Nonqualified Deferred Compensation Plans
A Review Is Required

The American Jobs Creation Act of 2004 imposes new, stricter rules on nonqualified deferred compensation arrangements. If your organization currently has one or more of these arrangements in place, you should review them now in light of the new law.

The Basics 

Nonqualified deferred compensation arrangements generally allow employees to defer the taxation of part of their current compensation to later years. Often, these nonqualified plans are used for highly paid executives who have already deferred the maximum pay allowed under qualified plans, such as 401(k) plans.

The basic premise behind nonqualified arrangements is that the deferred compensation is not taxable as long as there are “strings attached” to the ability of the participating employee to withdraw the deferrals. For example, these strings could include a risk of forfeiture if the employee should leave employment or if the employer should go out of business.

Over the past several years, strategies were developed that allowed tax deferral in situations that lawmakers believed were inappropriate. Some nonqualified arrangements, for instance, contained so-called “haircut” provisions that allowed employees to make nonqualified plan withdrawals on request, subject to the forfeiture of a minimal portion of the benefits.

The 2004 Law Changes 

The American Jobs Creation Act (AJCA) clarifies that any plan that provides for the deferral of compensation constitutes a nonqualified deferred compensation arrangement, except (1) qualified employer plans (such as a qualified pension or profit sharing plan or 401(k), a 403(b) tax-deferred annuity, or SIMPLE plan, among others) and (2) bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans. Also excluded are bonuses paid within 2½ months after the end of the tax year in which the services were performed.

In general, AJCA provides that, for amounts deferred under a nonqualified deferred compensation plan after December 31, 2004, new rules apply as to when income deferral is allowed. The new law imposes strict requirements governing distributions, as well as rules governing the acceleration of benefits and when and how the initial deferral election and any later election to change the time or form of distribution must be made.

If the new requirements are not met, all compensation that is deferred under a nonqualified plan for the current tax year and all preceding tax years is includable in the participant’s gross income for the tax year (to the extent the deferrals are not subject to a substantial risk of forfeiture). Therefore, failure to meet the new rules will not only result in current-year deferrals being disallowed, but also will mean that all prior deferrals under the plan will be accelerated into income for that year.

In addition to taxes, the law imposes interest on underpayments of tax that would have occurred had the compensation been includable in income when first deferred (or, if later, when not subject to a substantial risk of forfeiture). The interest is calculated at the IRS underpayment rate plus one percentage point. The amount includable in income is also subject to a 20% penalty.

It is important to note that the new rules will apply to amounts deferred in tax years beginning before 2005 if the arrangement has been materially modified after October 3, 2004.

What You Should Do Now 

The IRS is expected to issue guidance soon as to how the new rules will apply to existing nonqualified arrangements that continue into 2005. However, because the timing of the regulations is likely to be late December, we strongly recommend that you arrange to meet with us soon.

We can discuss with you any existing nonqualified arrangements (including “plans” that might now be considered nonqualified arrangements, such as certain employment contracts) in light of the new law and what steps might have to be taken (possibly including freezing the existing plan). For more information, contact us today.

The information provided in the newsletter has been obtained from sources believed to be reliable but its accuracy is not guaranteed.