Labor Logic

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John D. Finerty, Jr.

Congress passed the American Jobs Creation Act of 2004 ("AJCA") on October 11, 2004 and President Bush is expected to sign this legislation into law in the next few days. The AJCA contains provisions that fundamentally affect all nonqualified deferred compensation arrangements by the creation of Internal Revenue Code Section 409A. These legislative changes are generally effective for amounts deferred on or after Jan. 1, 2005.

The Basis of New Deferred Comp Rules

Employee benefits law allows employers to promise employees future, or deferred, compensation in exchange for work performed today. These types of deferred compensation plans are popular among employees because they allow employees to defer, not only compensation, but also taxes until later in life when they may be in lower tax brackets. Plans that provide deferred compensation through arrangements other than tax-qualified retirement plans (such as 401(k) plans and pension plans) are called "non-qualified deferred compensation" or "NQDC". Those plans include almost any arrangement in which an individual’s payment for work done in the current tax year is deferred until a later tax year.

The general rule under new IRS Code Section 409A is that any amounts deferred under a nonqualified deferred compensation plan or arrangement are immediately subject to tax to the extent the amounts are not subject to a substantial risk of forfeiture. There are important exceptions to this new rule that require a plan to conform to very specific requirements. These requirements include limitations on the timing and manner of the deferral decision, limitations on distribution options, and rules regarding how plans and arrangements are funded.

Failure to meet these requirements will subject deferred amounts that are not subject to a substantial risk of forfeiture to immediate taxation as well as a 20 percent excise tax (plus applicable interest). This significant excise tax will be levied on the individual who deferred the compensation.Plans Affected by the New Rules

Of particular concern is the sweeping nature of these changes. The following is a partial list of plans and arrangements that this legislation is likely to affect:

• Supplemental Executive Retirement Plans;
• Typical Deferred Compensation Arrangements;
• Bonus Plans that include deferral features;
• Incentive Deferral Plans;
• 457(f) Deferred Compensation Plans (for tax-exempt entities);
• Employment agreements that contain provisions deferring compensation;
• Stock options not granted at fair market value;
• Phantom stock plans;
• Restricted stock plans; and
• Deferred compensation arrangements for board of director members or for consultants.

The primary goals for the enactment of Code Section 409A are: (1) to put controls on executive compensation; and (2) to raise revenue for the U.S. Treasury. With these goals in mind, the new requirements are likely to be strictly enforced.

Review All Compensation Plans

Very few nonqualified deferred compensation arrangements subject deferred amounts to a substantial risk of forfeiture. The "substantial risk of forfeiture" test, however, and whether a plan does or does not pass the test, could mean the difference between deferred income tax or an order to pay tax immediately plus a 20 percent penalty and interest. Accordingly, almost every nonqualified deferred compensation arrangement will have to be reviewed for compliance with the new legislative requirements in order to avoid immediate taxation and excise taxes on amounts deferred on and after Jan. 1, 2005.

Because Code Section 409A is a new rule, most NQDC arrangements will have to be modified. In addition, even arrangements that are not referred to as nonqualified deferred compensation should be reviewed (e.g., long term incentive plans, deferred bonus plans, employment agreements) because these arrangements may also fall within the purview of the new legislative requirements if they provide for any deferral of compensation.

For more information, contact John D. Finerty, Jr. at Michael Best & Friedrich LLP at (414) 225-8269 or on the Internet [email protected], or Martin P. Tierney at (414) 270-2707 or on the Internet [email protected].