Nonqualified deferred compensation plans: new rules under the AJCA.
Notice 2005-1 provides initial guidance under Sec. 409A. Also, several helpful examples and guidelines appeared in the AJCA Conference Report (CR); see Conf. Rep't No. 108-755, 108th Cong., 2d Sess. (2004). Additional IRS guidance expected later this year will probably be consistent with the examples in the CR. Any such guidance should be considered before taking action.
Perhaps the most significant aspect of the new rules is the tax liability that plan participants will incur if the rules are not followed. It is hard to imagine that an employer or individuals covered under a plan would chance noncompliance with the new distribution, funding and election rules, as it would trigger inclusion of the entire cumulative post-2004 deferred compensation in income (plus any investment earnings) at regular rates. An additional 20% penalty would apply to the deferred compensation. A third component relates to interest. The taxpayer has to pay interest on the income taxes that would have been paid had the deferred compensation been reported as income as services were performed in each prior year. The interest is calculated using the underpayment rate, plus one percentage point.
Current taxation can be avoided for noncompliance if any of the deferred compensation amounts are subject to a substantial risk of forfeiture; such amounts will not be taxed. It is only a matter of time, though, until they are taxed. Taxation occurs as soon as there is no longer a substantial forfeiture risk.
Under the new rules, rights to compensation are subject to a substantial risk of forfeiture if they are conditioned on the future performance of substantial services by any individual, or the occurrence of a condition related to a purpose of the compensation (e.g., the attainment of a prescribed level of earnings or equity value) .Thus, "significant risk of forfeiture" refers to whether amounts are vested.
AJCA Section 885 very broadly defines an NQDC plan to include any plan that provides for the deferral of compensation, except for the following:
* Qualified retirement plans (e.g., defined benefit, Sec. 401(k), taxdeferred annuity, simplified employee pension, savings incentive match plan for employees).
* Bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan.
* Sec. 457(b) plans (i.e., eligible deferred compensation plans maintained by tax-exempt entities, as well as by state and local governments).
* Incentive stock options (Sec. 422).
* Nonqualified employer stock options with an exercise price equal to or greater than the stock's fair market value on the grant date (as long as the option does not include a deferral feature other than the option holder having the right to future exercise).
* Employee stock purchase plans (Sec. 423).
* Amounts paid within 21A months after the end of the tax year in which vesting occurs, using the later of the plan sponsor's tax year or the participant's tax year.
A plan or arrangement not listed above is subject to the new rules. Under new Sec. 409A(d)(3), the term "plan" includes any agreement or arrangement, even if it includes only one person. Nothing in the AJCA suggests that the new rules apply only to written agreements. The agreement's substance, rather than its name or degree of formality, is what matters. Also, the rules are not limited to arrangements between an employer and an employee. Thus, arrangements involving independent contractors and directors are also covered.
The types of plans that also may be treated as NQDC plans include supplemental executive retirement plans, employment agreements that include a retirement benefit, phantom stock, stock appreciation rights (SARs), discounted stock options and Sec. 401(k) "mirror" plans. Given the all-inclusive definition of an NQDC plan, it will be a significant challenge to ensure that all of an employer's plans are properly identified.
Notice 2005-1, Q&A-4(iv), provides that, pending further guidance, nondiscount SARs granted under a plan in effect before Oct. 4, 2004 are not subject to Sec. 409A, if the SAR does not allow any compensation deferral other than the participant's exercise right. Q&A-4(iv) also provides conditions under which SARs granted by publicly held companies are not subject to Sec. 409A. In addition, under Q&A-19(d) and (a), severance plans collectively bargained or that cover no key employees are not required to comply with Sec. 409A in 2005, as long as such plans are amended before 2006.
Prior law did not contain specific, detailed rules governing NQDC plans. General tax principles (e.g., the constructive-receipt doctrine) applied instead.
The new rules' primary theme aims to put a significant distance between the time an individual elects to defer compensation and when he or she receives payouts. In fact, the new rules can best be described as "hurry up and wait": hurry up and make deferral elections before it is too late; wait for distributions until the AJCA says sufficient time has passed to receive them.
The new rules can be divided into three broad categories--distributions, elections and funding.
Under the new rules, no distribution can be made until one of the following occurs:
* A date (or series of dates) specified under the plan at the date of the deferral;
* A change in ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation's assets;
* An unforeseeable emergency;
* Separation from service;
* Disability; or
Planning opportunity: The greatest opportunity for individuals to direct the timing of distributions will be to select a specific distribution date. The date must be chosen at the time of the deferral election.
Planning opportunity: There is a risk that a specific date selected will ultimately be undesirable (e.g., a year in which individual tax rates are high). However, one way to lessen this effect is to select multiple payout dates.
