New Legislation Makes Significant Changes to Non-Qualified Deferred
Compensation Plan Rules
By Steven B. Lapidus, Esq.,
Mindy B. Leathe, Esq.,
Thomas LaWer, Esq.,
W. Tracy Haverfield III, Esq.,
View or download the PDF version of this Alert.
Congress has just passed the American Jobs Creation Act of 2004 (the
"Act"), which includes provisions that significantly change the tax rules
relating to non-qualified deferred compensation plans. The Act is expected
to be signed by the President soon. The new rules imposed by the Act generally
are effective with respect to amounts that are considered under the Act
to have been deferred on or after January 1, 2005. For this purpose, amounts
deferred before January 1, 2005 are considered to be deferred on or after
January 1, 2005, and thus are subject to the new rules, if and to the extent
that they vest on or after January 1, 2005, or if the plan is materially
modified after October 3, 2004.
|"The new rules imposed
by the Act generally are effective with respect to amounts that
are considered under the Act to have been deferred on or after
January 1, 2005."
The Act provides that Treasury Regulations are to be issued that will
permit some time within which existing plans may be retroactively amended
to comply with the new rules, and for participants to revoke elections for
2005 as a result of the law changes. Nevertheless, the changes are significant,
and most employers will wish to communicate the changes to participants
before they make their deferral elections with respect to their 2005 compensation.
Accordingly, all non-qualified deferred compensation plans should be reviewed
as soon as possible to determine the changes that will be required to comply
with the new rules.
The most important provisions of the Act relating to non-qualified deferred
compensation plans may be summarized as follows:
- Distributions from non-qualified deferred compensation plans only
would be permitted on account of death, disability, separation from service,
at a specified time or pursuant to a fixed schedule, on account of a change
in control (to the extent permitted by regulations), or on account of
an unforeseeable emergency.
- Provisions permitting an acceleration of the timing of benefit payments
(such as those allowing for distributions subject to a 10% "haircut" penalty)
will cause benefits to be immediately taxable.
- Initial deferral elections generally will need to be made prior to
the taxable year for which the compensation is earned.
- Subsequent elections as to the timing or form of payments generally
would need to be made at least 12 months before the payments otherwise
would commence, and subsequent deferrals generally would need to be for
at least 5 years.
- Violations of these rules will result in immediate tax plus interest
(at the tax underpayment rate plus 1%) from the date of the deferral and
an additional tax of 20% of the taxable compensation.
- Transfers of assets to offshore trusts and employer financial triggers
will cause benefits to be immediately taxable.
What You Should Do Now
In light of the significance of the changes made by the Act, the breadth
of types of plans that may be subject to the new requirements, and the January
1, 2005 effective date, we recommend that employers take the following immediate
- Identify any plans or arrangements they maintain that fall within
the broad definition of a non-qualified deferred compensation plan under
- Analyze the changes that would be required to be made to each plan
in order to satisfy the new law.
- Avoid making any amendments to their plans that would result in a
loss of grandfathering of amounts that are considered to have been deferred
prior to January 1, 2005. In general, we recommend that employers delay
if possible making any amendments to their nonqualified deferred compensation
plans until Treasury Regulations are issued clarifying some of the provisions
of the Act. If amendments need to be made, however, care must be taken
to be sure that they do not add any benefit, right or feature to the plan
that could cause a loss of grandfathering for deferrals made before January
- Consider adopting new plans for deferrals after January 1, 2005 to
ensure that grandfathering will not be lost for existing deferrals.
- Communicate the changes to plan participants as soon as possible,
so that they are aware of them before they make their 2005 elections.
Also, communicate to participants the extent to which their consent will
be required to make any changes.
Definition of Non-Qualified Compensation Plan
The new tax rules apply with respect to "non-qualified deferred compensation
plans", which are broadly defined to include any plans that provide for
the deferral of compensation. The term "plan" is defined to include an agreement
or arrangement with one or more persons. "Qualified employer plans", and
any bona fide vacation leave, sick leave, compensatory time, disability
pay, or death benefit are not treated as non-qualified deferred compensation
plans for purposes of these rules. The term "qualified employer plan" is
defined to include any plan that is qualified under §401(a) of the Internal
Revenue Code of 1986, as amended (the "Code") (including pension, profit
sharing and 401(k) plans), annuity plans or contracts described in §403(a)
or §403(b), simplified employee pensions described in §408(k), any simple
retirement account described in §408(p), any eligible deferred compensation
plan described in §457(b) and any qualified governmental excess benefit
arrangement described in §415(m) of the Code.
|"By negative implication
from the language of the Conference Report, it would appear that
the new rules may apply with respect to options to purchase
employer stock where the exercise price is less than the fair
market value of the underlying stock on the date of grant..."
