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Nonqualified Deferred Compensation Plans

Target Audience: Legal Professionals, Professional Service Firms, Partners, Tax Law Interest

Jobs act makes sweeping changes

Last fall, a new law was enacted that has brought sweeping changes to the rules governing how nonqualified deferred compensation (NQDC) plans are taxed. The American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. The new law includes significant changes to the elections and distributions of NQDC plans. It also affects bonus deferrals and partnership interests received for services and several aggressive funding mechanisms. And it redefines NQDC plans to include arrangements such as supplemental executive retirement plans (SERPs), restricted stock units, stock appreciation rights (SARs) plans and, in some cases, severance agreements.

The good news is that the law doesn’t affect traditional qualified retirement plans such as pension or 401(k) plans, paid time off for vacation and sick days, comp time, or disability and death benefits.

Guidance issued

The Treasury and the IRS have issued the first in an expected series of promised guidance regarding the new rules. Notice 2005-1 provides for a transition period ending Dec. 31, 2005, during which plan sponsors may amend or terminate their NQDC plans and still comply with the law.

In general, a plan will be treated as being operated in "good faith compliance" during 2005 if it’s operated in accordance with the terms of Notice 2005-1, and a good faith reasonable interpretation is used for issues not covered by the notice.

Law firms will be particularly interested in these items discussed in Notice 2005-1:

Bonus deferrals. Services performed over a period of at least 12 months will be treated as satisfying the performance-based compensation provisions of the new law as long as the election is made at least six months before the end of the performance period, and the payment of the bonus is contingent on certain performance criteria being met.

Grants of partnership interest

Law firms should take particular note of the potential inclusion of certain partnership interests as NQDC arrangements. Until additional guidance is provided, the NQDC rules that govern the issuance of stock may be applied to the receipt of partnership interests for services. This would include: (1) a partnership capital interest, (2) an interest in profits, or (3) an option to purchase a partnership interest granted in connection with performance of services. In other words, if grants of partnership interest don’t result in income at the time of the grant, under normal tax rules, they won’t result in a deferral of compensation.

SARs and restricted stock

While this aspect of the new law will not apply to many law firms, it will certainly be of interest to a number of clients. The notice provides a limited exception for most SARs that are issued with respect to and paid solely in publicly traded stocks. Moreover, the SARs cannot include any deferral feature other than the deferral of recognition of income upon the exercise of the SAR.

Going forward

You have until the end of this year to make sure your NQDC plan documents comply with Sec. 409A. In the meantime, certain decisions must be made, including:

• How plans will be set up in the future,
• Whether it will be necessary to negotiate with plan participants regarding the plans, and
• When to revise and distribute descriptions of changes.

Certain actions that are permitted during the transition period will raise accounting and tax issues. The Treasury and the IRS have stated that additional guidance on Sec. 409A will be forthcoming in 2005. We will keep you informed as we become aware of new guidance and help you amend and restate your compensation plans as needed to comply with the new law.

Find out how our expertise in accounting for professional service firms can add value to your business. Email us or call us at 1 (888) 875-9770.

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