- Tax-Exempt Organizations Significantly Impacted By New Nonqualified Deferred Compensation Legislation
- November 4, 2004 | Author: Timothy D. Goodman
- Law Firm: Dorsey & Whitney LLP - Minneapolis Office
The mammoth tax overhaul just passed by Congress and signed by the President, the American Jobs Creation Act of 2004 (H.R. 4520) (the "Act"), contains drastic new restrictions on deferred compensation that generally go into effect on January 1, 2005. The penalties on deferred compensation arrangements that fail to comply with the law include a 20% tax on the deferred compensation in addition to regular income tax. The Act affects deferred compensation at both taxable and tax-exempt organizations. Given the potentially severe tax consequences, organizations should consult with tax and benefits counsel now so that necessary changes can be made by year end.
The Act's scope is very broad -- almost certainly broader than the term "deferred compensation" previously would have brought to mind. The breadth includes:
Tax Consequences and Penalties
The Act imposes tax consequences and penalties on deferred compensation that fails to meet the requirements of the newly created section 409A of the Internal Revenue Code. An employee whose deferred compensation fails to meet the requirements must immediately include the deferred compensation amount in gross income, unless it is subject to a substantial risk of forfeiture. In addition, the employee must pay:
- An additional tax of 20% on the amount of deferred compensation (plus earnings).
- An interest payment equal to the underpayment rate (currently 4%) plus 1% on the underpayments that have occurred because the compensation was not included in gross income when it was first deferred.
Restrictions Imposed By New Section 409A of the Internal Revenue Code
Elective Contributions. The Act requires an employee's election to defer regular compensation such as wages to be made in the taxable year preceding the taxable year in which the employee performs the services that earn the compensation (with limited exceptions). For example, Salary payable in 2005 must be deferred before December 31, 2004.
Distributions. The Act prohibits distribution before the following events:
- Separation from service (termination)
- A future date specified at the time of deferral
- A change in ownership
- An unforeseeable emergency
Distributions upon a change in ownership are only permitted to the extent permitted under regulations to be issued by the Secretary of the Treasury.
Acceleration of Distributions. The Act prohibits accelerating the payment of distributions except as permitted under regulations to be issued by the Secretary of the Treasury. For example, 10% "haircut" provisions.
Delay of Distributions. The Act restricts an employee's ability to make subsequent deferral elections. In general, elections to delay distribution must be made by an employee at least 12 months before the date the first payment was initially scheduled to be made. It generally also requires that the first payment be delayed for at least five years from the original payment date.
Funding. The Act restricts an organization's ability to fund deferred compensation. Under the Act, an organization's transfer of assets to a rabbi trust in connection with an adverse change in the organization's financial health will result in immediate taxation (even though the assets are still subject to the claims of creditors). In addition, an organization's transfer of assets to an offshore rabbi trust will result in immediate taxation.
Reporting of Deferred Compensation
The Act requires an organization to report deferred compensation on the employee's or individual's Form W-2 or 1099 for the taxable year in which the deferral occurs.
Withholding on Deferred Compensation
The Act expands the definition of "wages" for withholding purposes to include amounts includible in gross income under section 409A of the Internal Revenue Code.
The Act covers tax-exempt organizations, but, in general, it will have limited impact due to exclusions in the Act. The Act excludes tax-qualified retirement plans, including 401(a) plans (pension and money purchase pension plans), and 401(k) plans, and bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans. In addition, the Act excludes 403(b) plans and 457(b) plans (a significant change from the draft legislation which excluded only governmental 457(b) plans). The Act, however, applies to the following agreements, arrangements, and plans:
- Bonuses.The Act applies to bonuses, although the Conference Report indicates it excludes bonuses earned in one year and paid before March 15 of the following year.
- 457(f) Plans.The Act does not exclude 457(f) plans, but deferred compensation subject to a substantial risk of forfeiture is not included in gross income until the substantial risk of forfeiture lapses. As a result, deferred compensation under a 457(f) plan, which must be subject to a substantial risk of forfeiture, would not be subject to inclusion in gross income or the penalties described above until the lapse provided it is subject to a valid substantial risk of forfeiture provision.Employers should review their 457(f) plans to determine whether they have a valid substantial risk of forfeiture requirements to avoid the taxes and penalties that will otherwise be imposed on executives and other highly compensated employees who participate in the plans. The Act raises the stakes with respect to what constitutes a valid substantial risk of forfeiture.The Conference Report indicates Congress is concerned about a substantial risk of forfeiture being used to manipulate inclusion in income and states that "substantial risks of forfeiture should be disregarded in cases in which they are illusory."
- Retention Plans.The Act applies to plans designed to retain employees by deferring compensation.
- Severance Agreements and Plans.The Act covers severance agreements and plans. Such agreements and plans should be reviewed.
- Employment Agreements.The Act covers employment agreements. Employment agreements that provide for deferred compensation beyond the amount permitted under section 457(b) are subject to section 457(f), and should be treated as 457(f) plans.
The Act has a more significant impact on taxable organizations and affects more types of deferred compensation arrangements. Please contact the attorney with whom you work to discuss these issues if you are affiliated with a taxable organization.
The Act is effective for all deferrals after December 31, 2004. If an organization materially modifies a deferred compensation agreement, arrangement, or plan before then to provide an additional benefit, right, or feature (i.e., such as permitting accelerated distribution before the end of the year), then the new rules apply immediately to the agreement, arrangement, or plan.
Organizations should review their agreements, arrangements, and plans. Almost all of these will need amendments to comply with the Act or the plans will need to be frozen and new plans established. If you have a question regarding the Act, please contact the attorney with whom you work.