Non-Qualified Deferred Compensation Plans After the American Jobs Creation Act of 2004

The American Jobs Creation Act of 2004 (the”Act”), was signed into law by President Bush on October 22, 2004. While the Act was originally proposed to compensate US businesses for the loss of US export subsidies declared illegal by the World Trade Organization, as finally enacted, the Act contains a variety of benefits for all manner of businesses. The Act also contains provisions which can adversely affect individual taxpayers. Among them are major changes to the tax treatment of non-qualified deferred compensation plans. If plan sponsors do not review their existing non-qualified plans and make appropriate changes, the beneficiaries of those plans could have significant tax liabilities in 2005.

Prior to the adoption of the Act, employees or independent contractors could enter into non-qualified deferred compensation agreements to defer the receipt of current compensation, and the tax due on such compensation until actual (or constructive) receipt of the funds. Further, it was possible for the employer to segregate funds for the payment of these deferred liabilities, in a trust (“rabbi trust”) as long as the funds were still subject to the general claims of creditors. Generally, a rabbi trust contains a trigger mechanism which accelerates the distribution of the funds or seals the trust against claims of the business’s general creditors if the business experiences financial difficulties. Now, unless a very strict set of rules are followed, a participant in a non-qualified deferred compensation plan will be immediately taxed on all deferrals which do not comply with the new statute.

The new law (Internal Revenue Code section 409A) apples to essentially all non-qualified deferred compensation plans including, voluntary deferral plans, excess benefit, supplemental and bonus plans, phantom stock plans, and rabbi trusts. An individual employment agreement which permits the deferral of compensation will also be subject to the new rules. Excluded from the scope of the section are qualified employer plans ( under Code section 401(a)), SEP and SIMPLE plans and certain governmental plans. Also excluded are “any bona fide vacation leave, sick leave, compensatory time disability pay or death benefit plan.” (Code section 409A(d)(1)) The Act applies to both employees and independent contractors who benefit under a covered non-qualified plan. Plan sponsors will be required to report on an employee’s W-2 or an independent contractor’s 1099 amounts deferred in a non-qualified deferred compensation plan.

A participant in a non-qualified plan under the Act must make deferral elections in the taxable year prior to the year in which services are performed, with a 30-day window for elections by new participants. Elections with respect to performance-based bonus compensation must be made at least 6 months before the end of the performance period. Benefits may distributed only upon the occurrence of specific events. These include death, disability, an unforeseen emergency, separation from service (with a 6-month delay for key employees of a publicly traded company), a change in control or a specified dated or fixed schedule that is specified at the time of the election to defer. The date for distribution or schedule of payments may be extended in very limited circumstances.

A non-qualified deferred compensation plan which allows distributions other than as permitted by section 409A or allows impermissible changes in the time or manner of payments will cause participants to loose the benefits of the deferral in income recognition. Similarly, if a plan contains a trust or other arrangement to accelerate payments or to insulate funds from the employer’s general creditors, income deferral will not be available. In such event the participants will be subject to immediate taxation on all their deferred income unless such income is subject to a substantial risk of forfeiture. Interest at the underpayment rate, plus 1% will be imposed on the underpayment that would have occurred at the time of the initial deferral or if later, at the time the funds were no longer subject to a substantial risk of forfeiture. The amount included in income will also be subject to an additional 20% tax.

These new rules will apply to amounts accrued or deferred under non-qualified deferred compensation plans after December 31, 2004. Amounts deferred in plans prior to January 1, 2005 will also be subject to these rules if the plan is materially modified after October 3, 2004. A grace period will be allowed for sponsors to freeze or terminate existing plans to eliminate the need to comply with the Act or to modify them to protect past or future deferrals from immediate taxation.

Businesses need to review existing non-qualified benefit plans and employment agreements to determine, which may be subject to Code section 409A. Existing plans with large account balances or attractive payment features may be frozen with no further contributions or accruals. New plans which comply with the Act may need to be established. Every plan which falls within the reach of the Act must either be amended, frozen or terminated to prevent unintended tax consequences to participants.

Attorneys at Akabas & Sproule can assist you if you have any questions about the interpretation or possible application of new Code section 409A, or in reviewing existing deferred compensation agreements and determining the most appropriate response to this new legislation.

The information in this article is intended solely for your information. It does not constitute legal advice. You should always seek the legal advice of competent counsel in your jurisdiction.