Nonqualified deferred compensation plans: new rules under the AJCA.

• Author: Adkins, Eddie
• Position: American Jobs Creation Act of 2004

"More plans, more rules, more taxes." This is the best way to describe the new world of nonqualified deferred compensation (NQDC) plans after the American Jobs Creation Act of 2004 (AJCA). AJCA Section 885 enacts new Sec. 409A and dramatically changes the operation of many NQDC plans and, as discussed below under "Effective Date" (p. 74), applies to amounts deferred in tax years beginning after 2004.

Notice 2005-1 provides initial guidance under Sec. 409A. Also, several helpful examples and guidelines appeared in the AJCA Conference Report (CR); see Conf. Rep't No. 108-755, 108th Cong., 2d Sess. (2004). Additional IRS guidance expected later this year will probably be consistent with the examples in the CR. Any such guidance should be considered before taking action.

More Taxes

Perhaps the most significant aspect of the new rules is the tax liability that plan participants will incur if the rules are not followed. It is hard to imagine that an employer or individuals covered under a plan would chance noncompliance with the new distribution, funding and election rules, as it would trigger inclusion of the entire cumulative post-2004 deferred compensation in income (plus any investment earnings) at regular rates. An additional 20% penalty would apply to the deferred compensation. A third component relates to interest. The taxpayer has to pay interest on the income taxes that would have been paid had the deferred compensation been reported as income as services were performed in each prior year. The interest is calculated using the underpayment rate, plus one percentage point.

Current taxation can be avoided for noncompliance if any of the deferred compensation amounts are subject to a substantial risk of forfeiture; such amounts will not be taxed. It is only a matter of time, though, until they are taxed. Taxation occurs as soon as there is no longer a substantial forfeiture risk.

Under the new rules, rights to compensation are subject to a substantial risk of forfeiture if they are conditioned on the future performance of substantial services by any individual, or the occurrence of a condition related to a purpose of the compensation (e.g., the attainment of a prescribed level of earnings or equity value) .Thus, "significant risk of forfeiture" refers to whether amounts are vested.

More Plans

AJCA Section 885 very broadly defines an NQDC plan to include any plan that provides for the deferral of compensation, except for the following:

* Qualified retirement plans (e.g., defined benefit, Sec. 401(k), taxdeferred annuity, simplified employee pension, savings incentive match plan for employees).

* Bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan.

* Sec. 457(b) plans (i.e., eligible deferred compensation plans maintained by tax-exempt entities, as well as by state and local governments).

* Incentive stock options (Sec. 422).

* Nonqualified employer stock options with an exercise price equal to or greater than the stock's fair market value on the grant date (as long as the option does not include a deferral feature other than the option holder having the right to future exercise).

* Employee stock purchase plans (Sec. 423).

* Amounts paid within 21A months after the end of the tax year in which vesting occurs, using the later of the plan sponsor's tax year or the participant's tax year.

A plan or arrangement not listed above is subject to the new rules. Under new Sec. 409A(d)(3), the term "plan" includes any agreement or arrangement, even if it includes only one person. Nothing in the AJCA suggests that the new rules apply only to written agreements. The agreement's substance, rather than its name or degree of formality, is what matters. Also, the rules are not limited to arrangements between an employer and an employee. Thus, arrangements involving independent contractors and directors are also covered.

The types of plans that also may be treated as NQDC plans include supplemental...