Sweeping Changes are Here for Exec Benefit Packages

As published in the Nashville Business Journal

Sweeping changes in the rules concerning nonqualified deferred compensation plans will have a far-reaching impact on a considerable number of programs that have been established to benefit corporate executives. The recent legislation will require virtually all non-qualified deferred compensation plans to be reviewed, and will require most of them be revised before the end of the year to meet the requirements of the new law. The American Jobs Creation Act of 2004, signed into law on October 22, added Section 409A to the Internal Revenue Code. This section tightens the rules governing nonqualified deferred compensation plans. Failure to satisfy the new rules can result in financial penalties on the employees who participate in the plan.

Plans subject to the new rules: The new rules apply to "nonqualified deferred compensation plans," which is defined quite broadly to include not only deferrals of otherwise-taxable wages, but also SERPs (supplemental executive retirement plans) and any other arrangements that result in the deferral of compensation. Plans benefiting "one person" are specifically covered. The new rules also apply to arrangements with non-employees such as consultants and directors. The new rules do not apply to "qualified employer plans," which includes private sector tax-qualified retirement plans (such as 401(k) plans), and 403(b) and 457(b) arrangements sponsored by tax-exempt organizations.

Rules for deferral elections: Under current law, deferrals of income can be made as long as the income is not yet "payable and ascertainable," a fuzzy concept at best. The new rules establish a bright-line test for the deferral of compensation in nonqualified plans. To be effective, a deferral must be made by December 31 of the preceding year in which the compensation is earned. The legislative history clarifies that the new regulations will require that deferrals of "performance-based compensation" be made no later than six months before the end of the measuring period, usually an employer's fiscal year. For employees of calendar year employers, this will mean that deferrals of performance-based bonuses must be made by June 30. A special rule for new participants allows them 30 days after becoming eligible in a plan to make an initial deferral of earnings, which can only apply to earnings after the date of the deferral election.

Rules for permitted distributions: Many nonqualified plans currently allow some degree of flexibility to participants regarding the timing of the distribution of their benefits. That will also change under the new rules. The new general rule requires that the time and form of a distribution must either be specified by the participant at the time of making a deferral or specified in the plan document. In addition, distribution of benefits can only be allowed upon the occurrence of certain specified events, including: separation from service, disability, death, a specified time (e.g., reaching a specified age or a specified date, but not the occurrence of a event, such as a child starting college), a change in control, or on account of an "unforeseeable emergency". A special rule likely to receive considerable interest requires that "key employees" of public companies (generally, officers earning more than $130,000 per year) who are separated from service must wait at least six months following separation from service to receive a distribution resulting from such separation.

Common distribution triggers no longer permitted: "Haircut" provisions, which allow participants to receive a distribution at any time in return for participant forgoing a portion (usually 10%) of his plan benefits, are common in many current plans. Other plans allow participants to accelerate a series of installment payments that would otherwise be made, as long as such election is made at least a year in advance of when the payments were scheduled to begin. The new rules expressly prohibit all such accelerated distributions, except as may be allowed under IRS regulations.

Changes in the time and form of distribution limited: Many plans also allow participants to change the time and form of distributions, as long as elected at least a year in advance. Under the new rules, a participant must still make such an election 12 months in advance, but the election to defer any payments must extend the first payment at least five years from the time the first payment was originally scheduled. 

The cost of violating the new rules: The new rules apply on a participant-by-participant basis.  If a participant makes a deferral to a plan that does not satisfy the new rules, all amounts deferred by such participant, including amounts deferred in other open tax years, are taxable. The only exception is if the deferred amounts are subject to a "substantial risk of forfeiture," in which case taxation occurs as required under Section 83, generally upon vesting. In addition, the new rules impose a penalty tax of 20% of the failed deferral, and interest at the tax underpayment rate plus 1%. These potential costs should cause most participants to pay special attention to the terms of their employer's plan.