CR Example: A participant could elect to receive 25% of his or her account balance at age 50 and the remaining 75% at age 60.
Change in ownership/control: Distributions on a change in the ownership or effective control of a corporation, or in the ownership of a substantial portion of the corporation's assets, may be made only to the extent provided in Treasury guidance. Notice 2005-1, Q&A-11 through -14, address changes in ownership or control, or ownership of assets.
Unforeseeable emergency: According to new Sec. 409A(a)(2)(B)(ii)(I), an unforeseeable emergency means a severe financial hardship to the participant resulting from:
* An illness or accident involving the individual, his or her spouse or a dependent;
* Loss of the individual's property due to casualty; or
* Other similar extraordinary and unforeseeable circumstances beyond the participant's control. Under new Sec. 409A(a)(2)(B)(ii)(II), a distribution must be limited to the amount necessary to satisfy the emergency, plus reasonably anticipated taxes resulting from the distribution. Distributions may not be allowed to the extent that the hardship may be relieved through reimbursement or compensation by insurance or otherwise, or by liquidation of the participant's assets (to the extent such liquidation would not cause a severe financial hardship).
Separation from service: For distributions made on separation from service, a special rule applies to "specified employees." A specified employee must wait for six months after separating from service to receive a distribution. All other employees may receive a distribution immediately after separation. Under new Sec. 409A(a)(2)(B)(i), determining whether an individual is a specified employee is a two-step process. The individual must:
1. Be an employee of a publicly traded corporation and
2. Fit into one of the following categories:
* An officer of the corporation with annual compensation greater than $135,000 in 2005 (as indexed for inflation);
* Owns more than 5% of the outstanding stock, or stock possessing more than 5% of the total combined voting power of all stock; or
* Owns more than 1% of the corporation and has annual compensation exceeding $150,000.
Disability: "Disability" is defined under new Sec. 409A(a) (2) (C) as a medically determinable physical or mental impairment, expected to result in death or to last for a continuous period of not less than 12 months. If this definition is met, then the individual must meet one of the following two additional criteria:
* Unable to engage in any substantial gainful activity; or
* Receives income replacement benefits for not less than three months under the employer's accident and health plan.
To reinforce the concept that distributions cannot be made earlier unless one of the six circumstances discussed above applies, new Sec. 409A(a)(3) specifically states that a plan cannot permit acceleration of the time of payment, except as provided in the regulations. However, payment acceleration is permissible under some circumstances, as indicated by several helpful CR examples.
CR Examples: A plan would not violate the ban on accelerations by providing that withholding of an employee's share of employment taxes will be made from the employee's interest in the NQDC plan.
In addition, a plan can make a distribution to comply with a court-approved settlement incident to divorce.
Fortunately, if a plan fails to comply with the new rules, only the individuals to whom the failure applies are subject to the consequences.
CR Example: If a plan covering all executives (including those subject to Section 16(a) of the Securities and Exchange Act of 1934) allows distributions to individuals subject to that section on a distribution event not permitted under the provision, those individuals, rather than all plan participants, would be required to include amounts deferred in income and would be subject to interest and the 20% penalty.
As noted above, the new law contains certain "hurry up" rules; new Sec. 409A(a)(4) addresses how soon an individual has to elect to defer compensation under an NQDC plan. There is a general rule, with two exceptions; see Exhibit 1 at right. Notice 2005-1, Q&A-21, provides yet another exception for 2005: a plan in existence before 2005 can allow a participant to make a deferral election until March 15, 2005. The election must be restricted to amounts not yet paid or payable, as of the date of the election.
Both the time and form of distributions (e.g., a lump-sum payment versus an annuity) must be specified at the time of the initial deferral.
An individual's circumstances often change after making the initial deferral election; while the new rules permit individuals to change an initial election, there are strict parameters for such "subsequent elections." For example, one cannot elect to accelerate the timing of a distribution. It is possible, however, to elect to delay the tinting of a distribution or to change the form of payment (e.g., from a lump-sum distribution to annuity payments).
The rules on subsequent elections are somewhat complex, largely because there are different rules for different types of distribution events. Exhibit 2 on p. 74 presents the various rules.
Planning point: When an individual's circumstances change, he or she should make a new election as soon as possible, because it will have to be ignored by the plan for the first 12 months.
The third major area addressed by the AJCA is funding. The rules take aim at two specific areas: (1) off-shore trusts and (2) funding triggered on a change in the employer's financial health.
