What Congress Did To Deferred Compensation Arrangements New rules for timing of deferrals and distributions
By John H. Fenton
President Bush recently signed the American Jobs Creation Act of 2004, a massive tax bill that includes new rules for nonqualified deferred compensation (NQDC) plans.
NQDC plans are a popular way for employers to attract and reward key employees. In exchange for deferring compensation, an employee can avoid current taxation and receive the compensation, along with some growth, at a later date. It is not a riskless trade-off, however. To avoid current taxation, the employee must bear some risk of losing the money, either by failing to meet conditions imposed by the plan or, in the event of financial trouble for the employer, by losing it to the employers creditors. In an effort to eliminate perceived abuses, the new rules impose strict requirements for the timing of deferrals, the timing of distributions, and the funding of deferred compensation plans, and a stiff new penalty for running afoul of the requirements.
In the past, a participant in an NQDC plan had to elect to defer income before it was payable, and as long as it was subject to a substantial risk of loss, taxation would be deferred. Now, a participant must make a deferral election before the end of the prior tax year. A first-time participant in a plan may make an election within 30 days after becoming eligible but may defer compensation only for services performed after the election.
In the past, there were few legal limitations on when a plan could allow distributions of deferred compensation. Now, a participant may receive a distribution in only 6 situations:
–separation from service;
–a fixed time specified in the plan;
–a change in the ownership or control of the corporation;
–an unforeseeable emergency.
Participants also may elect to delay distributions from a plan as long as the new election is made at least 12 months in advance and delays the distribution at least 5 years. Distributions later made on account of disability, death or unforeseeable emergency are not subject to the 5-year rule.
In any NQDC plan, there is a desire to protect an employees deferrals as much as possible without eliminating the substantial risk of loss. To prevent plans from pushing too far, the Act prohibits a plan from setting aside assets in an off-shore trust or providing for any triggers that shield assets upon a change in the employers financial health.
The Act also includes substantial penalties for violating any of the new requirements when deferring compensation or funding plans. Any violation results in the deferred compensation being taxable to the participant as of the time of the deferral. In addition to the normal income tax on the compensation, the participant must also pay a 20% penalty tax, with interest at a rate 1% higher than the normal underpayment rate.
The new rules are effective for compensation deferred after Dec. 31, 2004. Pre-existing deferrals under a pre-existing plan are grandfathered, as long as there is no material modification of the plan after Oct. 3, 2004.
John H. Fenton, J.D., M.S.B.A., is a staff writer for Tax Facts, a National Underwriter Company publication. He can be reached via e-mail at [email protected] .
Reproduced from National Underwriter Edition, November 4, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.