New Tax Rules for Nonqualified Deferred Compensation Plans

Transcription

1 OCTOBER 12, 2004 New Tax Rules for Nonqualified Deferred Compensation Plans By Brian Kopp Congress just passed the American Jobs Creation Act of 2004, and it is expected that President Bush will sign the legislation shortly. Included in the new legislation are provisions that will significantly change the tax rules for nonqualified deferred compensation plans. Employers need to review their deferred compensation plans and take prompt action to comply with the new rules, which generally become effective for amounts deferred after December 31, The new rules will apply to all nonqualified deferred compensation plans. This term is defined to include any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. Examples of qualified employer plans that are exempt from the new rules include qualified retirement plans, Section 403(b) annuity plans, Section 457(b) plans, simplified employee pension plans and SIMPLE plans. Examples of deferred compensation plans that will be subject to the new rule include nonqualified deferred compensation plans, Section 457(f) plans and supplemental executive retirement plans. Moreover, it appears that the new rules could also apply to a number of other arrangements such as phantom stock plans, stock appreciation rights, restricted stock units, discounted options (other than offered through a Section 423 plan) and other arrangements that you might not typically consider as being a deferred compensation plan. If you do not comply with the new rules, harsh consequences will follow. Generally, a participant is immediately taxed on the value of his/her deferred compensation once the benefit is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20% excise tax on the amount that is included in his/her income, as well as an interest penalty. Such amounts are treated as wages and are subject to the usual withholding rules. Given these ramifications, ignoring the new rules is not an alternative. 1 of 5

2 Here is a summary of the new rules: Less Flexibility on Timing of Initial Election to Defer. Generally, a participant electing to defer compensation for services performed during a taxable year must make his/her deferral election before the year in which the services are rendered. In other words, an election to defer compensation relating to services performed in 2005 must be made on or before December 31, Two exceptions exist. First, an exception applies for performancebased compensation that is paid based on services performed over a period of at least twelve months. This exception permits deferral elections for such compensation to be made up to six months before the end of the performance period. Second, an exception applies for individuals who first become entitled to participate in the plan. Under this exception, the deferral election must be made within thirty days of the date the individual first becomes eligible and must only apply to compensation earned after the election. Only Limited Distribution Triggers Permitted and No Accelerated Distributions. Amounts may be distributed from a nonqualified deferred compensation plan only upon the occurrence of the following events: separation from service; disability; death; a specific date established when the deferral election is made; a change in control; or an unforeseeable emergency that causes a severe financial hardship to the participant. Accelerated distributions are not permitted. For example, the practice of allowing a haircut withdrawal is prohibited, e.g., allowing a distribution to a participant if the participant is willing to incur a substantial penalty, such as a 10% forfeiture of the amount withdrawn. Less Flexibility in Changing the Time and Form of Payment. A participant will only be able to change his initial election as to the timing and form of payment under very limited circumstances. Generally, the new rules permit such changes only if the subsequent election does not become effective until twelve months after it is made; the election is accompanied by a new payment commencement date that is at least five years later than original payment date; and, in the case of an election to defer payment until a specified date, the election must be made at least twelve months before the first scheduled payment under the previous election. For example, if a participant who initially elected to receive his benefit in the form of a lump sum at termination of employment wanted to change the form to installment payments, the first installment payment could not commence until five years after the participant terminates employment. Delayed Distributions for Key Executives. Distributions to key employees of publicly traded companies cannot commence until six months after termination of employment. The definition of key employee is tied to the definition under Code Section 416(i), which generally includes: (i) officers whose annual compensation is greater than $130,000 (limited to no more than fifty employees); (ii) individuals who own 5% or more of the employer; and (iii) 2 of 5

