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New Corporate Tax Act Affects Virtually All Non-Qualified Deferred Compensation Plans

March 2005


The newly-enacted American Jobs Creation Act ("AJCA") adopts sweeping new requirements for virtually every executive deferred compensation benefit. Each plan or arrangement providing non-qualified deferred compensation will have to be reviewed and possibly amended.

1.  When does the law go into effect?

The law is effective January 1, 2005. All vested benefits accrued prior to October 4, 2004 will be grandfathered under the old non-qualified rules; however, existing plans which are materially modified after October 3, 2004 and benefits under existing plans or arrangements which vest after October 3, 2004 are governed by the new rules.

2.  What types of plans or arrangement are covered under AJCA?

Virtually every non-qualified plan or arrangement, including those found in employment agreements, which defers the recognition of income tax until a later period than which it is granted or accrued, including benefits in employment agreements, are covered. These include, but are not limited to:

  • Elective deferrals;
  • Deferred bonuses;
  • Supplemental Executive Retirement Plans ("SERPs");
  • Stock Appreciation Rights Plans;
  • Multiple year incentive plans; and
  • Change in Control Plans.

3.  What types of Plans or arrangements are not covered by the changes in AJCA?

  • Qualified Plans, IRAs, 403(b) Plans, 457(b) Plans;
  • Incentive Stock Option Plans and Employee Stock Purchase Plans; and
  • Non-Qualified Stock Option Plans where the exercise price is at least equal to fair market value on the grant date
  • Annual Bonuses or other compensation paid within 2-1/2 months after the taxable year in which the services are performed.
  • It is not clear whether restricted stock and phantom stock plans will be covered by AJCA.

4.  What new rules will apply to Non-Qualified Deferred Compensation Plans?

Under the AJCA, amounts deferred under a deferred compensation plan will be included in the participant's gross income at such time as the amounts are not subject to a "substantial risk of forfeiture (i.e., when they become vested) unless the following requirements are met:

  • Distributions from non-qualified plans may only be permitted upon:
    • separation from service (to be defined by the IRS);
    • death;
    • a specified time (e.g., attaining age 65);
    • a Change in Control (to be defined by the IRS);
    • the occurrence of an unforeseen emergency (as defined by the IRS); or
    • permanent and total disability (as defined by AJCA).
  • Accelerations of distributions will be generally prohibited.
  • Generally, elections to defer income must be made generally more than 12 months prior to the time income is earned. A special rule permits participants to elect to defer income within 30 days after a new plan is implemented or a participant first becomes eligible to defer compensation.  Also, in the case of "performance-based" compensation, elections must be made at least 6 months before the end of the period in which the performance criteria for such compensation will be measured.
  • Generally, the time and method of distribution (e.g., lump sum or installment distributions) must be election by the time the compensation is earned. Elections to change the timing of distributions must be made at least 12 months prior to the original distribution date and the new distribution date must be at least 5 years after the original distribution date.

5.  What rules apply to trusteed deferred compensation?

Generally, rabbi trusts are still permitted, with two exceptions:

  • Trusts which hold assets outside the United States are generally prohibited; and
  • "Springing trusts" (i.e., trusteed assets that arise based on the declining financial health of the employer) are prohibited.

6.  What happens if the deferred compensation plan does not comply with the new rules?

  • All deferred compensation under non-grandfathered arrangements which is no longer subject to substantial risk of forfeiture and has not been previously taxed will be included in the participant's gross income and subject to income taxation.
  • The participant will be required to pay interest at a rate equal to the IRS underpayment rate plus one percent on the amount of taxes that would have been due if the deferred compensation was included in the participant's gross income in the year of deferral (or, if later, when the amount became vested).
  • The amounts included in the participant's gross income will be subject to an additional 20% penalty tax.

7.  What should employees do?

  • Each plan or arrangement of deferred compensation should be identified and reviewed for compliance.
  • The Treasury Department is to issue transitional guidance on AJCA within 60 days after enactment, and define "Change in Control" within 90 days after enactment.

On December 20, 2004, the IRS released its initial guidance (IRS Notice 2005-1) concerning the AJCA which addressed several issues regarding the new deferred compensation rules.  Notice 2005-1 also clarified that plan sponsors were not required to take any actions to comply with the new requirements set forth in the AJCA in 2004 and provided various transition rules for 2005.  Specifically, the IRS provided that (i) deferred elections for deferred compensation paid in 2005 can be made through March 15, 2005, (ii) plans do not need to be formally amended to comply with the AJCA requirements until December 31, 2005, and (iii) participants will be permitted to modify their prior elections based on the changes in the law affecting deferred compensation through December 31, 2005.

Additional guidance on the new rules affecting deferred compensation plans is expected to be released by the IRS throughout 2005.  Pedersen & Houpt will continue to monitor these new developments and will publish updates to this article as necessary.

If you have any questions regarding the new rules affecting deferred compensation arrangements, please contact a member of our Employment Practice Group. 

This communication is provided as a general informational service to clients and friends of Pedersen & Houpt. It should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. This material may be considered Attorney Advertising in some states. Please note that any prior results discussed in this material do not guarantee similar outcomes.

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