For many months the House and Senate have been reviewing proposed deferred compensation rules, see the article in the June 2004 Industry Insider. Both the House and Senate recently passed a bill which includes significant non-qualified deferred compensation plan reform. It is expected that President Bush will sign this legislation. Many people expect him to sign it before the November 2nd election.

The following is a summary of these new provisions:

Definition of Non-Qualified Deferred Compensation Plan: A non-qualified deferred compensation plan is any plan that provides for the deferral of compensation other than a qualified employer plan or any bona fide vacation, sick leave, compensatory time, disability pay or death benefit plan. Such a plan is not limited to arrangements between an employer and employee.

A stock option plan where the exercise price is not less than the fair market value of the stock on the date of the grant would not be included in this definition. Additionally, annual bonuses or other compensation paid within 2 ½ months after the close of the taxable year in which services are performed would not be included in the definition.

Effective Date: The new rules are effective for amounts deferred in taxable years beginning after December 31, 2004. Earnings on deferrals will not be subject to the new rules so long as the deferrals are not subject to the new rules.

Amounts deferred prior to January 1, 2005 will become subject to the new rules if the plan is materially modified after October 3, 2004. Future regulations will define "materially modify."

Stock appreciation rights that are not vested before January 1, 2005 are subject to the new provisions.

Permissible Distributions: Distributions from non-qualified deferred compensations plans will only be allowed in the following circumstances:

1. Separation from service
   Note: Key employees of publicly traded corporations may not receive distribution earlier than six (6) months after the date of separation of service. Key employees include officers earning more than $130,000 in annual compensation (limited to 50 employees), five percent (5%) owners, and one percent (1%) owners with annual compensation from the employer in excess of $150,000.
2. Death
3. Disability
4. At a specified time or pursuant to a fixed schedule. The occurrence of an event will not qualify under this provision.
5. Upon a change of control.
6. Unforeseeable emergency arising as a result of events beyond the control of the employee and the distribution must be limited to the amount needed to satisfy the emergency.

Requirements with Respect to Elections: A deferral election must be made no later than the close of the preceding taxable year in order to be effective for the succeeding taxable year. This means that in order to elect to defer income in 2005, the deferral election has to be made prior to January 1, 2005.

The time and form of the distribution must be specified at the time of the initial deferral. Changes to the time and form of distribution that allow a delay in distributions will be allowed only if:

1. The plan requires that such election cannot be effective for at least 12 months after the date of the election.
2. The additional deferral must be made for a period of not less than five (5) years from the time payment would have otherwise been made.
3. The election may not be made less than 12 months prior to the date of the first scheduled payment.

Triggers Upon Financial Health: No deferral of income tax will be allowed if the plan provides that upon a change in the employer's financial health assets will be restricted to the payment of benefits under the plan. This is true even if the assets would be subject to the claims of general creditors, such as in a rabbi trust.

Employers' Tax Deduction: Nothing in the new rules changes the timing of the employers' income tax deduction. Thus employers will only be able to deduct amounts actually paid even if this new law accelerates the timing of the income taxation for employees.

Reporting Requirements: Employers will be required to report on Form W-2 or Form 1099 amounts deferred even if the amount is not currently taxable. This will provide the IRS with greater information regarding the existence of plans during the deferral period and will allow greater enforceability of the rules.

Penalties: If a plan is found to violate the rules, amounts deferred will become immediately taxable. In addition, interest at the underpayment rate plus one percentage point will be imposed on underpayments of tax that would have occurred had the compensation been includible in income when first deferred. The amount included in income will also be subject to a 20% additional tax.