The Conference Report, prepared by the staff of the House and Senate
Conference Committee, that summarizes and explains the provisions of the
Act (the "Conference Report") indicates that it is not intended that the
term "non-qualified deferred compensation plan" include "any arrangement
taxable under §83 of the Code providing for the grant of an option on employer
stock with an exercise price that is not less than the fair market value
of the underlying stock on the date of grant, if such arrangement does not
include a deferral feature other than the feature that the optionholder
has the right to exercise the option in the future." The Conference Report
also indicates that the provision is not intended to change the tax treatment
of incentive stock options meeting the requirements of §422 or options granted
under an employee stock purchase plan meeting the requirements of §423,
or to change the rules applicable to annual bonuses paid within 2 1/2 months
after the close of the taxable year in which the relevant services required
for payment have been performed.
By negative implication from the language of the Conference Report, it
would appear that the new rules may apply with respect to options to purchase
employer stock where the exercise price is less than the fair market value
of the underlying stock on the date of grant (or options, perhaps whether
or not discounted, to purchase assets other than employer stock), and to
arrangements pursuant to which income derived from the exercise of a stock
option is deferred to a date after the date on which the option is exercised.
The new rules also would seem to apply with respect to restricted stock
units and any arrangements to delay the recognition of income with respect
to restricted stock that has vested, and most likely also will apply in
some manner to be prescribed by Treasury Regulations with respect to stock
appreciation rights and phantom stock arrangements.
The Act imposes three basic requirements that must be satisfied by all
non-qualified deferred compensation plans.
Under the first set of requirements, compensation deferred under the
plan may not be distributed earlier than: (i) separation from service, as
determined pursuant to Treasury Regulations to be issued; (ii) the date
on which the participant becomes "disabled"; (iii) the date on which the
participant dies; (iv) a time (or pursuant to a fixed schedule) specified
under the plan when the deferral election is made, (v) to the extent provided
within Treasury Regulations, a change in the ownership or effective control
of the corporation, or in the ownership of the substantial portion of the
assets of the corporation, or (vi) upon the occurrence of an "unforeseeable
The Act also provides that distributions cannot be made to "specified
employees", of publicly traded companies on account of separation from service
until six months after the date of separation from service (or, if earlier,
the date of the employee's death). A "specified employee" is defined for
this purpose as a "key employee" within the meaning of § 416(i) of the Code,
which generally includes officers receiving compensation in excess of $130,000
(as adjusted for inflation), 1% owners receiving compensation in excess
of $150,000, and 5% owners.
For purposes of these rules, the term "unforeseeable emergency" is defined
to be a severe financial hardship to the participant resulting from an illness
or accident of the participant, the participant's spouse or a dependent
(as defined in §152(a) of the Code) of the participant, loss of the participant's
property due to casualty, or other similar extraordinary and unforeseeable
circumstances arising as a result of events beyond the control of the participant.
Further, to qualify for distribution on account of an "unforeseeable emergency,"
the amounts distributed with respect to the emergency cannot exceed the
amounts necessary to satisfy the emergency, plus amounts necessary to pay
taxes reasonably anticipated as result of the distribution. The amount needed
is determined after taking into account amounts that would be received by
the participant by insurance or that could be obtained, without severe financial
hardship, through the liquidation of the participant's assets.
A participant is considered to be disabled under the new rules if he
or she (i) "is unable to engage in any substantial gainful activity by reason
of any medically determinable physical or mental impairment which can be
expected to result in death or can be expected to last for a continuous
period of not less than 12 months, or (ii) is, by reason of any medically
determinable physical or mental impairment which can be expected to result
in death or be expected to last for a continuous period of not less than
12 months, receiving income replacement benefits for a period of not less
than 3 months under an accident and health plan covering employees of the
No Acceleration of Benefits
The second new requirement applicable to non-qualified deferred compensation
plans is that the plan may not permit the acceleration of the time or schedule
of any payment under the plan except as provided in Treasury Regulations.
Many existing plans include provisions that permit participants to elect
to receive distributions of their deferred benefits subject to a penalty
(typically 10% of the amount withdrawn). Practitioners generally believe
that such a penalty constitutes a "substantial risk of forfeiture", and
that the participant therefore is not in constructive receipt of his benefits
as a result of the existence of such a right under the plan. This feature
has provided participants reasonable comfort in knowing that if financial
conditions of the employer deteriorate, they at least can access 90% of
their funds and thereby prevent them from being subject to creditor claims
against their employer. The new law would preclude participants from making
this election with respect to amounts deferred (or deemed under the effective
date provisions of the new rules to be deferred) on or after January 1,
The Conference Report indicates that changes in the form of distribution
that accelerate payments are subject to the rule prohibiting acceleration
of distributions. The Conference Report goes on to state, however, that
this rule is not violated merely because the plan provides a choice between
cash and taxable property if the timing and amount of the income inclusion
is the same regardless of the medium of distribution, and that Treasury
Regulations should be issued under which the choice between different forms
of actuarially equivalent life annuity payments is permitted. Treasury Regulations
also are intended to provide other limited exceptions, such as when the
accelerated distribution is required for reasons beyond the control of the
participant and the distribution is not elective. The Conference Report
provides, as examples of the types of exceptions that should be provided
in the Regulations, distributions to comply with a court-approved settlement
incident to a divorce, amounts required to be withheld to pay the employee's
share of employment taxes, or amounts required to be withheld as income
taxes due upon a vesting event under § 457(f). The Conference Report also
indicates that it is intended that Treasury Regulations would provide that
automatic distributions of minimal interests for administrative convenience
would not violate the prohibition on acceleration.
