President Bush is expected to sign the American Jobs Creation Act of 2004 ("AJCA"), which contains many significant tax law changes, including the most sweeping change to income tax rules related to deferred compensation in over 25 years. This legislation will require virtually all non-qualified deferred compensation plans to be reviewed, and will require most of them be revised to meet the requirements of the new law.
In general, AJCA adds rules to regulate:
Plans and Arrangements Subject to New Law. The law applies to all non-qualified deferred compensation plans and arrangements, whether elective or non-elective, including traditional deferred compensation plans, supplemental executive retirement plans (SERPs), and, in some cases, employment agreements and severance plans. The new rules do not apply to qualified pension or 401(k) plans or to bona fide vacation leave, sick leave, compensatory time, disability pay, death benefits or bonuses paid within 2 ½ months following the end of a calendar year.
Note: The AJCA is not limited to the employer-employee relationship. It also applies to deferrals made under plans and arrangements for non-employees such as directors, consultants, and independent contractors.
Equity Compensation Awards. The new rules also apply to equity compensation awards deferring the receipt of compensation, other than incentive stock options (ISOs), options granted under employee stock purchase plans (ESPPs) and nonqualified stock options with an exercise price equal to or greater than the fair market value of the stock on the date of grant. This means that discounted stock options, stock appreciation rights (SARs) and restricted stock are covered under the new rules.
Effective Date of New Rules. The new law applies to all amounts payable to a participant from a deferred compensation plan after December 31, 2004, unless (1) the participant is vested in such amounts by December 31, 2004, and (2) the plan is not materially amended after October 3, 2004. Under the Conference Committee Report that accompanied AJCA, the Internal Revenue Service has 60 days after the enactment of AJCA to issue rules allowing a period within which plans can be revised to meet the requirements of AJCA.
Major Deferred Compensation Provisions of AJCA
Date by Which Employees Must Make Deferred Compensation Elections
Basic Rule: Under AJCA, an employee must generally make an election to defer the receipt of compensation in the year prior to the year in which the employee earns such compensation.
Example: To defer amounts that an employee earns in 2005, the employee must make an election to defer receipt of such amount by December 31, 2004, even if the employee will not actually receive such amount until 2006 in the absence of the election. An initial election to defer compensation must specify the timing of the distribution (see Paragraph B. below) and the form of the distribution (e.g. lump sum, installments or annuity).
First Exception to Basic Rule: A participant who is newly eligible in a plan during a calendar year has until 30 days after such initial eligibility to make an election, but only with respect to amounts earned after the date the election is made.
Second Exception to Basic Rule: For certain performance based compensation for which the performance period is at least one year; the employee has until six months prior to the end of the performance period to make a deferred compensation election. The IRS is required to publish rules defining "performance based compensation" to which this exception will apply. The House and Senate Conferees expect that the IRS definition of performance based compensation for this purpose will be similar (but not identical) to the definition of performance based compensation under Section 162(m) of the Internal Revenue Code (the $1 million limit on deductible compensation to executives).
Date by Which Amounts Deferred Must be Distributed to Employees
In general, amounts cannot be distributed to employees from a deferred compensation plan under AJCA before the earliest of:
Note: These new distribution rules will prohibit many distribution options that have been standard in deferred compensation plans for years. For example, AJCA will prohibit a SERP from distributing amounts to a participant based on when the participant elects to receive a distribution from a qualified pension or 401(k) plan. AJCA will also prohibit in-service distributions in which a part of the benefit is forfeited (often 10%) (sometimes called a "haircut distribution").
Changes to Distribution Date
Under AJCA an employee is permitted to change a distribution date he or she originally elected only if:
AJCA imposes substantial limitations on viability of off-shore rabbi trusts as funding mechanisms for deferred compensation plans. Off-shore rabbi trusts are employed to protect deferred compensation assets while still conforming to the IRS's mandate that these assets generally be available to satisfy the claims of the plan sponsor's creditors. Although these trusts are nominally available to the plan sponsor's creditors, local law may make it impractical or impossible for the creditors to gain access to the assets they hold. Under AJCA, deferred compensation assets that are held in or transferred to an offshore rabbi trust will be taxed to employees to the extent they are vested in such amounts.
In addition, AJCA limits the use of "springing" trusts to protect deferred compensation assets in the event of a plan sponsor's financial distress. The inclusion of, any provision in a trust that restricts access to the assets of the trust upon any trigger related to the financial health of the employer will cause employees to be taxed on the amount of their vested deferred compensation benefits held in the trust even if the triggering event never occurs.
Penalties for Non-Compliance
Employees with benefits under deferred compensation plans that do not meet the requirements of AJCA will be taxed on the amount of their deferred compensation at the later of the year in which the violation occurred, or the year in which the employee becomes vested in such amounts. In the case of any violation, the employee must also pay an excise tax equal to 20% of the amount of deferred compensation required to be taken into income. Finally, to any extent the tax is not paid in the year in which the plan is first out of compliance, interest accrues at the statutory rate for underpayments of tax plus 1%.
Note: This penalty applies on an individual basis. For example, if a participant is permitted to accelerate the timing of his distribution but the plan itself does not generally make this option available, the AJCA penalty provisions should only be applicable to that participant and should not generally impact the plan or its other participants.
In response to AJCA, employers may wish to:
In addition, any election to defer amounts that will be earned after December 31, 2004 should be undertaken cautiously to take into account the new rules, including the possibility, mentioned in Paragraph 3. above, that certain distribution dates not elected in an employee's initial deferral election, may not be correctible by making a later election.