Required Changes to Non-Qualified Deferred Compensation Plans
On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004. This legislation adds new Section 409A to the Internal Revenue Code. Section 409A will require most employers to amend their non qualified deferred compensation plans (“NQDCPs”) and to operate the plans under new rules imposed by Section 409A.
Failure to comply with Section 409A will lead to immediate taxation of deferrals, with interest and penalties. Section 409A is generally applicable to amounts deferred after December 31, 2004; this gives employers only a short time to address the new legislation.
What Plans Are Subject to Section 409A? Section 409A covers every “non qualified deferred compensation plan.” This means any plan that provides for the deferral of compensation other than a “qualified employer plan” or a bona fide vacation, sick leave, compensatory time, disability pay or death benefit plan. Section 409A will apply to a supplemental executive retirement plan (sometimes referred to as a “SERP”), a phantom stock plan, a stock appreciation rights plan, a severance plan or a “457(f) plan” for executives of tax exempt employers.
How will Section 409A Affect Deferred Compensation Plans? In general, Section 409A will affect (1) when benefits can be paid under a NQDCP, (2) when a participant must make elections to defer compensation; and (3) the manner in which unfunded benefits are secured.
Payment of Benefits: Section 409A requires that compensation deferred under a NQDCP may not be paid earlier than the participant’s separation from service, disability, death, at a time or under a schedule specified at the date of deferral, following a change of control or upon an unforeseeable emergency. New Section 409A provides definitions of “disability, change in control and unforeseeable emergency. In addition, payment must be deferred for six months after separation from service for “key employees” of companies whose stock is publicly traded.
Elections: Generally, if a NQDCP allows a participant to elect to make deferrals of compensation, the deferral elections must be made no later than the close of the taxable year preceding the year compensation to be deferred is earned. Different requirements apply for the first year in which a participant becomes eligible to participate in a NQDCP and for bonuses. Many NQDCPs require that the participant elect the timing and form of payments under the plan, but also permit the participant to change his or her election. Section 409A places substantial restrictions on changes in the time and form of payment.
Rules Relating to Funding: Section 409A also provides severe tax consequences if assets deferred under a NQDCP are held in an off-shore trust or if the NQDCP provides that the assets will be restricted to payment of plan benefits if the employer’s financial health changes.
What Happens if a NQDCP Fails to Follow the Rules of Section 409A? If a NQDCP fails to meet the requirements of new Section 409A, all compensation deferred under the plan in that taxable year, and all preceding taxable years, may be includible in the participant’s gross income. In addition, the normal income tax will be increased by the amount equal to 20% of the compensation, plus interest at the IRS underpayment rate, plus 1 percentage point.
What Immediate Steps Should An Employer Take? The first step is for an employer to identify and inventory every plan or arrangement subject to new Section 409A and determine areas in which changes will be required as a result of Section 409A. Second, the employer should consider a fail safe amendment to each NQDCP to provide that all deferrals made after 2004 will be subject to the requirements of Section 409A. Unless guidance from the IRS provides a later date, we recommend this amendment be adopted prior to January 1, 2005. Finally, the employer should communicate in writing to all participants, advising them of the required changes and restrictions.
This article is for general information only and does not constitute legal advice. Please contact one of the attorneys named below if you have any questions. Paul W. Madden 410-347-8742 Mary Claire Chesshire 410-347-9465