Employee Benefits Advisory Bulletin
New Tax Law Requires Prompt Action on Nonqualified
Deferred Compensation Plans
By Jeff
Belfiglio
[Oct. 2004]
The American Jobs Creation Act, passed Oct.
11, includes the most significant changes to nonqualified deferred
compensation plans in decades. These changes will affect elections
made in the next two months to defer compensation earned after Jan.
1, 2005. Plan sponsors must understand the changes, communicate
them to participants, and review their election procedures before
the end of 2004. As to plan documents, the IRS has informally said
that it plans to issue a “model” amendment, probably
coupled with an extension to allow plan sponsors a reasonable amount
of time to amend their plans. As explained below, the new law eliminates
aggressive practices such as late deferral elections and early distributions
with a “haircut.” But it also creates pitfalls for many
common plan designs.
Action Needed Now
- Inventory all affected plans. This includes
not only salary deferral plans, but defined-benefit style SERPs,
stock appreciation rights (SARs), deferrals of stock option gains,
discounted stock options, and individual contract arrangements.
The IRS has indicated it may issue guidance easing the rules for
some of these plans, but the employer must know all potentially
affected plans.
- Correct elections for 2005. Make sure that
elections to defer 2005 salary are made by Dec. 31, 2004 and include
a choice of the time and form of distribution, as explained below.
Companies may want to pay or permit deferral of 2004 bonuses before
the end of the year to make sure they fall under the prior law,
although transition relief is expected for deferrals of 2004 bonuses
payable in 2005.
- Review plan features. Determine which plan
features do not comply with the new rules and how to revise them.
Some examples are given below.
- Decide whether to grandfather pre-2005 deferrals.
The old law applies to them, unless the plan is amended to conform
to the new law. Some employers will prefer to freeze existing
plans and implement new plans for future deferrals. The IRS is
supposed to issue guidance on how to amend or “unwind”
existing plans.
- Get board approval. We will not know how quickly
action will be needed until IRS transition guidance appears. It
may be prudent to obtain your board’s authority to revise
the plan (or institute a new plan) in order to comply with the
law, and delegate authority to management to implement the changes.
However we recommend waiting until after IRS guidance, which is
supposed to be issued within 60 days, before adopting an amended
plan.
New Rules for Nonqualified Deferred Compensation
The American Job Creation Act changes several current practices.
Timing of Initial Deferrals. The act adopts the
IRS’s long-held position that salary deferrals must be made
before the beginning of the year in which the salary is earned,
except that new plan participants have 30 days after their eligibility
date to elect their deferrals for the remainder of the year. For
performance-based bonuses earned over a period of at least 12 months,
the election must be made at least six months before the period
ends. Example: for a 2005 calendar year
bonus paid in February 2006, any deferral election must be made
by June 30, 2005. Many plans currently allow bonus deferral elections
later in the year.
Method of Distribution. The time and method of
distribution of the deferrals must also be chosen at (or before)
the time the deferral election is made. The participant will have
to elect one of the distribution times allowed by the plan (see
below) and a form of distribution. Combined with the new rule that
no acceleration of distributions is allowed, participants who want
to preserve the option of taking a lump sum will have to elect that
form up front. They will have a limited opportunity to change the
election later (see below).
Distribution Dates. Plans will be allowed to offer
the choice of distributions only upon:
- Separation from service (with a 6-month delay for key employees
of public companies)
- Death or disability (as determined by Social Security or under
an LTD plan)
- A date or fixed schedule specified at time of deferral (Example:
distribution at age 65 or starting after 10 years is allowed;
distribution when a child starts college is not)
- Change of control of the employer or sale of a substantial
part of its assets
- Unforeseeable emergency (a strict definition of hardship)
Different elections can be made for different events, such as a
lump sum upon separation from service but installments starting
at age 65.
Subsequent Elections. Changes to initial elections
are severely limited, much more so than most current plans. The
subsequent election must be made at least 12 months before a scheduled
payment of deferred compensation and cannot be effective for at
least 12 months. No acceleration of the time or schedule of payments
is permitted, either by the employee or unilaterally by the employer.
Any additional deferral of receipt must be for a period of at least
five years after the date the payment would otherwise have been
received. This rule is expected to impact all plans with a “rolling
risk of forfeiture,” although again IRS guidance is needed.
Example: the participant makes an initial
election after 2004 to receive a lump sum distribution at age 65.
To delay that payment, he or she would have to elect, before age
64, to delay payment for at least another 5 years (to age 70), and
could change to installment distributions.
These election rules pose special problems for SERPs, which are
often structured to mirror the participant’s elections as
to time and method of distribution made under the qualified plan,
which is not subject to these constraints. The IRS is expected to
issue guidance on how to revise SERP election procedures. Likewise,
SARs that allow a participant to choose when to exercise a SAR after
it has vested are effectively allowing a subsequent election and
will not meet these rules.
Other Issues. The act prohibits other less common
features of some plans, such as offshore trusts and transfers to
a rabbi trust triggered by changes in the company’s financial
condition.
Effective Date. Generally the law is effective
for deferrals made after 2004. Deferrals made before 2005 under
existing plans are governed by current law, unless the plan is amended
after October 3, 2004 to expand the participant’s rights,
in which case all deferrals are subject to the new rules. New plans
adopted after October 3, 2004 are subject to the new law.
Special Note for Non-Profit and Government Plans.
The final act exempts all eligible 457(b) plans, so they
can continue to operate as before. It does apply to all ineligible
457(f) plans, including past deferrals that have not vested. While
457(f) plans that simply pay out a lump sum upon vesting at a specified
date should not be affected, each 457(f) plan should be reviewed
for any provisions that conflict with the new time of payment rules.
Also, many 457(f) plans use a “rolling risk of forfeiture,”
where vesting is periodically delayed at the participant’s
election. The IRS is authorized to issue regulations that are likely
to eliminate or severely restrict this practice for future deferrals.
For more information on the new rules, contact any
of the following or your usual DWT business contact:
Ralph
L. Hawkins, Seattle, (206) 628-7673, RalphHawkins@dwt.com
Anne
L. Northrup, Seattle, (206) 628-7735, AnneNorthrup@dwt.com
Stuart
Harris, Portland, (503) 778-5428, StuartHarris@dwt.com
This
Employee Benefits Advisory is a publication of the Employer Services
Department of Davis Wright Tremaine LLP. Our purpose in publishing
this Advisory is to inform our clients and friends of recent developments
in employment law. It is not intended, nor should it be used, as
a substitute for specific legal advice as legal counsel may only
be given in response to inquiries regarding particular situations.
Copyright
© 2004, Davis Wright Tremaine LLP.
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