On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (referred to below as the “Act” or “AJCA”). This legislation makes significant changes to the rules governing nonqualified deferred compensation arrangements – which can include anything from a plan covering several executives to an individual’s own employment contract. Failure to comply with these new rules will result in current taxation as well as significant tax penalties.
The new rules are effective beginning January 1, 2005, requiring employers to take immediate action to avoid harsh tax consequences to executives and other employees covered by nonqualified deferral arrangements. This alert highlights the Act’s main provisions and recommends action steps that employers should take at this time in light of the short time frame between the law’s enactment and effective date. In addition, because of the amount of uncertainty prevailing until the IRS issues guidance, certain recommendations in this Alert relate to actions not to take, at the risk of jeopardizing current plans.
Overview of New Nonqualified Deferred Compensation Requirements
The Act imposes a number of new requirements and restrictions on nonqualified deferred compensation arrangements. These requirements focus primarily on the following areas: (1) deferral elections; (2) timing of distributions; (3) acceleration events; and (4) limitation on certain types of funding arrangements. Under the new rules, deferral elections generally will be required to be made prior to the year in which services are performed, subject to special rules related to the deferral of performance-based compensation. The Act also restricts the timing of distributions from nonqualified deferred compensation arrangements to specified triggering events. The acceleration of distributions through provisions such as “haircut” clauses (clauses that allow distribution subject to a penalty) is now prohibited. Some types of funding arrangements are also prohibited by the Act, specifically foreign-based rabbi trust arrangements and “springing” rabbi trusts that become funded only if the employer becomes financially distressed. Failure to follow the new rules will result in the deferred compensation being immediately includible in income and subject to a 20% excise tax.
One of the most important.aspxects of the new legislation is its broad coverage. Generally, the Act applies to any type of plan, arrangement or agreement that results in the deferral of compensation, the only exceptions being qualified retirement plans, 457(b) plans and bona fide vacation, sick leave, compensatory time, disability pay or death benefit plans. As a result of the Act’s broad coverage, many types of arrangements not generally thought of as deferred compensation arrangements will be subject to the Act’s requirements, such as certain severance plans or equity compensation plans. For example, stock appreciation rights and phantom stock will most likely be subject to these new rules even if paid in the form of stock. Discounted stock options will also likely fall within the Act’s coverage provision.
As mentioned above, the Act is effective for compensation deferred on or after January 1, 2005. It is important to note that amounts are considered deferred before January 1, 2005 only if they were earned and vested prior to that date. Therefore, compensation deferred prior to January 1, 2005 will not be grandfathered if not vested. In addition, arrangements will lose grandfathered status and be subject to the new rules if “materially modified” on or after October 3, 2004.
The Act directs the Internal Revenue Service to issue general guidance on the new requirements within 60 days of enactment (by December 21, 2004) and guidance regarding change in control provisions within 90 days of enactment.
Next Steps
In light of the short time until the Act’s effective date and the need for additional guidance and clarification on many issues, we recommend that employers take the following actions at this time:
- Inventory and review current compensation arrangements or agreements for those that could potentially be subject to the new Act and provisions that might require amendment. As mentioned above, the Act covers a broad range of compensation arrangements that result in the deferral of income. Employers should review all employment agreements, SERPs (supplemental executive retirement plans), nonqualified deferred compensation arrangements, section 457(f) plans (tax-exempt employers), equity-compensation arrangements, severance plans, bonus arrangements, and other similar types of agreements or arrangements to determine which ones could potentially be subject to the Act and identify those provisions that might require amendment.
- Do NOT make any amendments to existing agreements or plans that are or could be subject to the Act. Because the Act will apply to any existing arrangements that are materially modified on or after October 3, 2004, we recommend that employers take NO action at this time to amend existing plans, agreements or arrangements that are or arguably could be subject to the Act. The IRS has indicated that it intends to broadly construe the “material modification” provision, including any change to benefits, rights or features, termination of an arrangement or the exercise of discretionary authority under an existing arrangement.
- Determine existing amendment provisions and obtain expedited amendment power. The short time period between the AJCA’s enactment and the January 1st effective date, coupled with anticipated IRS guidance that will not be issued until December, puts employers in a difficult position for compliance purposes. Although it is likely that for compliance purposes the IRS will provide a transition period during 2005 (and the IRS has informally indicated that it will do so), we recommend that employers review existing arrangements for amendment provisions and be certain that the employer, through its board or a designated group or committee, is in a position to take expedited action under those amendment provisions if the need should arise following the IRS guidance in December.
- Watch for future updates. Employers will need to take action following the issuance of IRS guidance mandated by the Act. Therefore, watch for future updates from us in late December or early January regarding recommended compliance actions based on IRS guidance.
These are just a few suggestions for immediate action; if you have questions about the Act or would like our assistance in reviewing your arrangements, please contact Lesley Russo at 304-347-1717 or Melody Simpson at 304-347-1755. Moreover, if your employees are asking questions about the impact of this Legislation on their arrangements, please contact us and we can provide you with a model Notice to Employees that you may wish to utilize.
The author presents these materials with the understanding that the information provided is not legal advice. Due to the rapidly changing nature of the law, information contained in this publication may become outdated. Anyone using these materials should always research original sources of authority and update this information to ensure accuracy when dealing with a specific matter. No person should act or rely upon the information contained in this publication without seeking the advice of an attorney.
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