compensation for services performed for a taxable year may be
deferred at the participant's election only if the election is
made not later than the close of the preceding taxable year or
at such other time as provided in Treasury Regulations."
The Act sets forth rules regarding the timing for making initial elections
under the plan and elections changing the time or form of distributions
under the plan.
In general, compensation for services performed for a taxable year may
be deferred at the participant's election only if the election is made not
later than the close of the preceding taxable year or at such other time
as provided in Treasury Regulations. Under this rule, for example, an election
to defer an annual bonus earned in 2005 and normally payable in January
of 2006 would need to be made by December 31, 2004 unless the exception
for performance based compensation described below applies. In the initial
year in which an individual becomes eligible to participate in the plan,
the election can be made with respect to services to be performed subsequent
to the election within 30 days after the participant becomes eligible to
participate in the plan.
In the case of "performance-based compensation" based on services performed
over a period of at least 12 months (i.e., a bonus based upon performance
criteria measured over a performance period that extends over 1 year or
more), the election may be made no later than 6 months before the end of
the performance period. The Conference Report indicates that rules similar
to those used under § 162(m) of the Code would be used to determine whether
compensation is "performance based" for this purpose. Thus, in order to
constitute "performance based compensation", the Conference Report indicates
that the amount would have to be variable and contingent on satisfaction
of "pre-established" organization or individual performance criteria and
not readily ascertainable at the time of the election. The performance criteria
would need to be specified in writing within 90 days after the service period
Changes in Time and Form of Distribution.
If a plan permits participants to elect to delay a payment or change
the form of payment after its initial deferral, the election must meet the
- The plan must require that the election takes effect at least 12 months
after the date on which the election is made.
- The first payment to which the election applies must be deferred for
a period of not less than 5 years from the date such payment would otherwise
have been made (except in the case of an election related to a payment
on account of the participant's disability, death, or an unforeseeable
- The plan must require that any election related to a payment at a
specified time or pursuant to a fixed schedule may not be made less than
12 months before the date of the first scheduled payment.
Consequences of Failure to Meet New Requirements
The Act generally provides that if at any time during a taxable year
a non-qualified deferred compensation plan fails to meet the new requirements
of the Act, or is not operated in accordance with those requirements, then
all compensation deferred under the plan for the taxable year and all preceding
taxable years is or becomes taxable to the extent it is not subject to a
substantial risk of forfeiture and was not previously taxable. The tax imposed
as a result of these new rules would be increased by interest at a rate
equal to the rate imposed on tax underpayments plus one percentage point,
and an additional tax equal to 20% of the compensation required to be included
The foregoing rules apply only to participants with respect to whom the
failure relates, and thus not necessarily to all participants in the plan.
The Act also imposes new rules relating to the funding of non-qualified
deferred compensation plans.
Under the new rules, assets set aside in a trust to pay deferred compensation
are treated as property transferred in connection with the performance of
services (and thus would be taxable under § 83 of the Code if they are no
longer subject to a substantial risk of forfeiture or are transferable)
if and when they are located or transferred outside of the United States.
This provision does not apply to assets located in a foreign jurisdiction
if substantially all of the services to which the non-qualified deferred
compensation relates are performed in that jurisdiction.
Triggers Based Upon Employer’s Financial Health
Similarly, participants will be deemed to have received property within
the meaning of Section 83 as of the earlier of the date on which the plan
first provides that assets will become restricted to the provision of benefits
under the plan in connection with a change in the employer's financial health,
or the date on which assets are so restricted.
The Conference Report indicates that the transfer of property occurs
under the foregoing rule as of the earlier of when the assets are so restricted
or when the plan provides that assets will be restricted. The Conference
Report states that if, for example, a Plan provides that upon a change of
the employer's financial health, a trust will become funded to the extent
of all deferrals, then all amounts deferred under the Plan are treated as
property transferred under § 83 at the time of deferral (even if the assets
of the trust to which deferrals would be transferred would be available
to satisfy the claims of the employer's general creditors). The Conference
Report states further, however, that this provision is not intended to apply
when assets are restricted for a reason other than a change in the employer's
financial health (such as upon a change in control) or if assets are periodically
restricted under a structured schedule and the scheduled restrictions happen
to coincide with a change in financial status.
