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A little-noticed part of the American Jobs Creation Act of 2004, which was signed by the president on Friday, mandates massive changes for nonqualified deferred compensation plans. The new rules will require changes to virtually every deferred compensation arrangement, including many that have not previously been viewed as deferred compensation (such as discounted stock options). Employers will need to react quickly because the new rules apply to all amounts deferred after Dec. 31, 2004 � such as many year-end bonuses. Although amounts deferred before 2005 are generally not subject to the new rules, employers will need to proceed cautiously because grandfather treatment will be lost if there are any “material modifications” after Oct. 3, 2004. THE BIG PICTURE The new set of requirements must be satisfied by all “nonqualified deferred compensation plans” both in form and operation. For this purpose, such plans are defined broadly to include any agreement or arrangement (including those covering only one person) that provides for the deferral of compensation. Excluded from this definition are certain tax-favored retirement plans, bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans. (The Internal Revenue Service is also expected to issue guidance exempting incentive stock options, employee stock purchase plans, and bonuses paid within 2.5 months after the end of a bonus year.) In the absence of regulatory relief from the Treasury, it appears that this broad definition would include stock appreciation rights, discounted stock options, phantom stock (an arrangement under which participants are promised the value of the company’s stock at some point in the future � typically payable in cash), restricted stock units (an arrangement under which participants are promised the company’s stock at some point in the future if they remain employed through a specified date), many bonus plans, certain severance arrangements, certain golden parachute payments, and deferred compensation arrangements under individual employment agreements. If the new requirements are not satisfied, there are significant adverse tax consequences. To begin with, all the compensation deferred under the arrangement, including deferrals in prior years, must be included in income in the first year in which the requirements are not satisfied. (An exception exists if the amounts are subject to a substantial risk of forfeiture � that is, they are not yet vested.) In addition, the tax imposed on the deferred compensation is increased by two amounts: (1) the amount of interest (plus 1 percent) that would have been assessed if the deferred compensation had been includable in income in the taxable year in which first deferred and (2) an amount equal to 20 percent of the deferred compensation. The one bit of good news is that these highly punitive consequences apply only to the participant to whom the failure relates. Thus, if the requirements are not satisfied for just one participant covered by a plan, the other participants will not be affected. NOW REQUIRED The new rules impose three major requirements that all nonqualified deferred compensation plans must satisfy: • Distributions. A nonqualified deferred compensation plan must provide that the deferred compensation cannot be distributed any earlier than one of six specified events � separation from service, disability, death, a specified time (but not an event), a change in ownership or effective control of the corporation or a substantial portion of the assets thereof, and an unforeseeable emergency. • Accelerations. A nonqualified deferred compensation plan must provide that the deferred compensation cannot be accelerated from the originally specified payment date or schedule, except as otherwise provided in regulations to be issued by the Treasury. As a result, so-called haircut provisions, which allow participants to accelerate the distribution of their deferred compensation if they forfeit a certain percentage, will no longer be permitted. • Elections. A nonqualified deferred compensation plan must provide that the initial election to defer compensation for services performed during a taxable year cannot be made later than the close of the preceding taxable year. There are two exceptions with respect to the initial deferral election: First, in the initial year that a participant becomes eligible to participate in a plan, an election with respect to services to be performed subsequent to the election can be made within 30 days after the participant becomes eligible. The authors understand (from informal discussions with the government) that the IRS will apply the special rule narrowly, and it will not be available if an employer establishes a “new” plan that is effectively a continuation of a previously established plan. Second, in the case of “performance-based compensation” based on services performed over a period of at least 12 months, the initial deferral election can instead be made as late as six months before the end of the performance period. IRS guidance expected by December will address what types of arrangements will qualify as “performance-based.” The time and form of distribution of the deferred compensation must also be designated at the time of the initial deferral election. If certain requirements are satisfied, however, the new rules allow changes that result in a further delay in payment or a change in the form of payment (e.g., changes must be made at least one year in advance and amounts must be redeferred at least five years). The legislation contains