This article is reprinted with permission
New York Law Journal.
© 2003 NLP IP Company.
New Legislation on Deferred Compensation
Rules Under Present Law
Basic rules under present law providing that unfunded deferred compensation generally is not subject to income tax until it is actually or constructively received continue in effect [subject, of course, to compliance with the new rules unless the deferral is "grandfathered" as discussed below]. Also, present rules relating to funded deferred compensation that is not in the form of a tax-qualified arrangement continue in effect. These rules provide, generally, that such funded deferred compensation is taxed when the employee's right to the "funds" [e.g., employer securities or a beneficial interest in a trust] is not subject to a substantial risk of forfeiture or is transferable free of such risk of forfeiture. Of course, an important exception to the "funding" rule is a so-called "rabbi trust," the assets of which are subject to the claims of the employer's creditors in the event of bankruptcy or insolvency [but otherwise are held for the exclusive benefit of the employee[s] for whose benefit it was created].1 [As discussed further below, the new legislation contains changes affecting rabbi trusts in certain circumstances.2]
Basic Rule Changes
Amounts includible in taxable income due to a failure to meet the new deferred compensation requirements of Code § [409A will be includible in taxable income in the year in which there is such a failure. In no event, however, will such amounts be includible prior to the year in which they are no longer subject to "a substantial risk of forfeiture" which is defined in Code § [409A[d] as follows:
[t]he rights of a person to compensation are subject to a substantial risk of forfeiture if such person's rights to such compensation are conditioned upon the future performance of substantial services by an individual.
In the event of taxability due to a failure to meet the requirements of Code § [409A, an additional 1 percent interest rate on the amount of the underpayment [calculated, together with the regular rate of interest on an underpayment, from the year in which the amount should have been included in income under the new rules] plus an additional 20 percent tax rate on such amount will apply. These consequences are discussed further below.
2. Covered Plans
[Code § [409A[d]-]. The new rules apply to "non-qualified deferred compensation plans" [NQDCPs]. Code § [409A[d] defines an NQDCP as any plan that provides for the deferral of compensation other than "[A] a qualified employer plan, and [B] any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan."
A "qualified employer plan" for this purpose includes a qualified retirement plan, tax-deferred annuity, simplified employee pension, a SIMPLE, a qualified governmental excess benefit arrangement under Code § [415[m] and an eligible deferred compensation plan under Code § [457[b].3 By definition, a nonqualified supplemental retirement plan [frequently called a SERP] is an NQDCP.
Code § [409A[d] provides that the term "plan" includes "any agreement or arrangement, including an agreement or arrangement that includes one person." An NQDCP is not limited to an arrangement between an employer and an employee. It includes arrangements with an independent contractor; thus, it will include deferral arrangements applicable to compensation of asset managers, consultants and nonexecutive directors.
The Conference Report accompanying the act provides that a nonqualified stock option plan is not an NQDCP if it provides for the grant of an option on employer stock that is not less than the fair market value of the stock on the date of grant and does not include a deferral feature other than the right to exercise the option at some point in the future. H.R. Conf. Rep. No. 108-755, at 524  [Conference Report]. The Conference Report leaves open the question whether a stock appreciation right is an NQDCP, stating that the Treasury "may ... address in regulations issues relating to stock appreciation rights."4 Conf. Rep. at 525. The Conference Report is silent as to whether a deferred stock unit is an NQDCP.
3. Permissible Distributions
[Code § [409A[a]]. With limited exceptions, deferral of taxes under an NQDCP will be permitted only if distributions of the deferred compensation are limited to the occurrence of one or more of the following:
[a] separation from service [a term to be defined by the Treasury]; certain specified employees of a corporation the stock of which is publicly traded cannot receive payment, if "separation from service" is the basis for the distribution, for six months after separation;5
[b] a disability as defined in Code § [409A[a][C];
[d] a specified time [or pursuant to a fixed schedule] specified under the NQDCP at the date of deferral of such compensation;
[e] a change in control [defined in Code § [409A[a][A][v] to mean "to the extent provided by the [Treasury], a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation"]; and
[f] an unforeseeable emer- gency as defined in Code § [409A[a][B][ii].6
The new law intends that the Treasury will prescribe rules pursuant to which other circumstances may permit distribution. Code § [409A[a]. Otherwise, acceleration of distribution is prohibited except in connection with one of the triggers noted above. Conf. Rep. at 521.7
4. Elections to Defer
Requirements with respect to elections to defer [Code § [409A[a]]. Elective deferrals under an NQDCP, in order to qualify under the new deferral rules, must meet the following requirements.
