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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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