Changes to Non-Qualified Plans

Changes to Non-qualified Plans

By: George Morrison, email gmorrison@cbginc.com

www.cbginc.com

The House and Senate passed the American Jobs Creation Act of 2004 (“AJCA”). While the coverage of AJCA is broad, it will have significant impact on the design of non-qualified deferred compensation (“NQDC”) plans.

The rules under AJCA apply to all NQDC plans including deferral plans, supplemental executive compensation plans and excess benefit plans. The most significant changes are discussed below.

To defer taxation, amounts contributed under a NQDC plan must avoid being “constructively received” by the employee. AJCA specifically addresses when amounts subject to deferral elections (e.g., an employee’s election to defer a portion of their salary) avoid constructive receipt. To be effective, a deferral election must be made before the close of the employee’s tax year preceding the year in which the service is performed (for which the compensation is paid), with the following two exceptions:

· Newly eligible employees may make a deferral election within 30 days of becoming eligible for the plan; and

· If the eligible compensation is based on performance over at least a 12-month period (i.e. annual bonus), the employee has until 6 months before the end of the performance period to make the election.

AJCA also provides that to avoid constructive receipt (and current taxation) distributions from a NQDC plan can only occur upon events specifically enumerated in the plan document including: separation from service; disability; death; passage of a specified length of time; a change-in-control; or an unforeseen emergency. Thus, the terms of the NQDC plan, or the employee’s election, must state when amounts will be distributed. The plan document or deferral election also must provide the method of distribution (e.g. lump sum or installments).

AJCA permits an election to change the timing or method of distribution only if made at least 12-months before the scheduled date. Also, the revised election must defer commencement of payment(s) for at least an additional 5 years (unless due to disability, death or unforeseen emergency).

AJCA prohibits acceleration payments. Many plans were designed to permit employees to withdrawal amounts ahead of the schedule set forth in the plan. Under prior law, these plans sought to avoid constructive receipt by subjecting such a distribution to a penalty (usually 10%). These were often referred to as “haircut” provisions and are not allowed under AJCA.

Assets under a NQDC plan generally must remain subject to general creditors of the company to avoid contributions to the Plan from being treated, for tax purposes, as a transfer of property. Traditionally, a rabbi trust may have been used to hold assets of the plan. A rabbi trust permits assets to be set aside from the company’s general assets. However, the rabbi trust remains subject to company creditors. Thus, contributions to the rabbi trust do not constitute a taxable transfer of property.

Under AJCA, a taxable transfer of property is deemed to occur:

· When an offshore trust is created; and

· When financial triggers or financial health restrictions apply.

In an effort to provide some level of security to employees inside a rabbi trust, some plans provide for distribution upon certain financial events. These “triggers” are often designed to permit the employee to withdrawal money from the rabbi trust before the company’s creditors take any action. These provisions can no longer be utilized.

AJCA is effective for amounts deferred on or after January 1, 2005. The legislation awaits the President’s signature, which is expected. All NQDC plans must be reviewed to determine compliance with AJCA.◄