3 individuals who own 1% or more of the employer and have annual compensation from the employer exceeding $150,000. Offshore Trusts and Trusts with Financial Triggers. The new rules are likely to end the practice of creating offshore trusts to hold assets to fund nonqualified deferred compensation benefits. Some employers have established offshore rabbi or similar trusts and have taken the position that they do not trigger immediate taxation to participants because the assets can be reached by the employer s creditors. Under the new rules, transferring assets to an offshore trust will be treated as creating a funded plan. Accordingly, plan participants will be taxed on the value of such assets (and earnings on such assets) when contributed to the trust, as well as have to pay a 20% excise tax and interest penalty. Other employers have established domestic rabbi trusts with provisions that restrict the ability of the employer s creditors to reach trust assets or require trust funding if certain financial triggers are reached (e.g., the employer s debt-to-asset ratio exceeds a certain level). The new rules also treat such a trust as creating a funded plan with the same adverse tax consequences. These new rules dramatically change the landscape for nonqualified deferred compensation plans. In fact, these rules are going to necessitate significant structural changes in many plans. Here are just a few of the ancillary impacts we envision: Many SERPs link the form of a participant s SERP benefit to the distribution form the participant elects under the employer s qualified pension plan. It appears that this linkage may not work under the new rules. Some plans allow participants to defer bonuses during the year the bonus is earned but before the bonus is determined. This practice will have to change to comply with the new deferral election rules. Some employers allow participants to defer gains from the exercise of stock options under a nonqualified deferred compensation plan. The new law will likely prohibit the deferral of such income under techniques that are currently used (e.g., allowing deferrals of option gains after the option vests but before the option is exercised). In order to introduce more flexibility into the timing and form of benefits, some plans permit payments to be made at the discretion of the employer notwithstanding an employee s original elections. The expectation was that the employee would not be in constructive receipt of income prior to actual payment if the employer, rather than the employee, had control over the payment. The new law s prohibition of payment until the occurrence of an originally elected payment date (termination of employment, a fixed date, change of control, etc.) suggests that these discretionary distributions will no longer be permitted. If you have an existing plan and are considering amending it to liberalize its rules, you should stop considering such an amendment immediately. The new rules will apply to amounts 3 of 5

4 deferred under existing plans if the plan is materially modified after October 3, 2004, to increase any benefit, right or feature under the plan. Accordingly, no liberalizing amendments should be made to your current plan if you want to grandfather existing deferrals under the old rules. The new rules raise many questions that need to be answered so that taxpayers can revise their plans. Congress understood this and has asked the IRS to issue guidance within sixty days from the date the statute is enacted to answer some of the questions. So what s an employer to do in light of this change? First, we would advise you to carefully review your plans to determine which plans may be subject to the new rules. Arrangements that you have not historically viewed as nonqualified deferred compensation plans should be considered. For example, a provision in a particular employee s employment contract could fall within these rules. Likewise, the rules may affect certain types of grants under an employer s equity compensation plans. Second, after you inventory your plans, you should carefully consider whether your current plans comply with the new rules. Third, you should develop a strategy for complying with the new rules. This may include amending current plans or adopting new plans. Fourth, you will need to carefully communicate the changes to participants. This is going to be a challenging task because the new rules are complicated. Moreover, participants are likely to have significant anxiety over how the new rules will affect their current benefits. 4 of 5

5 Employee Benefits Team Please feel free to call or your usual contact or any of the attorneys on our Employee Benefits Team listed below. ATTORNEY NAME PHONE BOSTON Thomas McCord tmccord (617) Laura Sanborn lsanborn (617) ROCHESTER Christian Hancey chancey (585) Brian Kopp bkopp (585) Lori Stone lstone (585) Bob Wild rwild (585) Albany, NY Omni Plaza 30 South Pearl Street Albany, NY Boston, MA 100 Summer Street Boston, MA Buffalo, NY 1600 Main Place Tower Buffalo, NY Garden City, NY 990 Stewart Avenue Garden City, NY Hartford, CT CityPlace 185 Asylum Street Hartford, CT Manchester, NH 889 Elm Street Manchester, NH McLean, VA 2010 Corporate Ridge, Suite 700 McLean, VA New York, NY 437 Madison Avenue New York, NY Orange County, CA 2040 Main Street, Suite 850 Irvine, CA Philadelphia, PA 1818 Market Street Philadelphia, PA Providence, RI One Citizens Plaza Providence, RI Rochester, NY Clinton Square Post Office Box Rochester, NY San Francisco, CA Two Embarcadero Center San Francisco, CA Washington, DC 401 9th Street, N.W., Suite 900 Washington, DC