Tax Law Alert: Overview of New Deferred Compensation Law
12/15/2004
By now you are likely aware of the new law, the American Jobs Creation Act of 2004, that changes the tax rules for non-qualified deferred compensation, effective January 1, 2005. The new law makes sweeping changes and also raises many questions. The IRS is expected to provide some transition guidance on December 17, 2004 to address some of the outstanding questions about the new law. In most cases, it is advisable to wait and make decisions about how to comply with the new law after the IRS issues guidance. We plan to send a Client Alert to our clients soon after the guidance is issued.
Highlights of the New Law
In the meantime, here are a few highlights of the new law:
- Deferral Elections
Generally, elections to defer compensation must be made before the beginning of the taxable year in which it is earned. There is an exception for performance-based compensation. If the performance period is at least 12 months long, the election to defer compensation may be made no later than 6 months before the end of the performance period.
- Distributions: Time and Form of Payment
At the time an employee elects to defer compensation, the employee must also specify when distributions will begin and the form of payment. An employee may later decide to further delay the distribution date (by five years or longer), but may not accelerate payments. The new law disallows "haircut" provisions under which participants have been allowed to cash out a benefit early by agreeing to give up part of the benefit. Other common designs for deferred compensation will be restricted or prohibited by the new law, such as giving the employer an unrestricted right to terminate the plan and cash out all participants and "coat-tailing" (having deferred compensation automatically pay out at the same time and in the same form as the participant chooses when starting benefits under a qualified retirement plan).
Distributions are permitted only upon separation from service, disability, death, a specified time elected at the date of deferral, "change of ownership," or unforeseeable emergency. Also, key employees in public companies must wait for 6 months after separation to begin receiving benefits.
- Reporting and Penalties
Employers will be required to report compensation deferrals on the employee's Form W-2 for the year of deferral. Penalties for non-compliance are severe. The affected employee can be taxed on all deferrals, for all years, with interest and owe a 20% penalty tax.
Actions by December 31, 2004
While awaiting IRS guidance, you may want to consider the following steps:
- Inventory Your Arrangements
and Begin Planning for Amendments
The new law may affect a broad range of deferral arrangements, including salary and bonus elective deferral plans, 401(k) mirror plans, supplemental executive retirement plans, board of directors deferral plans, severance arrangements, and individual employment contracts. It also may affect discounted stock options, stock appreciation rights, restricted stock units, performance units/shares, phantom stock, and deferred stock option gains. Now is a good time to identify arrangements that may need to be modified in the future to comply with the new rules. You may also want to confirm that the appropriate amendment authority and procedures are in place. Public companies should also consider whether potential amendments will trigger public company reporting and disclosure obligations.
- Communicate with Participants
You may want to alert participants who will be affected by the new rules to let them know you are monitoring the new law and will communicate any plan design changes after the compliance strategy is determined.
The IRS has informally indicated that companies should continue "business as usual" until additional guidance is issued. The regulations are expected to provide for liberal transition rules to allow participants to confirm or modify elections made through December 31, 2004. However, many companies are also making special efforts to ensure that deferral elections with respect to 2005 compensation (including 2005 bonuses to be paid in 2006) are signed by participants on or before December 31, 2004 and that such elections specify the time and form of payment.
- Do Not Modify Existing Arrangements
Benefits under existing arrangements that are accrued and vested as of December 31, 2004 will not be subject to the new rules, provided the existing arrangement is not materially modified to improve or accelerate benefits on or after October 3, 2004. A material modification could result in significant tax consequences with respect to existing deferrals. For example, if a plan is frozen or terminated after October 3, 2004, and distributions are triggered as a result of the freeze or termination, that modification could subject deferrals for all prior years to retroactive taxation and penalties.
- Watch for More Guidance
The IRS has already started issuing guidance that relates to the new law. For example, Announcement 2004-96 explains that 2005 deferrals must be reported on Form W-2, Box 12 and should be coded "Y." The first wave of IRS guidance under the new law is expected on December 17, 2004, and the IRS has indicated that additional guidance will be issued during 2005. Employers will likely need to monitor new guidance for at least the next 12 months.
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If you have any questions about this update or if you would like our assistance in this matter, please call your Stoel Rives lawyer or any of the following lawyers:
Stuart Chestler, schestler@stoel.com, 503-294-9500
Ronald Grossmann, rsgrossmann@stoel.com, 503-294-9214
Chris Heuer, ckheuer@stoel.com, 503-294-9206
Dick Hopp, rahopp@stoel.com, 206-386-7609
Jeffrey Krueger, jmkrueger@stoel.com, 503-294-9856
Carl Lewis, cslewis@stoel.com, 206-386-7688
Dennis Leybold, dleybold@stoel.com, 503-294-9424
Greg Macpherson, ghmacpherson@stoel.com, 503-294-9205
Peggy Noto, mhnoto@stoel.com, 503-294-9348
Bob Thomson, rhthomson@stoel.com, 503-294-9585
Mimi Warner, mgwarner@stoel.com, 206-386-7628
Steve Woodland, sdwoodland@stoel.com, 801-578-6976
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