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GT Alert

Proposed Legislation Would Make Significant Changes to the Rules Relating to Nonqualified Deferred Compensation Plans

May 2004
By Steven B. Lapidus and W. Tracy Haverfield III, Greenberg Traurig, Miami Office

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On May 11, 2004, the U.S. Senate passed the Jumpstart Our Business Strength (“JOBS”) Act (S.1637). One of the principal purposes of the JOBS Act is to reform certain U.S. tax laws that were found by the World Trade Organization (“WTO”) to constitute illegal U.S. export subsidies. However, JOBS would also (among other things) add a new Section 409A to the Internal Revenue Code to make certain changes, unrelated to compliance with the WTO ruling, with regard to the taxation of nonqualified deferred compensation plans. If enacted, the nonqualified deferred compensation provisions of JOBS would impose significant limitations on the flexibility currently available under these plans for participants to change their elections with regard to the form or timing of the distribution of their benefits and would eliminate some features in current plans designed to minimize the risk that assets intended to fund benefits under these plans would become subject to the employer’s creditors.

Steven Lapidus
"If enacted, the nonqualified deferred compensation provisions of JOBS would impose significant limitations on the flexibility currently available under these plans..."

The provisions would:

  • only permit distributions from nonqualified deferred compensation plans:
    • after a participant’s separation from service, disability, or death;
    • at a specified time (or pursuant to a fixed schedule) specified under the plan as of the date of the deferral of the compensation, to the extent permitted by the IRS,
    • upon a change in ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation; or
    • upon the occurrence of an unforeseeable emergency;
  • require that the initial deferral election be made during the taxable year preceding the taxable year in which the services for which the compensation is being paid were performed or at such other time as provided in regulations (or, in the case of a participant’s first year of eligibility, within 30 days after the participant first becomes eligible);
  • prohibit the acceleration of the time or schedule of any payment under the plan, except as provided in regulations (this change would prevent the use of so-called “haircut provisions,” now commonplace, pursuant to which participants can access their deferred compensation accounts by incurring a penalty (typically 10% of the amount withdrawn));
  • require that elections to defer the date on which payment was to be made to a later date be made at least 12 months after the original election was made and at least 12 months before the distribution otherwise would have been made, and that the deferred commencement date be at least five years later than the original commencement date (and only permit one subsequent election to delay payment);
  • require that distributions on account of a change in control not be made to any participants subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) until one year after the change in control;
  • require that the investment options that a participant may elect under the plan be comparable to the investment options a participant may elect under the qualified plan of the employer that has the fewest investment options (it is unclear what effect, if any, this provision would have upon the use of life insurance contracts as investment vehicles under nonqualified deferred compensation plans);
  • provide that assets set aside in offshore trusts, and assets that are restricted to the provision of benefits in connection with a change in the employer’s health, be treated as transfers of property under Section 83 of the Code which are immediately taxable to the extent not subject to a substantial risk of forfeiture;
  • • increase the tax on amounts that become taxable as deemed transfers of property under Section 83 (as described above) by interest computed at the rate applicable to underpayments of tax from the date on which the deferred amounts would have been includible in gross income if no deferral had been made, plus 10% of the amounts required to be included in gross income, and
  • prohibit the deferral of income that otherwise would be recognized as a result of the exercise of a stock option and other equity based gains by exchanging those arrangements for unfunded, unsecured promises to pay compensation in the future.

These rules would apply to amounts deferred in taxable years beginning after December 31, 2004.

Another bill proposed in the U.S. House of Representatives last year that is designed to comply with the WTO ruling, the American Jobs Creation Act of 2003 (H.R.2896), and which was approved by the House Ways and Means Committee last year (the “House Bill”), included similar provisions with regard to the taxation of nonqualified deferred compensation plans. However, the deferred compensation provisions of the House Bill differ from those contained in the JOBS Act in some respects:

  • the House Bill, like JOBS, would require that elections to defer the date on which payment was to commence to a later date be at least five years later than the original payment commencement date, however, unlike JOBS, the House Bill would not restrict the number of times that the payment commencement date may be deferred;
  • the House Bill, unlike JOBS, would not require that distributions on account of a change in control not be made to any participants subject to the reporting requirements of Section 16(a) of the Exchange Act until one year after the change in control;
  • the House Bill, unlike JOBS, would not require that the investment options under a nonqualified deferred compensation plan be comparable to those under a qualified plan of the employer; and
  • the House Bill would increase the tax on amounts that become taxable under its proposed rules by interest computed at the rate applicable to underpayments of tax plus one additional percentage point, from the date on which the deferred amounts would have been includible in gross income if no deferral had been made.
  • the House Bill, unlike JOBS, does not contain provisions relating to the deferral of income from the exercise of a stock option.

These rules proposed in the House Bill would apply to amounts deferred in taxable years beginning after December 31, 2003.

There have been a number of proposed bills in the last few years that included provisions that would affect the taxation of deferred compensation. Of course, there still is uncertainty as to whether either of these bills will become law. However, as mentioned above, one of the principal purposes of both JOBS and the House Bill is to reform certain tax laws in order to comply with a WTO ruling. Consequently, the likelihood of ultimate enactment of legislation related to deferred compensation certainly has increased as a result of both the House’s and the Senate’s inclusion of the nonqualified deferred compensation provisions in these bills.

Companies with existing nonqualified deferred compensation plans should continue to monitor the progress of these bills, since if enacted, most plans may need to be amended by year end to comply with these new rules. Companies considering establishing or amending a nonqualified deferred compensation plan may want to delay action pending the outcome of this proposed legislation.

If you have any questions with regard to the foregoing, please do not hesitate to contact us.

 

© 2004 Greenberg Traurig


Additional Information:

For more information, please review our Tax Practice or Executive Compensation & Employee Benefits Group description, or feel free to contact one of our attorneys.


This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.