Deferring comp: how the American Jobs Creation Act redefines deferred compensation.

The provisions of Sec. 409A of the American Jobs Creation Act of 2004 made sweeping changes to what qualifies as deferred compensation--a critical distinction that impacts 2005 federal tax returns.

The legislation is already in effect for amounts deferred on or after Jan. 1, 2005, or amounts previously deferred if the plan was materially modified after Oct. 3, 2004. Coupled with the official IRS definition of "deferred," the only way compensation can qualify as deferred before Jan. 1, 2005, is if the amounts in question were fully earned and vested prior to 2005.

If you have clients who offer deferred compensation plans to their employees, then you probably have clients who are affected by Sec. 409A, and some may not realize it.

Now is the time to prepare and inform yourself and, if necessary, assist your clients in making the necessary changes to meet the new deferred compensation requirements without incurring penalties. The penalties, once they kick in, are steep: taxation on the income and a 20 percent additional tax, plus any applicable interest.

SEC. 409A

As summarized during a recent Tax Talk Today webcast, there are four key provisions in Sec. 409A that impact deferred compensation.

Timing of elections: The election to defer compensation must be made the year before the year in which the services to which the compensation relates will be provided. Two exceptions to this provision are newly eligible participants and certain performance-based compensation.

Permissible distributions: Distributions due to extreme circumstances are allowed only for certain events. The IRS allows for six types of qualifying situations: death; disability; separation from service; fixed time of schedule (established at the time of the deferral); unforeseen hardship; and change of control.

Accelerating benefits: Except as provided in guidance from the IRS, there is no acceleration of benefits allowed. Exceptions provided so far include accelerations in connection with a divorce order; to cover withholding obligations; or to comply with a federal conflict of interest.

Securing payment obligations: Two types of funding problems can result in noncompliance with Sec. 409A. They include offshore "rabbi" trusts--in which funds are placed outside the United States--and trusts or other arrangements that are funded as a result of an adverse change in the financial condition of the employer or the service recipient.

Stay tuned for additional information to these key components of Sec. 409A, especially the election provisions.

"We have fairly broad regulatory authority under the law," says Tax Talk Today panelist William Schmidt, senior counsel, executive compensation, office of the division counsel/associate chief counsel, Tax Exempt and Government Entities, IRS. "We have the ability to add additional opportunities for people to make elections if we believe it's the correct thing to do."

TRANSITION GUIDANCE

IRS Notice 2005-1 provides guidelines to help tax practitioners transition their clients to full compliance by the end of this year, including some tricky deferred compensation issues such as stock options and stock appreciation rights. Notice 2005-1 also provides some notable exceptions affecting short-term deferrals, partnerships and 401(k) plans that may be useful for taxpayers.

Schmidt emphasized that Notice 2005-1 is important, but not all-inclusive. More transition guidance is on the way for 2005. "We anticipate putting out additional guidance," he says.

Even though guidance is still in the works, tax professionals need to act now to evaluate their clients' deferred compensation plans. Any tax practitioner whose clients employ deferred compensation needs to:

* Understand what compensation arrangements the client offers. Things like employment agreements, severance arrangements or other plans can qualify--or fail to qualify--as deferred compensation under the new legislation.

* Determine whether the client's deferred compensation plans can be brought into compliance with Sec. 409A, or if those plans should be cashed out.

* Identify which deferred compensation plans can remain unchanged for now, and which plans need to be revised or shut down altogether.

* Explain to the client what types of qualified deferred compensation plans can be offered under the new legislation.

* Watch for additional notices and guidance from the IRS.

"I stick to my prediction that if you use the transition rules, and keep your wits about you, you will not incur the 20 percent penalty this year," says Elizabeth Drigotas, principal, Deloitte Tax LLP. "But that does require you to know what you're working with, and to be aware of the transition guidance."

Les Witmer is the moderator of Tax Talk Today, and was a 23-year veteran of the IRS before becoming an Atlanta-based communications consultant. For additional information, visit www.taxtalktoday.tv.