Nonqualified Deferred Compensation Legislation Has Broad Implications

On June 17, the House approved the American Jobs Creation Act (H.R.4520), which would make several significant changes to the rules on nonqualified deferred compensation (NQDC). The Senate approved similar NQDC provisions in the Jumpstart Our Business Strength (JOBS) Act (S.1637). Now, lawmakers must work out a compromise between the two bills. Although the legislation and the politics surrounding the bills are still evolving, employers that sponsor NQDC arrangements should prepare for the possibility of new rules.

The American Jobs Creation Act and the JOBS Act would impose new restrictions on NQDC arrangements, but the effects of the legislation could extend well beyond arrangements generally considered “nonqualified deferred compensation.”

New Requirements and Restrictions for Nonqualified Plans

Under the American Jobs Creation Act and the JOBS Act, failure to comply with the NQDC requirements would cause all compensation deferred under the plan — to the extent it is not subject to substantial risk of forfeiture and had not been previously included in income — to be includible in gross income and subject to interest penalties. General requirements in the legislation include:

• Restrictions on distributions. Accelerations would be prohibited and distributions generally would be permitted only upon separation from service, death, disability or an unforeseeable emergency; or at a specified time or pursuant to a fixed schedule; or due to a change in ownership or control of the corporation.



• Requirements relating to the timing of deferral elections. Initial deferral elections generally would have to be made during the taxable year preceding the year in which the services are performed.



• Restrictions regarding elections to change the timing of a distribution or form of payment. Subsequent elections to delay a payment or change the form of a distribution would not take effect for at least 12 months and must delay the initial payment by at least five years.



• Prohibition on offshore funding. Assets set aside or transferred outside the United States for purposes of paying benefits under an NQDC plan would be treated as property transferred in connection with the performance of services, whether or not the assets were available to pay the claims of general creditors.



• Taxation if assets are restricted upon change in employer’s financial health. Assets restricted to the payment of benefits under an NQDC plan in connection with a change in the employer’s financial health would be treated as a transfer of property under section 83.



• W-2 reporting of NQDC. Employers would have to report amounts deferred under a nonqualified plan on the W-2.

Conference Committee Must Negotiate Differences

The NQDC provisions in the American Jobs Creation Act and the JOBS Act are similar. But there are some important differences, which must be reconciled by a conference committee that will be assigned to work out a compromise between the two bills. For example, under the Senate-approved JOBS Act, the investment options available in the NQDC arrangement would have to be “comparable to” those offered by the employer’s qualified defined contribution plan with the fewest investment options. The American Jobs Creation Act does not include this provision. In addition, the JOBS Act would prohibit the deferral of gains from the exercise of stock options, restricted stock and other employer securities.

The JOBS Act and the American Jobs Creation Act also have different effective dates. The JOBS Act would apply to compensation deferred after December 31, 2004. The American Jobs Creation Act would apply to compensation deferred after June 3, 2004, but would grandfather compensation deferred between June 4, 2004, and December 31, 2004, as long as an irrevocable election or binding agreement was in place on June 3, 2004. In addition, under the American Jobs Creation Act, a subsequent election relating to compensation deferred before June 3, 2004, would subject such compensation to the act’s new rules.

Scope of Act Extends Beyond Traditional Nonqualified Plans

The JOBS Act and the American Jobs Creation Act would define “nonqualified deferred compensation” as any plan 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. Currently, NQDC is not defined as arrangements under which participants choose to defer their compensation. So the bills’ restrictions would extend to nonqualified defined benefit arrangements — and could be applied to stock options, restricted stock units and other compensation arrangements.

Effective Date and New Election Requirements Could Create Compliance Problems

The American Jobs Creation Act and the JOBS Act would require that plan participants make their initial election deferrals in the taxable year preceding the year in which they will perform the services associated with the compensation. This provision presents special concerns involving the timing of enactment and the effective date of the act, as well as deferrals from bonuses and long-term incentive programs.

If it’s enacted this year, the legislation could take effect for compensation deferred beginning in 2005 or earlier. An early effective date may not give employers enough time to accept and process elections for services that will be performed during the 2005 taxable year. Employers may wish to change their election process to help smooth the transition if new rules are enacted this year.

The election requirement could also pose problems for deferrals from bonuses that would be paid in 2005 based on services performed in 2004. Unless the legislation provides transition relief or employees made deferral elections in 2003, deferrals from such bonuses could be prohibited. In the future, employers would have to ensure compliance with the election requirement.

The election requirement could create significant difficulties for companies that pay long-term incentive bonuses over a period of several years, since elections would have to be made in advance of the first payment — in some cases, three or four years before the final payment would be made. Report language that accompanies the American Jobs Creation Act states that the Treasury regulations would provide that, “in appropriate circumstances, elections to defer incentive bonuses earned over a period of several years may be made after the beginning of the service period, as long as the election is made at least 12 months before the earliest date on which the incentive bonus is initially payable. The Secretary may consider other factors in determining the appropriate election period, such as when the amount of the bonus payment is determinable.”

Outlook and Action Steps

Different employers could be affected differently, depending on their current plans and practices and the final legislation. The timing of further legislative action and the ultimate outcome of the legislative debate are unclear. But, if changes are enacted this year, employers might be hard-pressed to implement the new rules in time to meet the new deadlines.

Congressional leaders have not yet appointed a conference committee to negotiate a compromise between the American Jobs Creation Act and the JOBS Act. So, we don’t know when — or even whether — lawmakers can achieve a compromise between the two bills this year. Although it would be premature to make significant changes just yet, now is the time to read up on the legislation and prepare for the possibility of important changes to come.