If assets are treated as transferred under the foregoing rules relating
to offshore trusts and employer financial triggers, then any increase in
value in, or earnings with respect to, those assets are to be treated as
additional transfers of property as realized. Amounts required to be included
in income under the foregoing provisions are increased by interest (at the
tax underpayment rate plus 1%) and an additional tax equal to 20% of the
Subject to any exceptions provided in Treasury Regulations, the aggregation
rules related to controlled groups under §§ 414(b) and (c) are to be applied
in connection with the Act's new rules, and Treasury Regulations are to
be issued to carry out the purposes of this provision. Thus, for example,
the Conference Report indicates that it is intended that those aggregation
rules would provide that separation from service from one entity within
a controlled group, but continued service for another entity within that
group, would not be a permissible distribution event. Similarly, the aggregation
rules would preclude distributions from being made to participants employed
by one member of a controlled group as a result of a change in control of
Authority to Issue Treasury Regulations
The Act authorizes the Secretary of the Treasury to prescribe such regulations
as may be necessary or appropriate to carry out the purposes of the Act,
- providing for the determination of the deferred amounts in the case
of a non-qualified deferred compensation plan that is a defined benefit
- relating to changes in the ownership and control of a corporation
or assets of a corporation for purposes of determining when distributions
on account of changes in control may be made;
- exempting certain arrangements from the new funding rules if those
arrangements will not result in an improper deferral of tax and will not
result in assets being effectively beyond the reach of creditors;
- defining "financial health" for purposes of the funding rules; and
- disregarding a substantial risk of forfeiture in cases where necessary
to carry out the purposes of the new rules. The Conference Report states
that it is intended that substantial risks of forfeiture be disregarded
if they are illusory, such as if an executive is effectively able to cause
the time when the risk of forfeiture lapses to be accelerated.
The Conference Report also indicates that Treasury Regulations may be
issued relating to stock appreciation rights and payments under non-elective,
supplemental retirement plans.
The new rules will require that deferred compensation be reported on
a Form W-2 (or Form 1099), even if it is not currently taxable, subject
to an exception that may be established by Treasury Regulations for certain
de minimus amounts. The Conference Report indicates that it is expected
that these annual reporting requirements will provide the IRS with an indication
of what arrangements should be examined or challenged.
|"The new rules generally
apply with respect to amounts deferred on or after January 1,
2005, and to earnings on deferred compensation only to the
extent that the deferred compensation itself is subject to the
The new rules generally apply with respect to amounts deferred on or
after January 1, 2005, and to earnings on deferred compensation only to
the extent that the deferred compensation itself is subject to the new rules.
Treasury Regulations are to provide guidance as to when an amount is considered
to have been deferred for this purpose. The Conference Report states that
the timing of an election to defer should not be determinative of when the
deferral is made.
The Conference Report further provides that for purposes of the effective
date, an amount is considered to be deferred before January 1, 2005 if the
amount is earned and vested before that date. It thus appears that amounts
deferred before January 1, 2005, but that do not vest until on or after
January 1, 2005, will be subject to the new rules.
For purposes of this effective date provision, amounts deferred in taxable
years beginning before January 1, 2005 are to be treated as amounts deferred
in a taxable year beginning on or after that date, and thus would be subject
to the new rules, if the plan under which the deferral is made is "materially
modified" after October 3, 2004, other than to conform the plan to the new
requirements of the Act. The Conference Report states that the addition
of any benefit, right or feature is a material modification, but that the
exercise or reduction of an existing benefit, right or feature is not a
The Conference Report also states that existing plans that comply with
current law and are not materially modified after October 3, 2004 may continue
to be operated in accordance with their terms with respect to amounts deferred
before January 1, 2005. Thus, for example, amounts deferred before January
1, 2005 under such a plan could be further deferred, and distributions could
be accelerated, to the extent permissible under prior law.
The Act further provides that not later than 60 days after the date of
its enactment, the Secretary of the Treasury must issue guidance providing
a limited period during which a non-qualified deferred compensation plan
adopted before December 31, 2004 may, without violating the requirements
under the new Act, be amended (1) to provide that a participant may terminate
participation in the plan, or cancel any outstanding deferral election with
regard to amounts deferred after December 31, 2004, but only if amounts
subject to termination or cancellation are includable in the income of a
participant as earned (or if later, when no longer to substantial risk of
forfeiture), and (2) to conform to the requirements of the new rules with
regard to amounts deferred after December 31, 2004.
The Secretary of the Treasury also is required to issue guidance within
90 days after the enactment of the Act on what constitutes a change in ownership
or control for purposes of the new rules.
© 2004 Greenberg Traurig
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