New Rules Governing Nonqualified Deferred Compensation Plans

By Lorin Barker

The American Jobs Creation Act of 2004 enacted new Section 409A of the Internal Revenue Code, which dramatically changes the treatment of nonqualified deferred compensation (“NQDC”) plans. Whereas employers and employees previously enjoyed tremendous flexibility in designing NQDC plans to accomplish a variety of objectives and purposes, Section 409A imposes rigid new requirements upon such plans. The penalties for failing to comply with the new requirements are rather severe. Consequently, 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 to protect your plan participants from these penalties.

Section 409A applies to any plan that provides for the deferral of compensation other than certain qualified plans (such as 401(k) plans) and bona fide vacation, sick leave, compensatory time, disability pay or death benefit plans. Thus, Section 409A applies to a wide variety of deferred compensation plans including bonus arrangements, severance packages, and certain types of stock options, stock appreciation rights, and so forth. Unless a plan satisfies each of Section 409A’s requirements, all amounts deferred under the plan will be currently included in gross income, subject to a 20% penalty, and subject to interest charges at the underpayment rate plus 1%.

Section 409A’s original effective date was January 1, 2005. In December 2004, recognizing the sweeping nature of Section 409A’s changes and the difficulty of bringing all NQDC plans into compliance, the Internal Revenue Service issued transition rules that delayed the effective date for some of Section 409A’s requirements until January 1, 2006. In recently issued proposed regulations, the Internal Revenue Service extended some, but not all, of those transition rules until January 1, 2007. Consequently, there are a series of effective dates for different aspects of the Section 409A requirements. Because plans will need to comply with some of the requirements by January 1, 2006, and because the recently issued proposed regulations contain several new requirements, it is important that your NQDC plans are reviewed before the end of the year to ensure that they will comply with the new requirements that become effective January 1, 2006. This is especially true for any stock-based plans such as stock options, stock appreciation rights, etc.

If you would like our assistance in reviewing and/or amending any deferred compensation plans or arrangements please contact Lorin Barker at lbarker@kmclaw.com or Ken Birrell at kbirrell@kmclaw.com.