What began as a response to sanctions imposed by the European Union for illegal trade subsidies, resulted in the most far-reaching business tax legislation in years. On October 22, 2004, the President signed into law the pre-election business tax legislation known as the American Jobs Creation Act of 2004 ("Act"). The Act includes 34 new Code Sections and 274 amendments to the Internal Revenue Code. While the legislation's primary intent was to repeal the foreign sales corporation and extraterritorial income exclusion provisions of the Internal Revenue Code, it eventually included, among other things, legislation to address perceived abuses in non-qualified deferred compensation arrangements ("NQDC"). The changes are substantial, broadly applied, and fundamentally change the tax treatment of NQDC. To avoid adverse income tax consequences to the participants, your company's NQDC arrangements should be analyzed for compliance with the Act, and possible modification, prior to January 1, 2005.
Failure to comply with the requirements under the Act will cause NQDC to be currently includable in the participant's gross income and taxable, with underpayments subject to interest at the underpayment rate plus one percentage point, plus a 20% penalty tax on the amount of compensation required to be included in income. Deferrals prior to 2005 under current NQDC plans will not be affected provided there are no material changes to the plan after October 3, 2004.
The Act does not apply to qualified deferred compensation plans, but defines NQDCs broadly as any plan that provides for the deferral of compensation, other than a bona fide vacation leave, sick leave, compensatory time, disability pay or death pay benefit plan. As a result, the Act applies to many arrangements that have not typically been considered deferred compensation plans.
For example, the Act applies to:
- Individual employment agreements;
- Phantom stock;
- Restricted stock units;
- Discounted stock options and supplemental retirement plans;
- Compensation agreements involving outside directors;
- Independent contractors;
- Elected deferral plans;
- Stock appreciation rights;
- Any option on property other than stock of the employer, whether or not the exercise price is discounted; and
- Severance and parachute payments.
The Act's requirements include restrictions on deferral elections, restrictions on distribution events, prohibitions on payment acceleration, restrictions on distribution elections, prohibition of the acceleration of distribution clauses, also known as haircut provisions, and prohibition of the use of funding arrangements that are tied to a payor's financial condition. The Act also imposes specific new definitions for terms that are common in many non-qualified deferred compensation agreements.
In effect, unless deferred compensation is subject to a substantial risk of forfeiture, post 2005 deferrals will result in immediate taxation and imposition of penalties and interest. To avoid that consequence, all NQDC plans, as defined in the Act, must be addressed to ensure compliance with the technical requirements of the Act by the effective date of January 1, 2005. After January 1, 2005, companies may rely on transition guidance, to be issued by the IRS, which is expected, but not certain, to allow current plans to be amended after 2004.
While each deferred compensation arrangement is unique and may require a unique strategy, the following actions are strongly recommended:
- Identify all existing deferred compensation arrangements, including those not historically treated or viewed as a NQDC plan, that may be subject to the Act, e.g.,independent employment contracts.
- Evaluate the deferral arrangements for compliance with the Act, and determine the changes that will be necessary to bring current plans into compliance. Determine whether to amend existing plans or adopt new plans.
- Determine the impact of elections made prior to January 1, 2005, and whether or not to apply the new rules to December 31, 2004, ahead of schedule.
- Decide whether to amend existing plans or adopt new plans, or await issuance of transition guidance from the IRS.
- Update communications materials that describe plan features.
Generally, employers must either amend their plans before the end of 2004, or rely on new rules that will be issued as Treasury regulations to implement the Act.
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