Recently several clients have contacted our firm asking for an explanation of the “new deferred compensation legislation.” They’ve been pleasantly surprised to learn that to date no such legislation has been enacted. However, two pieces of proposed legislation, the “National Employee Savings and Trust Equity Guarantee Act” (“NESTEG”) and the “American Jobs Creation Act of 2003” (“AJCA”), now moving to the full Senate and House respectively, contain rules that, if enacted, would significantly affect the design and operation of “nonqualified deferred compensation” arrangements, as well as the taxation of deferred compensation.
For purposes of the proposed legislation, “nonqualified deferred compensation” is defined as any plan or arrangement that provides for the deferral of compensation, other than a “qualified employer plan” or any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. “Qualified employer plan” means a tax-qualified plan, a tax-deferred annuity, a SEP, a SIMPLE or a governmental 457(b) plan.
The proposed legislation, if enacted, would impact nonqualified deferred compensation arrangements in the manner described below.
AJCA and NESTEG would require initial deferral elections to be made before the beginning of the taxable year in which the compensation to be deferred is earned, except that newly eligible participants could elect to defer within 30 days of their eligibility date. Deferral elections would no longer be allowed with respect to compensation to be earned later in the taxable year.
The bills target two financing concepts and render them virtually ineffective. The first involves the setting aside of assets in a foreign trust to be used for paying nonqualified deferred compensation. Because the trust is outside the jurisdiction of the U.S. courts, more protection is afforded the plan participants and less for the employer’s creditors. Under AJCA and NESTEG, assets set aside in this manner would be treated as property transferred to the employee at the time set aside or transferred outside the U.S. and would be taxable if the property is not subject to a substantial risk of forfeiture or is transferable by the employee. Under NESTEG, assets set aside in a foreign jurisdiction would be excepted from this treatment if substantially all of the services to which the deferred compensation relates are performed in such foreign jurisdiction.
The second concept involves the inclusion of a provision in a nonqualified deferred compensation plan which states that, upon a change in the employer’s financial health, assets will become restricted to pay benefits thereunder. If such a provision exists, AJCA and NESTEG provide that a taxable transfer of property occurs on the earlier of the date the assets are so restricted or the date on which the plan first provides that assets will be restricted, assuming no substantial risk of forfeiture.
Under AJCA and NESTEG, the arrangement would only be allowed to provide for distributions upon:
- separation from service (6 month delay applies for separation distribution to key employee of a publicly traded company);
- a specified time or pursuant to a fixed schedule specified under the arrangement as of the date of deferral;
- a change in ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, to the extent provided in Treasury regulations; or
- the occurrence of an unforeseeable emergency.
By limiting distributable events to those above, the proposed legislation would invalidate a plan that permits distributions, for example, upon an employee’s reduction in hours worked from full-time to part-time or upon an employee’s change in job classification or location.
The proposed legislation prohibits a subsequent election to accelerate payments, such that neither a “haircut,” whereby a small percentage of payments are forfeited in order to accelerate payment of the rest, nor an election to change the payment form from an annuity stream to a lump sum would be permitted.
As for an election to delay the time or change the form of payments, the legislation would require such an election:
- to be made at least 12 months prior to the first scheduled payment, and
- to result in an additional deferral for at least five years from the date of the subsequent election (or five years from the date of the first-scheduled payment under the House version).
An employee would be prohibited from making a subsequent election within the 12 months prior to the first payment under any circumstance, clearly contrary to the current rules which permit an election to delay the time or change the form before the payments become determinable or due and payable.
Tax Consequences for Employees
An arrangement which fails to comply with the proposed rules results in immediate taxation of the amounts deferred by the employee (or of the amount of assets restricted for an employee’s plan benefits) plus the imposition of interest on the tax underpayments that would have occurred had the compensation been taxable when first deferred. NESTEG would also impose a ten percent penalty on amounts included in income.
New reporting rules are contained in the proposed legislation, requiring that deferred amounts be reported to the IRS on the employee’s Form W-2 for the year deferred, even if the amounts are not currently available.
NESTEG alone requires that investment options available under a nonqualified deferred compensation plan be comparable to those under the employer’s qualified plan with the fewest investment alternatives. This provision is specifically intended to prohibit open brokerage windows, hedge funds, and investments in which the employer guarantees a rate of return above what is commercially available. Given that employers seldom design their nonqualified plan to mirror the investment options in their qualified plan with the fewest alternatives, and often offer a self-directed brokerage option in the nonqualified plan, this provision would clearly require a contraction in the investment menu of many nonqualified plans.
Effective Dates and Implementation Issues
If the legislation passes this year, these new, restrictive rules would generally be effective for amounts deferred in tax years beginning after December 31, 2003. However, AJCA contains a transition provision under which the new rules would not apply to amounts deferred in 2004 pursuant to an irrevocable election or binding agreement made before October 24, 2003. Amounts deferred post-2004, even if pursuant to a pre-October 24, 2003 election or arrangement, would be subject to the new rules. AJCA also provides that, within 90 days of enactment, the Secretary of the Treasury will issue guidance providing a limited period of time during which an individual participating in a nonqualified deferred compensation plan adopted on or before December 31, 2003, may terminate participation or cancel an outstanding deferral election with regard to amounts earned after December 31, 2003 and include such amounts in income without additional penalty. NESTEG does not contain similar transition provisions.
Pending enactment of this legislation, some employers are notifying employees of the proposed changes in the tax rules governing nonqualified deferred compensation plans and advising them that their year-end deferral elections may be affected. If and when enacted, the legislation will require a review of an employer’s nonqualified deferred compensation arrangements, revision of any offending plan provisions, and an update of the Form W-2 system to capture and report all deferrals made each year. Furthermore, to the extent the employer is contractually obligated to preserve election and distribution features associated with pre-2004 deferrals, the employer must undertake separate accounting to accurately track which deferral amounts are, and which are not, subject to the current rules.