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Update: Since the initial posting of this Article, the President in late October,
2004 signed into law the American Jobs Creation Act. As well as creating jobs
(we hope), it also creates new Internal Revenue Code Section 409A. The scope
of the new law is vast, with 20% excise taxes and back interest imposed on
arrangements that do not qualify.
SEE OUR MAY, 2005 ARTICLE
ACTION REQUIRED TO AVOID 409A PENALTIES"
Will Deferred Compensation Rules Change ?
Tracking the JOBS Bills.
George L. Chimento
June, 2004
1. Background.
Two bills are working through Congress in this election year. Each has the
catchy title of the JOBS Bill. Each offers massive cuts in the top corporate rates,
as part of a complicated trade deal which will lower tariffs. The bills have
attracted an array of unrelated amendments, including a “reform” of certain tax
principles which apply to non-qualified deferred compensation.
The “reforms” will affect all types of non-qualified deferrals, including elective
contributions to individual account plans, non-elective SERP’s, and stock
appreciation rights, also known as phantom stock. But don’t panic. There are
protective grandfathering rules, and many of the reformed practices, such as
"offshore" Rabbi trusts, for example, are not common. In this article, we will
summarize the main points, point out differences in the two bills, and caution you
to examine your own plan(s) with counsel.
2. Two Bills may make a Law.
The Jumpstart Our Business Strength Bill, S.1637, was passed by the Senate on
May 11, 2004 by vote of 92-5. The vote followed a Democratic Party filibuster
effort in the Senate, and a dramatic letter from Senate Majority Leader Frist to
Senator Kerry warning of potential lost jobs.
The American Jobs Creation Act of 2004, H.R.4520, was introduced in the House
on June 4 and went to a Ways and Means Committee markup session on June
10. It is unclear whether the House will pass H.R.4520. If it does, there will be
joint committee action to reconcile the differences, and if reconciliation is
possible and acceptable to the President, a JOBS law, with deferred
compensation “reform” as a small piece, will go into effect.
We won’t predict whether there will be a JOBS law in 2004, or whether it is a
smart political move to champion a corporate tax cut, although portrayed as a
jobs protection bill, before November. We will predict, however, that there will be
“reform” of the deferred compensation rules, so let’s peek at the contents of
each bill, which are reasonably similar and virtually parrot 2003 ideas that were
not enacted.
3. Timing of the Initial Election.
Both Bills require that elective deferral agreements must be executed in the year
before services are rendered. This is consistent with the IRS position in Rev.
Procs. 71-19 and 92-65. It affects accrued bonuses earned in one year and paid
in the next (i.e. a March bonus attributable to the prior calendar year’s services).
Plans desiring to be in alignment with the IRS have conservatively required this
practice already. Others have allowed participants to make deferral elections
after the services were performed but prior to the right to the actual payment (i.e.
a December 2003 election for an accrued 2003 bonus which is payable in 2004).
The new law would affect those more aggressive plans.
Planning strategy: Some executives don’t want to elect a bonus deferral more
than 12 months in advance when the amount is unknown. Provided that an
executive has a good estimate of the bonus at the end of the “service year”, and
prior to the year it will be paid, he or she can just makes a larger deferral
election with respect to the following year’s base compensation and stay within
the new rule. The combination of an unreduced bonus and greatly reduced base
pay will still yield the desired W-2 result.
As is the case under present law, new participants will continue to have 30 days
from initial eligibility to make an election.
4. Postponing the payment.
The IRS position in Rev. Proc 92-65 was that the timing of the payment must be
established at the time of the deferral, and that an exception would be permitted
only for bona fide hardships. In practice, many deferred compensation plans
permit executives, in the year prior to payment, to postpone the starting date, or
to convert a lump sum payment into an installment form.
The Bills strike a compromise position. Provided that the election is made at least
12 months before the payment date, and provided that the new payment starting
date is at least five years after the original payment date, elections are
permitted. S.1637 would only permit one postponement right for each amount
deferred.
Planning strategy: Although less flexible than the year by year strategy used in
some plans, this does add a measure of certainty. Considering the large
amounts involved with some lump sums, such as actuarial equivalents of SERP
benefits, we believe that participants will welcome the certainty of a Code
provision which expressly permits further deferral.
5. Accelerating the payment.
The Bills do not endorse the common practice of charging a 10% “haircut” to
permit early payments. (If you are too worried, skip down to the discussion of
effective dates in Section 9, where deferrals, at least prior to June 4, 2004, get
the benefit of former law. But remember that IRS never has acknowledged the
legality of haircut provisions.)
