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C hanges in Treatment of Nonqualified Deferred Compensation Plan s
The American Jobs Creation Act of 2004 made changes to the treatment of nonqualified deferred compensation (NQDC) plans that may result in the inclusion of deferred compensation in gross income. It is important that you review all of your deferred compensation plans to determine whether any amendments or other action to your plans are necessary.
An NQDC plan is any plan that provides for the deferral of compensation other than to a qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. An exception applies to §457(e)(12) plans that were in existence as of May 1, 2004, were providing nonelective deferred compensation on that date, and received a favorable determination letter on or before May 1, 2004. However, if the plan has a material change in the class of individuals eligible to participate in the plan after May 1, 2004, these tax law changes apply to compensation provided under the plan after the date of such change.
For tax years beginning on or after January 1, 2005, unless certain requirements are met (discussed below), all amounts deferred under an NQDC plan will be includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. If the requirements are not met, in addition to income inclusion, interest at the underpayment rate plus 1% will be imposed and the amount required to be included in income also will be subject to a 20% additional tax.
Distributions
Distributions from an NQDC plan only are allowed upon: (1) separation from service; (2) death; (3) a specified time (or pursuant to a fixed schedule) in the plan determined at the date of deferral; (4) change in control of a corporation; (5) occurrence of an unforeseeable emergency; or (6) disability of the participant.
No accelerations of distributions are allowed, except as permitted by future regulations.
Elections
A plan must provide that compensation for services performed during a taxable year may be deferred at the participant's election only if the election to defer is made no later than the close of the preceding taxable year, or at such other time as provided in the regulations. In the case of a participant’s first year of eligibility, the election may be made with respect to services to be performed subsequent to the election within 30 days after the participant’s eligibility date. In the case of any performance-based compensation based on services performed over a period of at least 12 months, the election may be made no later than six months before the end of the service period.
Generally, the time and form of distributions have to be specified at the time of initial deferral. Subject to certain requirements, a plan may allow changes in the time and form of distributions. A plan may specify the time and form of payments that are to be made as a result of a distribution event or could allow participants to elect the time and form of payment at the time of the initial deferral election.
Funding rules
Assets set aside in a trust to pay nonqualified deferred compensation are treated as property transferred in connection with the performance of services under §83, regardless of whether they are available to satisfy the claims of general creditors, if the assets or the trust are located outside of the United States or if the assets are later transferred outside of the United States. Any subsequent increases in the value of, or any earnings on, such assets are treated as additional transfers of property. Interest will be imposed on any underpayments and the amount required to be included in income also will be subject to the 20% excise tax.
A transfer of property in connection with the performance of services under §83 also occurs as to compensation deferred under a NQDC plan if the plan provides that upon a change in the employer's financial health, assets will be restricted to the payment of nonqualified deferred compensation. Any subsequent increases in the value of, or any earnings with respect to, such assets are treated as additional transfers of property. Interest on the underpayments and the additional 20% tax would apply.
Amounts required to be included in income are subject to reporting and federal income tax withholding requirements. Deferred amounts are required to be reported annually to the IRS. Such amounts are reported on an individual's Form W-2 (or Form 1099) for the year deferred even if the amount is not currently includible in income for that taxable year.
Amounts deferred in taxable years beginning before January 1, 2005, are subject to these changes if the plan under which the deferral is made is materially modified after October 3, 2004. Earnings on amounts deferred before January 1, 2005, also are subject to these changes.
The rules regarding the timing of an employer's deduction for nonqualified deferred compensation are not affected by these tax law changes.
Failure to comply with these changes will result in the immediate taxation of participants’ deferred compensation; participants’ deferred compensation benefits will be treated as having been subject to income tax back to the date when the plan failed to comply with these changes; and the income tax on each participant will be calculated from that date (or eligibility date) to the current date, adding interest on the underpayment and a 20% excise tax.
The IRS is to prescribe regulations before the end of the year regarding NQDC plans; we will keep you up to date on any new developments.
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