| American Jobs Creation Act of 2004: Rules Change for Nonqualified Deferred Compensation Plans |
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November 18, 2004 |
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| The American Jobs Creation Act of 2004 significantly changes the playing field for nonqualified deferred compensation plans beginning in 2005. An Overview of the New Law |
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| · | Restricts the flexibility that executives currently enjoy in controlling the timing of distributions | |
| · | The Act requires that a nonqualified deferred compensation plan comply with the new Section 409A of the Internal Revenue Code. |
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| · | The use of offshore rabbi trusts have been virtually eliminated. When an offshore trust is created to fund participant's benefits it will trigger a taxable transfer of property under Code Section 83. |
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| · | A taxable transfer under Code Section 83 also occurs when payments of benefits under the plan are triggered upon some change in the employer's financial health. |
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| · | Compensation deferred under the plan is subject to immediate taxation if the new rules are not followed. |
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| · | The law becomes effective for amounts deferred after December 31, 2004. Amounts deferred and vested prior to January 1, 2005 are covered under current law. A material modification to a plan after October 3, 2004, will cause that plan’s pre-2005 deferrals to be subject to the post-December 31, 2004 rules. |
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How the new rules will affect existing nonqualified plans
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| Deferral Elections The initial deferral election must now be made prior to the end of the employee’s tax year preceding the year in which the service is performed in order to avoid constructive receipt. There are two exceptions to this rule. The first is newly eligible participants, will have until 30 days after becoming eligible for the plan to make an election.; Secondly, Participants who make an election to defer performance based compensation (if based on performance over a period of 12 months or longer) have until six months prior to the end of the performance period in which to make an election. Distribution Rules The Act defines permissible distributable events for nonqualified plans. These events include: separation from service, disability, death, at a specified time or pursuant to a fixed schedule, change in control of the plan sponsor (change in control will be defined by regulation), or an unforeseen emergency. Plan termination under the new law is not defined as a distributable event. Thus, similar to Code Section 403(b) Plans, plan termination will only stop future accruals, but will not cause the movement of existing plan assets. Other significant changes to the distribution rules include: |
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| · | Distributions to a "Key Employee" who is a participant in a publicly-traded corporation's nonqualified deferred compensation plan may not be earlier than six months after the participant's separation from service. |
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| · | Disability and unforeseeable emergency now are defined by the Act and these definitions must be incorporated into the plan document. These are not as liberal as hardships in 401(k) plans. |
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| · | Specific rules for establishing the time for a distribution and/or the schedule for distribution have been defined and must be incorporated into the plan document and deferral election. |
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| · | Participants will be prohibited from changing the form of the distribution, for example, from an installment or an annuity distribution method to a lump sum. |
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| · | Participants in these arrangements may not make an unscheduled withdrawal in exchange for forfeiting a portion of their deferred compensation (a "haircut" provision) except to the extent permitted by regulation. |
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| Penalties The penalties for failure to comply with the new law expose plan participants to adverse tax consequences. Each affected participant is taxed on the compensation deferred for the current and all prior taxable years. They are also assessed interest and a 20% penalty tax unless these amounts were previously taxed or are subject to a substantial risk of forfeiture. The participant is also assessed interest at the IRS underpayment rate plus one percentage point. Only the affected participant is subject to these tax consequences. Effective Date The legislation is affective for deferrals made on and after January 1, 2005. Next Steps These rules are extremely complex and any action must be carefully considered. We recommend sponsors of these arrangements review their plan documents to determine whether the new law applies to their arrangement. They should be extremely careful about amending their existing documents until further guidance is issued. If the arrangement or plan is "materially modified" after October 3, 2004, the grandfathered treatment of prior deferrals may be lost. If you have a client that requires a new plan document, our nonqualified deferred compensation and 457 (f) plan documents have been amended to comply with the se new provisions. The Act requires that further guidance be issued within sixty days after enactment. Among other items, the guidance is to address limiting the periods in which a plan may be amended to allow a participant to terminate their participation or cancel an outstanding deferral election relating to amounts deferred after December 31, 2004 without being subject to the new rules. If you have a client that requires a new plan document, our nonqualified deferred compensation and 457(f) plan documents have been amended to comply with these new provisions. At the time further guidance is issued we will provide a further analysis of this new provision in the law and its effect on nonqualified deferred compensation plan. In the interim should you or your clients have any questions please call our consulting staff. |
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| Click here for Code Section 409(A) which is effective for amounts deferred after 12/31/2004, except as provided in Sec. 885(d)(2) and (3) of P.L. 108-357, reproduced in the history of this Code Section. | ||
Notice 2005-1 provides further IRS Guidance.
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