Under the Bills, a plan may permit payments only after:
a) separation from service;
This will be defined in regulations, and is a broader concept than “termination of
employment.” The plan must require a further six month delay for distributions to
“key employees” of public companies.
b) a specified, elected, period of time;
In the initial election, an executive may still elect that payments start at a specific
date, rather than after an event;
c) disability or death;
d) hardship;
That’s real hardship, causing serious and unforeseen loss, where an executive
must also show that other assets cannot be liquidated.
e) change in control;
This will be defined in regulations. S.1637 requires that payments to Exchange
Act Section 16(a) officers be postponed for at least one year from any change in
control, and any violation will be automatically subject to the golden parachute
tax of Code Section 280G even if the overall payments are less than 2.99 x the
applicable base amount under that section.
f) other events permitted by regulations.
Don’t expect much latitude. A person leaving employment to take public office
might be allowed to accelerate to avoid conflicts of interest. Acceleration for
court approved settlements (such as for divorce ?) should be allowable.
6. No more off-shore and springing Rabbi trusts.
In recent years, we have seen the "offshore" and “springing” varieties of the
famous trust of Private Letter Ruling 8113107. The "offshore" variant put an
obstacle in front of company creditors. The “springing” version required, if
company affairs got rocky, that the company fund the balance of any liabilities
and the trust then self-sealed against company creditor claims. Use of such
trusts will now cause current taxation of vested amounts. The status under
present law remains unclear and is not necessarily protected.
7. Deferral of Stock Option Gains and Restricted Stock on Vesting.
Restrictions on Plan Investment Choices.
The two Bills differ. HR 4520 permits, and S.1637 prohibits, deferrals of gains on
stock option exercise and restricted stock vesting.
S.1637 also would restrict non-qualified plans to the type of investment menu
available to employees for their qualified plans. If enacted in its present form, this
would conceivably prohibit the use of "shadow" employer stock choices if
employer stock is not a permitted 401(k) investment.
8. W-2 Reporting.
There was a concern that IRS was not aware of all of the machinations in the
deferred compensation universe. So reporting will be required. Reporting of
individual annual accruals of the typical defined benefit SERP will probably be
required, subject to IRS possibly granting an exemption when the amounts are
not readily ascertainable. As we know, many SERPS are based on offsets, such
as future qualified plan accruals, that are not readily known in the years before
retirement. Calculating this one item for W-2’s could be a full-time job if the IRS is
unreasonable in its regulations.
9. The Effective Date.
Here is good news. At a minimum, deferrals prior to a particular date -- June 4,
2004 for the House and December 31, 2004 for the Senate -- are entitled to “old
law” treatment. And the earnings on those deferrals have similar deference. That
probably means that these deferrals can continue to be withdrawn under “haircut
provisions”, and other variants which deviated from the strict regimen of Rev.
Procs. 71-19 and 92-65. Bear in mind, however, that the Bills do not sanction
these practices. It is also not clear that "year by year" deferrals of amounts which
come due after the effective date will get the benefit of old law, or be under the
new, minimum five year, re-deferral rule discussed in Section 4, above.
Still, IRS efforts to take away protections from grandfathered deferrals should be
stymied. A 1978 Congressional dictate -- Sec. 132(a), PL 95-600 -- prohibits
IRS from issuing deferred compensation rules that supersede the law as it was in
effect at February 1, 1978. The JOBS bills do not repeal this 1978 “gloves-off”
approach, although a stalled piece of legislation (S.2424, known as the NESTEG
Bill) would do that. We are predicting (hoping) that the benign regulatory
environment that has been in effect since 1978 will continue to apply to
grandfathered deferrals.
The Bills will also allow individuals, if they do not like the new rules, to cancel
deferral arrangements and to take amounts into income. This might be attractive
for individuals in troubled companies. But the new rules really are not that bad,
and we doubt that many will decide to pay taxes early.
Finally, in H.R. 4520, there is a wrinkle to the grandfather (what’s wrong with
grandmothers, we ask) rule. For deferrals from June 4 through December 31,
2004, they will get the benefit of “old law” only if there are not material changes
to the underlying plan in that timeframe. This will be a matter for negotiation and
mark-up by the joint committee.
10. Too much detail ?
There’s more detail in these bills, but let’s stop for the moment. You should
review your deferred compensation plans. Under the bills, that includes any plan
which defers compensation other than qualified plans, bona fide vacation, sick
leave and comp-time plans, and disability and death benefit plans. Contracts with
a single executive are considered to be deferred compensation plans.
Note that severance plans would appear to be deferred compensation plans
under each Bill, but this should not be a real problem, due to the fact that these
plans are generally non-elective and only pay money after employment
“termination.” Provided that the “termination” is also a “separation from service”
as described in the Bills, and that there is no provision to defer receipt of
severance benefits, the Bills will not cause unintended consequence.
Stay tuned. If it does not happen this year, it will happen in the foreseeable
future. Let’s hope that the actual changes are as benign as those in these two
bills.
This memorandum is prepared and made available as a courtesy. Under
the ethical rules applicable to lawyers in some jurisdictions, it may be
considered advertising.
This article is not a substitute for specific tax or other legal advice
directed to your particular situation. It may not be used for the
avoidance of tax obligations (including penalties), and may not be relied
upon as a legal opinion of the writer or any member of the Firm.
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