By Robert L. Thomas and Jean H. Bender
In October 2004 Congress enacted the American Jobs Creation Act of 2004 (the “Act”). The Act adds a new Section 409A to the Internal Revenue Code which significantly changes the operation and taxation of nonqualified deferred compensation arrangements (“NQDC”) for amounts deferred or that become vested on or after January 1, 2005.
The Act instructs the IRS to issue regulations and guidance in implementing the new requirements. At the end of December, the IRS issued Notice 2005-1. Although the guidance addresses many important questions, it leaves to subsequent guidance issues relating to certain distributions, plan documentation and consequences of noncompliance with Code §409A.
Below is a brief summary of the Act’s rules relating to NQDCs. Under Section 409A, a NQDC plan is any plan that provides for the deferral of compensation other than tax qualified retirement plans (such as a 401(k) Plan) or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans. Therefore, NQDC plans include stock appreciation rights plans (SARs), phantom stock arrangements, and other similar employer equity participation arrangements.
Effective Date/Plan Amendments
The new law applies to amounts deferred in 2005 or later and generally does not apply to amounts deferred in 2004 or earlier. For this purpose, “deferred” means both earned and vested. Therefore, only vested amounts will be grandfathered under the existing law; amounts that have been deferred before 2005 but do not vest until 2005 or later are subject to the new rules.
An employer has until December 31, 2005 to amend its plan(s) to comply with Code §409A. Pending amendment, effective January 1, 2005, employers must operationally comply with Code §409A and Notice 2005-1.
Material Modification
Vested balances in existing plans are only grandfathered if there are no material modifications to the plan after October 4, 2004. A material modification will occur if the employer adds or enhances a benefit or right existing as of October 3, 2004. Amending the plan solely to comply with Code §409A generally will not be a material modification, unless it adds or increases a benefit.
Participant Elections
A plan must provide that compensation for services performed during a taxable year may be deferred at the participant’s election only if the election to defer is made no later than the close of the preceding taxable year with a transitional period in 2005. In the case of a participant’s first year of eligibility, the election may be made with respect to services to be performed subsequent to the election within thirty (30) days after the participant’s eligibility date. In the case of any performance-based compensation based on services performed over a period of at least twelve (12) months, the election may be made no later than six (6) months before the end of the service period.
Distributions
Under new Section 409A, the time and form of distributions of deferred compensation must be specified either in the plan or by the participant at the time the deferral election is made. Distributions from a NQDC plan only are allowed upon: (1) separation from service; (2) disability of the participant; (3) death; (4) a specified time (or pursuant to a fixed schedule) in the plan determined at the date of deferral; (5) change in the ownership or effective control of a corporation or in the ownership of a substantial portion of the assets of a corporation; or (6) occurrence of an unforeseeable emergency.
No acceleration of distributions are allowed, except as permitted by future regulations. A subsequent election to defer distributions can only become effective twelve (12) months after the date the election is made. In addition, if the participant is further deferring a payment that was to be made at a specified time, the participant must make the subsequent election at least twelve (12) months in advance of the scheduled payment date, and the new election must defer the payment for at least five (5) years from the time the payment was originally scheduled to be made (except in the case of death, disability, or unforeseeable emergency). Changes in the form of payment (e.g. lump sum to annuity) must also comply with these rules.
Reporting
Amounts required to be included in income are subject to reporting and federal income tax withholding requirements. Deferred amounts are required to be reported annually to the IRS. Such amounts are reported on an individual’s Form W-2 (or Form 1099) for the year deferred even if the amount is not currently includible in income for that taxable year. The rules regarding the timing of an employer’s deduction for nonqualified deferred compensation are not affected by these tax law changes.
Consequences of Noncompliance
For tax years beginning on or after January 1, 2005, unless the NQDC Plan meets the requirements of Section 409A discussed above, all amounts deferred under the NQDC plan will be includible in the employee’s gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. If the requirements of Section 409A are not met, in addition to income inclusion, interest at the underpayment rate plus 1% will be imposed and the amount required to be included in income will be subject to a 20% additional tax.