and death benefit plans; and arrangements that do not involve a "deferral" when the compensation vests.
Key features of the changes include the following:
Deferral Elections – An election to defer compensation generally must be made prior to the start of the year in which the services for which the compensation is earned are performed. In practical terms, this means that because of the Act's effective date, an election to defer compensation for services to be performed in 2005 must be made no later than December 31, 2004. Important exceptions to this rule apply in the case of a new deferred compensation plan or the first year of a participant's eligibility under an existing plan and with respect to "performance-based" compensation.
Distribution Restrictions – Elections regarding the time and form of payment of deferred compensation must be irrevocable and set forth in a written plan or agreement, or agreed to by the participant in writing at the time the compensation is initially deferred. Under the rules, payments of deferred compensation may only be made on a fixed date (or according to a fixed schedule) or in connection with a separation from service, death, disability, an unforeseeable emergency, or a change in control of the employer.
Once the time and form of payment have been elected, changes to that election are permitted only if (1) the subsequent election is not effective for at least 12 months, (2) if the subsequent election relates to a payment due on a fixed date (or according to a fixed schedule), the election is made at least 12 months before the first payment is due, and (3) the subsequent election defers the payment for a period of at least 5 years (unless the change relates to a payment on account of disability, death or an unforeseeable emergency).
No Acceleration – A nonqualified deferred compensation arrangement may not permit acceleration of the time or schedule of any payment, except as specifically authorized by the IRS in future regulations. This effectively eliminates "haircut" provisions (i.e., accelerations if the person gave up some portion of the deferred amount).
Funding Restrictions – The new rules preclude employers from transferring assets set aside to pay deferred compensation outside of the United States. Also, the mere inclusion of a financial health clause to provide that, upon a change in the financial health of the employer, amounts will be set aside in a “rabbi trust” triggers sanctions. However, the new rules do not eliminate traditional rabbi trusts, including those that spring into existence on a change in control.
Sanctions for Failure to Comply – If a nonqualified deferred compensation arrangement fails to comply with the new rules, vested amounts (or amounts set aside in violation of the funding restrictions) will be subject to income taxes and vested amounts also will be subject to a 20% excise tax and an additional amount equal to the IRS underpayment interest rate, plus 1%.
Significantly, these rules are in addition to the rules currently in effect for "ineligible" deferred compensation arrangements under Section 457(f). Most "ineligible" arrangements have been structured so that the deferred compensation is not vested (in order to delay taxation) under Section 457(f). Consequently, the new rules will apply to SERPs and other forms of ineligible deferred compensation of associations, even though the compensation may have been deferred long ago. Furthermore, the new law gives the IRS the ability to ignore a substantial risk of forfeiture that is illusory or is inconsistent with the purpose of the new rules. The ability of the IRS to ignore a substantial risk of forfeiture may effectively eliminate the ability to delay taxation of "ineligible" deferred compensation under Section 457(f) through the use of a rolling risk of forfeiture. Associations that have arrangements with a rolling risk of forfeiture will need to carefully monitor IRS guidance to determine the extent to which these provisions remain viable.
What steps should associations take to prepare for the new rules?
The new rules affect SERPs; 401(k) wrap around plans; bonus and incentive deferral plans; elective deferral arrangements; other deferred compensation subject to Section 457(f); and severance pay. The new rules do not affect eligible deferred compensation plans under Section 457(b); tax-qualified plans; Section 403(b) tax-sheltered annuities and custodial accounts; simplified employee pensions and SIMPLE plans; governmental excess plans under Section 415(m); "bona fide" vacation leave, sick leave, compensatory time, disability, and death benefit plans; and arrangements that do not involve a "deferral" when the compensation vests.
Key features of the changes include the following:
Deferral Elections – An election to defer compensation generally must be made prior to the start of the year in which the services for which the compensation is earned are performed. In practical terms, this means that because of the Act's effective date, an election to defer compensation for services to be performed in 2005 must be made no later than December 31, 2004. Important exceptions to this rule apply in the case of a new deferred compensation plan or the first year of a participant's eligibility under an existing plan and with respect to "performance-based" compensation.
Distribution Restrictions – Elections regarding the time and form of payment of deferred compensation must be irrevocable and set forth in a written plan or agreement, or agreed to by the participant in writing at the time the compensation is initially deferred. Under the rules, payments of deferred compensation may only be made on a fixed date (or according to a fixed schedule) or in connection with a separation from service, death, disability, an unforeseeable emergency, or a change in control of the employer.
Once the time and form of payment have been elected, changes to that election are permitted only if (1) the subsequent election is not effective for at least 12 months, (2) if the subsequent election relates to a payment due on a fixed date (or according to a fixed schedule), the election is made at least 12 months before the first payment is due, and (3) the subsequent election defers the payment for a period of at least 5 years (unless the change relates to a payment on account of disability, death or an unforeseeable emergency).
No Acceleration – A nonqualified deferred compensation arrangement may not permit acceleration of the time or schedule of any payment, except as specifically authorized by the IRS in future regulations. This effectively eliminates "haircut" provisions (i.e., accelerations if the person gave up some portion of the deferred amount).
Funding Restrictions – The new rules preclude employers from transferring assets set aside to pay deferred compensation outside of the United States. Also, the mere inclusion of a financial health clause to provide that, upon a change in the financial health of the employer, amounts will be set aside in a “rabbi trust” triggers sanctions. However, the new rules do not eliminate traditional rabbi trusts, including those that spring into existence on a change in control.
Sanctions for Failure to Comply – If a nonqualified deferred compensation arrangement fails to comply with the new rules, vested amounts (or amounts set aside in violation of the funding restrictions) will be subject to income taxes and vested amounts also will be subject to a 20% excise tax and an additional amount equal to the IRS underpayment interest rate, plus 1%.
Significantly, these rules are in addition to the rules currently in effect for "ineligible" deferred compensation arrangements under Section 457(f). Most "ineligible" arrangements have been structured so that the deferred compensation is not vested (in order to delay taxation) under Section 457(f). Consequently, the new rules will apply to SERPs and other forms of ineligible deferred compensation of associations, even though the compensation may have been deferred long ago. Furthermore, the new law gives the IRS the ability to ignore a substantial risk of forfeiture that is illusory or is inconsistent with the purpose of the new rules. The ability of the IRS to ignore a substantial risk of forfeiture may effectively eliminate the ability to delay taxation of "ineligible" deferred compensation under Section 457(f) through the use of a rolling risk of forfeiture. Associations that have arrangements with a rolling risk of forfeiture will need to carefully monitor IRS guidance to determine the extent to which these provisions remain viable.
What steps should associations take to prepare for the new rules?
- Inventory all nonqualified deferred compensation plans that could be affected by the new rules.
- Determine what impact the new rules will have on the design of existing plans and elections – i.e., Are there "haircut" withdrawal provisions that will need to be eliminated? Rabbi trust provisions that need modification? Distribution limitations that need to be imposed?
- Determine what impact the new rules will have on plan design.
- Ensure that 2005 deferral elections for existing plans are made by December 31, 2004.
- Consider whether existing plans should be amended or new plans established. Prior to adopting a post-October 3, 2004 amendment to an existing deferred compensation arrangement, consider whether the amendment would "materially modify" the arrangement (thereby triggering application of the new rules).
- Maximize deferrals under 401(k), 403(b) and eligible Section 457(b) plans before deferring compensation under a Section 457(f) arrangement.
The new rules are complex and involve a fundamental change in the way many deferred compensation arrangements of associations will work. However, while the rules will present new challenges for associations, nonqualified deferred compensation will remain a valuable compensation technique for association executives.