Off-shore trusts: If assets are set aside in a trust or other arrangement under an NQDC plan and located outside the U.S., the assets are treated as property transferred in connection with performing services. This will result in immediate taxation of the deferred compensation to plan participants at ordinary income tax rates, plus the additional 20% penalty, as well as interest. This would occur even if the assets were available to satisfy general creditors' claims. If a trust or arrangement initially has no assets outside the U.S., but later transfers them outside the U.S., participants will be taxed at the transfer date. Assets can be located outside the U.S. without triggering taxation if substantially all of the services to which the nonqualified deferred compensation relates are performed in the foreign jurisdiction in which the assets are located.
Employer's financial health: The new rules do not permit a plan to trigger a restriction of assets for paying NQDC plan benefits when an employer's financial health changes. If such a trigger occurs, the assets are treated as property transferred in connection with performing services. Like the off-shore trusts described above, this would result in immediate taxation of the deferred compensation to plan participants at ordinary income tax rates, plus the additional 20% penalty, as well as interest. Moreover, the transfer of property is deemed to occur if the plan simply contains a provision to restrict assets, even if none were actually restricted. Of course, an actual asset restriction is also treated as a property transfer.
The new rules require annual reporting to the IRS of deferred amounts on an individual's Form W-2 (or Form 1099, for a nonemployee) for the year deferred, even if the amount is not currently includible in income for that tax year. In Ann. 2004-96, the IRS indicated that deferral amounts under an NQDC plan should be reported in box 12 of 2005 Form W-2, using a new code (Code Y--Deferrals under a section 409A nonqualified deferred compensation plan).
The new rules are effective for amounts deferred in tax years beginning after 2004. An amount is deemed deferred before 2005, if it is earned and vested before that year. Thus, amounts not vested as of Dec. 31, 2004 will be subject to the new rules.
Amounts deferred in tax years beginning before 2005 are subject to the new rules if the plan under which the deferral is made is "materially modified" after Oct. 3, 2004.
CR Example: Accelerating vesting under a plan after Oct. 3, 2004, would be a material modification.
Notice 2005-1, Q&A-16 through -23, provide transition guidance, which gives both plan sponsors and participants time to make important decisions. Plan sponsors have until Dec. 31, 2005 to amend plans to comply with the AJCA; plan participants have until the same date to opt out of plans. The plan may allow the participant to stop participating in the plan, or simply cancel a deferral election, for amounts deferred after 2004. The sponsor may distribute to the participant the amounts affected by the participant's decision at any time during 2005 (or, if later, during the year in which the amount is earned and vested); the amounts are taxed at that time. Additional transition rules allow participants to revise payment elections until Dec. 31, 2005. In addition, sponsors who no longer wish to provide an NQDC benefit may stop participant deferrals, or terminate a plan and distribute benefits by Dec. 31, 2005.
The AJCA added many NQDC plan rules, with significant tax penalties for noncompliance. The IRS has indicated that it will continue to issue guidance during 2005. Such guidance, coupled with Notice 2005-1, should be very helpful in operating plans to comply with the new rules.
Exhibit 1: Initial deferral elections Rule and exceptions Conditions General rule: The election must be N/A made by the last day of the tax year preceding the year in which the services are performed (Sec. 409A(a)(4)(B)(i)). Exception for first year of plan The election can be made only for participation: The election may be services to be performed after the made within 30 days after the election date. participant first becomes eligible to participate in the plan (Sec. 409A(a)(4)(B)(ii)). Exception for performance-based The performance period on which compensation. The election may be the compensation is based must be made as late as six months before at least 12 months for this the end of the performance period exception to apply. (Sec. 409A(a)(4)(B)(iii)). According to the CR, "performance-based compensation" includes compensation that is (1) preestablished organizational or individual performance criteria and (2) not readily ascertainable at the time of the election. The election applies retroactively to the beginning of the performance period. Exhibit 2: Subsequent election rules (Sec. 409A(a)(4)(C)) Distribution event Change Unforeseeable Rule Specified time in control emergency General rule: No subsequent election will take effect until at least 12 months after it is made. [check] [check] [check] Restriction on when a subsequent election maybe made: The new election must be made at least 12 months before the first scheduled payment date selected in the original election. [check] N/A N/A Restriction on the revised payment date: The revised payment date must be at least five years from when the payment would have been made under the original election. [check] [check] N/A Distribution event Separation Rule from service Disability Death General rule: No subsequent election will take effect until at least 12 months after it is made. [check] [check] [check] Restriction on when a subsequent election maybe made: The new election must be made at least 12 months before the first scheduled payment date selected in the original election. N/A N/A N/A Restriction on the revised payment date: The revised payment date must be at least five years from when the payment would have been made under the original election. [check] N/A N/A
FROM EDDIE ADKINS, WASHINGTON, DC
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|Title Annotation:||American Jobs Creation Act of 2004|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2005|
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