Retirement Plan Solutions

New Law Provides Dramatic Changes to Deferred Compensation
By: Roger P. Prince, APA, JD

The latest major tax act provides some significant changes for deferred compensation arrangements effective in 2005.

A new section in the Act provides that all future non-forfeitable deferred compensation amounts will be fully taxable unless the design and operation of the deferred compensation plan conforms to the requirements of Section 409A. The Act defines deferred compensation very broadly and applies to both employees and nonemployees (e.g., outside directors). In order to continue to put off taxation on amounts deferred, the Act generally requires that:

    ü Deferral elections must be made in the year before the taxable year in which the compensation is earned (there are exceptions for performance based compensation)

    ü Amounts deferred may not be distributed earlier than:
      § Separation from service
      § Disability or death
      § A specified time (or pursuant to a fixed schedule) established under the plan at the date of deferral
      § Upon a change in control
      § Upon the occurrence of an unforeseeable emergency.
    ü The plan may not provide for the acceleration of benefits.

    ü The plan may not provide for distribution based upon the employer’s financial health.

    ü The plan may not use an offshore foreign trust (in most cases).

    ü Amounts deferred must be reported on Form W-2 or 1099-MISC.

All of the rules enumerated above constitute, to some degree, changes to current law regarding the taxation of deferred compensation. Therefore, it is expected that many current deferred compensation arrangements are out of compliance. There is some grandfathering for prior deferrals.

The new provisions apply to amounts deferred on or after January 1, 2005. They do not apply to prior deferrals (and earnings thereon) provided there is no material modification of the arrangement governing such deferrals after October 3, 2004.

The effects of failure to comply with the new rules are significant:

  1. All amounts deferred are subject to taxation.
  2. A 20% penalty applies.
  3. Interest is assessed at the underpayment rate plus 1%.

The Internal Revenue Service has been instructed to issue guidance within 60 days of enactment (i.e., by December 21, 2004) providing for a limited transition period, during which a plan adopted before December 31, 2004, may be amended to allow a participant to terminate participation or to cancel a deferral election with respect to amounts deferred to a period after December 31, 2004.

Clearly, all employers and employees (and nonemployees) with deferred compensation arrangements must take steps to ensure compliance with the new rules. Such steps should include:

  1. Inventory all deferred compensation arrangements of any type.
  2. Determine which arrangements are subject to the new laws.
  3. Discuss the new rules with affected employees.
  4. Decide whether to “freeze” current arrangements which do not qualify under the new rules so as to ensure grandfather treatment.
  5. Amend old arrangements or initiate new ones to comply with the new rules.
  6. Review, contemporaneously, all Rabbi Trusts to ensure compliance.

Employers should be sure to be comprehensive in their inventory of arrangements providing for the deferral of compensation. They should review all employment agreements, severance agreements, bonus plan arrangements, SERPs, non-qualified deferred compensation arrangements, restricted stock units, stock options with discounted exercise prices, change-of-control arrangements, stock appreciation rights and any other compensation arrangements to see if the new rules apply.

Unfortunately, the Act does not provide much time for employers and employees to comply with the new rules. We are here to help.

Please contact Ken Jones or Roger Prince for assistance at (207) 775-2387 and we will work with you to maintain compliance with these important new provisions.