Major Changes For Deferred Compensation

The American Jobs Creation Act of 2004, signed into law by the President on October 22, 2004, added section 409A to the Internal Revenue Code to correct perceived abuses in the use of deferred compensation arrangements. Under the new rules, a deferred compensation plan is any arrangement under which compensation is paid more than 2-1/2 months after the end of the calendar year in which it is earned.

The new rules impact the full spectrum of deferred compensation plans and dramatically restrict the ability of participants to make deferral elections, change the time and form of their benefits, and the type of structures that may be used to hold assets under such plans. The penalties for violating these rules are severe and are imposed against the participant. Generally, if a deferred compensation plan fails to comply with these new rules:

1. All amounts previously deferred are immediately treated as gross income;

2. Interest and penalties are imposed on the underpayments that would have occurred had the compensation been taxable when first deferred; and

3. A 20-percent penalty tax is imposed on all amounts treated as gross income.

These new rules apply to deferrals occurring after December 31, 2004 as well as deferrals made prior to January 1, 2005 that were not vested as of December 31, 2004. In certain circumstances, these rules may even apply to vested deferrals. The expansive changes to deferred compensation plans mandated by section 409A will require amendments to nearly all such plans. Employers are cautioned to give careful thought about how these rules impact their compensation programs and, in particular, before amending any current plans.

Update: On April 10, 2007, the Treasury Department released long-awaited final regulations to section 409A giving employers until December 31, 2007 to bring their plans into compliance with these new rules.