new rules regarding assets that are set aside to fund deferred compensation, typically in trusts popularly known as “rabbi trusts.” Any such assets that are located outside the United States or that become restricted to the payment of the deferred compensation in connection with a change in the employer’s financial health will be taxable to the participants when set aside. Thus, offshore (as contrasted to domestic) rabbi trusts will no longer be viable. To the extent the deferred compensation is included in income under these rules, adverse tax consequences would apply. There are also new special withholding rules, and any deferred compensation must be reported on IRS Form W-2 or Form 1099 when deferred, even though the compensation is not yet taxable. EFFECTIVE DATES Because the grandfather treatment for amounts deferred before Jan. 1, 2005, can be lost (at any time) for material modifications after Oct. 3, 2004, plan sponsors should be cautious about amending or modifying existing arrangements until additional guidance is issued. The legislative history also indicates that for purposes of the effective date provisions, an amount is considered deferred only if it is both earned and vested before Jan. 1, 2005. Thus, amounts deferred in earlier years that are still subject to a service requirement will not be considered deferred until the vesting occurs. If vesting is not scheduled to occur until 2005 or later, those amounts will be subject to the new rules. Further, any attempt to vest individuals before year-end would likely be deemed a material modification, thereby triggering the application of the new rules. For example, amounts deferred in 2002 that will be paid in 2006 if the executive is still employed on Dec. 31, 2005, are not grandfathered. The legislation directs the Treasury to issue guidance addressing the new rules. The authors understand (from the legislative history and informal discussions with Treasury representatives) that the Treasury is planning to issue guidance that will provide a grace period under which plans can be modified to bring them into compliance with these new requirements. That grace period is likely to extend for three to six months. Rules will also be provided under which employees can cancel elections and exit plans if they do not wish to comply with the new rules. The Treasury is also expected to issue a “snap-on” amendment that will enable plan sponsors to quickly adjust plans to comply with the new rules until a more careful revision of plan documents can be done. TAKING ACTION In light of the massive and somewhat uncertain aspects of these new rules, plan sponsors should contemplate a series of immediate steps. These would include the following: 1. Determine what plans are subject to the new rules. Because the coverage of the rules is extremely broad, employers should review all existing arrangements. 2. Determine how to proceed. A fundamental issue will be whether to freeze all existing plans that are grandfathered and create new plans for all future deferrals. Separating the grandfathered plan from any new plans may be advisable because of concerns about inadvertent material modifications to the old plan. (The grandfathered deferrals will have to be separately accounted for, anyway.) Plan sponsors will need to begin drafting new plans (or modifying existing plans) in compliance with the new rules, as well as freezing existing plans. Changes to existing deferrals may require employee consent as well as action by the board of directors. 3. Make 2005 deferral elections. Many plans require deferral elections for 2005 compensation (including 2004 bonuses payable in 2005) to be made before the end of 2004. Representatives from the Treasury have informally indicated that plan sponsors should follow their normal deferral election procedures this fall. If they do, sponsors will be able to modify their plans during a grace period to comply with the new rules. However, this is only informal advice at this time. Plan sponsors may be reluctant to rely on this approach, particularly given that any formal guidance from the Treasury will not be issued until mid-to-late December of this year, if not later. In addition, plan sponsors should keep in mind that the special 30-day election period for new plans will probably not be available if a new plan, established to segregate old and new deferrals, is essentially a continuation of an old plan. Therefore, sponsors should obtain 2005 deferral elections before the end of this year for such new plans. 4. Communicate with participants. Plan sponsors should soon begin communicating about these changes and the potential consequences to the participants so that the participants can decide whether to agree to certain changes. Participants also may need to decide whether to continue deferring amounts under the new rules. The new rules will affect virtually every deferred compensation arrangement in the United States, whether elective or nonelective, whether established through formal plan structures or through simple board resolutions, and whether applied to a group or a single participant. Because of the short time frame in which plan sponsors must react to these new rules, it is imperative that sponsors give prompt consideration to these new rules and their consequences. Ron Platt, Keith Mong, and Stuart Lewis are partners in the D.C. office of Buchanan Ingersoll. Platt is director of federal government relations, Mong practices in the tax section, and Lewis is chair of the tax section and employee benefits group.

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