American Jobs Creation Act of 2004 Makes Sweeping Changes to the Taxation of Deferred Compensation Arrangements
The American Jobs Creation Act of 2004 significantly changed the rules governing the taxation of deferred compensation arrangements. The purpose of the new rules is to attack perceived abuses in deferred compensation arrangements where participants received what were viewed as inappropriate levels of control or access to deferred compensation benefits. Such plans will now be subject to the new rules' punitive tax. As a result, all existing deferred compensation plans should be reviewed to determine if changes are required to avoid non-compliance penalties under the new law. Additionally, all new plans will have to be designed to meet the principles set forth in the new statutory framework
Failure to Satisfy the New Rules
If a nonqualified deferred compensation plan fails to satisfy the new rules, all compensation deferred under the plan for the current tax year and all prior tax years will be taxable to the employee/service provider at such time as the deferred compensation is vested and not subject to a substantial risk of forfeiture. A "substantial risk of forfeiture" generally exists when a person's right to receive the compensation deferred under the plan is conditioned on the future performance of substantial services. In addition to the acceleration of taxable income (on benefits that the employee may not yet have the right to receive under the plan), any tax imposed as a result of the new legislation is increased by 20% of the compensation required to be included in gross income. Interest is also imposed at the underpayment rate plus 1% on any underpayment that would have occurred if the compensation was included in income for the taxable year first deferred or, if later, the first taxable year that the compensation is not subject to a substantial risk of forfeiture.
Non-Qualified Deferred Compensation Plans Subject to the New Rules
The new rules apply to a wide range of compensation arrangements - specifically covering any plan, agreement or arrangement that provides for the deferral of compensation, other than qualified plans, tax deferred annuities, simplified employee pension plans, simple retirement accounts, tax-exempt or governmental eligible deferred compensation plans under Internal Revenue Code (the Code) Section 457(b) and vacation leave, sick leave, disability pay and death benefit plans. The new law is not intended to apply to incentive stock option plans satisfying Code Section 422, employee stock purchase plans satisfying Code Section 423, and nonstatutory option plans if options granted under the plan have a fair market value exercise price and there are no other deferral features other than the ability to exercise the options in the future.
Examples of non-qualified deferred compensation plans subject to the new rules are stock appreciation rights plans, phantom stock plans, supplemental executive compensation plans, severance plans, stock option plans providing for less than fair market value exercise price, noneligible tax-exempt or governmental deferred compensation plans described in Code Section 457(f) and bonus plans where payments are not required to be made within 2½ months after the close of the tax year.
Summary of New Rules
To qualify for deferral of taxation under the new rules, deferred compensation arrangements must satisfy the following new requirements:
Plans must provide that compensation deferred under the plan not be distributed earlier than:
- Separation from service.
- A specified time (or pursuant to a fixed schedule) specified under the plan at the date of deferral of the compensation.
- A change in ownership or control of a corporation or ownership of a substantial amount of the assets of a corporation.
- The occurrence of certain limited unforeseen emergencies.
Acceleration of Benefits
The plan may not permit acceleration of the time or schedule of any payment under the plan other than as provided in regulations. Thus, for example, "haircut" provisions that allow participants to voluntarily withdraw "deferred benefits" with a penalty or provisions that give plan administrators the discretion to allow certain early withdrawals (eg., for college or home purchases or otherwise) will not likely be permitted under the new rules.
The plan must provide that compensation for services performed during the taxable year can generally (with some exceptions) be deferred at the participant's election only if made prior to the tax year when the services are to be rendered or at such other time provided in regulations. In the event the plan permits a subsequent election to delay a payment or change the form of a payment, the plan must require that such elections cannot take effect until at least 12 months after the date on which the election is made. In addition, in the case an election related to payments other than as a result of disability, death or unforeseeable emergencies, the plan must require that the first payment with respect to such election be deferred for a period of not less than 5 years from the date such payment would have otherwise been made. Further, the plan must require that any election related to a payment at a specified time or pursuant to a fixed schedule cannot be made less than 12 months prior to the date of the first scheduled payment.
Reporting and Withholding Rules
Amounts required to be included in income under the new rules will be subject to reporting and withholding requirements. Additionally, beginning 2005, employee form W-2s will require employers to report (for information purposes) all amounts deferred for each employee under a deferred compensation plan - even if the benefits are not included in the employee's income in that year.
The new rules are effective for amounts deferred in taxable years beginning after December 31, 2004. Amounts deferred in taxable years beginning before January 1, 2005, are subject to the new rules if the plan under which the deferrals are made is materially modified after October 3, 2004. For this purpose an addition of any benefit, right or feature would be considered a material modification. However, the exercise or reduction of any existing benefit, right or feature would not be deemed a material modification. An amount is considered deferred before January 1, 2005, if the amount is earned and vested before such date.
The Internal Revenue Service must publish additional guidance with respect to the new rules by the end of 2004. It is anticipated the Internal Revenue Service will provide a reasonable time after the issuance of guidance for existing plans to be amended in accordance with the new rules.
Actions To Be Taken
In response to the recent legislation, employers should review all deferred compensation plans, agreements and arrangements to determine whether they are subject to and satisfy the new rules. In addition, employers should inform employees covered by nonqualified deferred compensation plans of the new rules. Employers should be prepared to implement any required changes. In addition, employers may consider freezing plans subject to the new rules and utilizing new plans going forward.
If you have any questions or need assistance with regard to issues discussed above do not hesitate to contact your tax advisor at the firm or a member of the firm's tax and trusts & estates group.