January 1, 2004

The American Jobs Creation Act of 2004 (the "Act") makes significant changes to the taxation of deferred compensation. Most executive compensation plans will need revision. The new rules are effective for amounts earned after December 31, 2004. Deferrals earned and vested before 2005 are grandfathered under prior law unless the plan is materially modified after October 3, 2004. Besides deferred compensation plans, the Act applies to all stock appreciation rights ("SARs") and all option plans except for options granted on employer stock with an exercise price at or above fair market value at time of grant. The Act does not apply to employer stock purchase plans under Code Section 423.

The key changes are as follows:

  1. Timing of Deferral Elections Limits: Deferral elections for salary must be made before the beginning of the calendar year. For bonuses, deferral elections may be made as late as six months before the end of the period during which the bonus is earned.

  2. Timing of Distribution Limits: Distribution may not be earlier than separation from service, date of disability, death, a fixed schedule specified at the date of deferral, change in control or the occurrence of an unforeseeable emergency. 

    a. Separation from Service: Distributions upon separation from service must be delayed at least six months (or death, if earlier) if the employee is employed by a publicly traded entity and such employee (i) owns more than 5% of the stock; (ii) owns more than 1% of the stock and has compensation in excess of 150,000; or (iii) is an officer with compensation in excess of 130,000. 

    b. Unforeseeable Emergency: Definition is based on definition in regulations under Code Section 457. Amount distributed may not exceed the amount which is reasonably necessary to meet the emergency and pay any anticipated tax on the distribution.

  3. Re-deferral Elections: A participant may elect to postpone distributions that would otherwise become due so long as (a) the re-deferral election is made at least 12-months before a scheduled payment; and (b) the re-deferral must be for at least five additional years. A distribution cannot be made for separation from service or change in control during that period.

  4. No Acceleration of Distributions: Some plans provide that upon payment of a significant penalty, such as 10% of the amount withdrawn, a participant could withdraw funds at any time. These haircut provisions are no longer allowed. In regulations, the IRS may create exceptions if the acceleration is unanticipated and non-elective. This provision will significantly affect SARs and other option plans. Often SARs and options are not in constructive receipt because the exercise requires the forfeiture of the right of future appreciation. The ability to exercise a SAR is an acceleration clause.

  5. Funding Limitations: Offshore rabbi trusts have been eliminated. The Act provides that deferred compensation will be deemed funded if assets are held in a trust located outside of the United States. The Act also eliminates financial condition triggers. Plans with this type of provision will be treated as funded (which would cause immediate taxation).

  6. New Penalties: If the plan fails to meet the new requirements, the participant is subject to an additional 20% tax and an interest penalty at the underpayment rate plus one percent. There are a number of provisions under discussion that were not included in the Act. The Act does not (a) limit investment options; (b) the use of domestic rabbi trusts; (c) limit the deferral amounts or tax deferred growth of earnings; or (d) prohibit the deferral of stock option gains.

The Act requires that the IRS issue guidance with respect to a number of issues raised by the new rules. Within 60 days of the date of enactment (October 22, 2004), the IRS must provide guidance concerning the amendment of plans and how plan participants may elect to terminate participation in an affected plan or cancel or modify an outstanding deferral election for amounts deferred after January 1, 2005.

Employers who sponsor plans affected by the Act should consider taking the following steps:

  1. Review plans affected by the Act and be prepared to amend such plans after the issuance of the IRS guidance.

  2. Review and if necessary revise deferral election forms prior to the 2005 election period.

  3. Depending upon the IRS guidance, let participants revise deferral elections and/or terminate participation in the affected plans.

If you have any questions concerning this subject or other employee benefit matters, please contact Bill Anspach or any other attorney at Much Shelist with whom you have contact.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.