[a] In the case of an NQDCP that is not "performance-based" [see next paragraph], if the compensation is for services rendered during a taxable year, the election must be made before the beginning of that year, except for the first year of eligibility in which case the election may be made within 30 days of eligibility. Code § [409A[a][B][i]-[ii].
[b] If the compensation is "performance-based" and the services are to be performed over a period of at least 12 months, the election may be made no later than six months prior to the end of the service period. Code § [409A[a][B][iii].8
A deferral arrangement may allow subsequent election to delay the originally elected timing for the distribution. Code § [409A[a][C]. But the arrangement providing for the subsequent election to further delay receipt must meet certain requirements. The arrangement must require that [a] the election cannot be effective for 12 months from the date of the election to delay, [b] except in the case of death, disability or unforeseen emergency, the minimum period for the additional deferral is five years and [c] in the case of a distribution based on a specified time, there must be a minimum period of 12 months between the election to delay and the first scheduled payment pursuant to the schedule specified at the date of the deferral. Code § [409A[a][C][i]-[iii].
5. Certain Funding Rules
[a] [Code § [409A[b]].
Foreign Trusts. The new rules include provisions
directed at assets located outside the
[b] [Code § [409A[b]]. Other "Securitization" Arrangements. These include arrangements intended to enhance security of an NQDCP that are triggered by "a change in the employer's financial health." The statute describes them as arrangements in which "assets will become restricted to the provision of benefits under the plan in connection with" such a change.10 This new provision applies even if, after the "restriction," the assets remain subject to the claims of general creditors of the employer. An example given in the Conference Report is a transfer of assets to a rabbi trust triggered by a change in the employer's financial health.11 Code § [409A[e] provides that the Treasury shall prescribe regulations covering such exceptions as well as defining "financial health."
6. 'Original Underpayment'
Additional One Percent Rate of Interest on "Original Underpayment" and Additional 20 percent Tax Rate [Code § [409A[a][B]].
[a] An additional 1 percent interest rate is charged on top of the regular interest charged on the underpayment of income tax as a result of failure to comply with new rules. Such additional interest is charged on the underpayment of tax that would have occurred if the NQDCP amounts had been "includible" in income for the taxable year in which originally deferred or, if later, the first taxable year in which it ceases to be subject to a substantial risk of forfeiture. As noted above, the meaning of a substantial risk of forfeiture is contained in Code § [409A[d].
[b] In addition, a 20 percent additional tax rate on top of the regular ordinary income tax rate is imposed on any compensation that is required to be included in gross income because the NQDCP does not comply with the new NQDCP rules [i.e., failure to comply with any of the new rules applicable to distributions, elections and funding and other securitization].
7. Effective Date
Section 885[d]. Section 885[d] of the act provides that "[t]he
amendments made by this section shall apply to amounts deferred after
Section 885[d] also provides that the amendments "shall apply to earnings on deferred compensation only to the extent that such amendments apply to such compensation."
Amounts deferred in taxable years beginning before Jan. 1, 2005 will nonetheless be subject to the new rules if the plan or other arrangement pursuant to which they are deferred is materially modified after Oct. 3, 2004 [except in compliance with Treasury guidance rules noted in the next paragraph].12
The act further provides for the Treasury to issue guidance "no later than 60 days after the date of enactment" to allow plans "adopted before Dec. 31, 2004" [presumably, the date of Jan. 1, 2005 was actually intended] to be amended  to allow participants, subject to certain conditions, to terminate participation and  to comply with the new rules in respect of deferrals made after Dec. 31, 2004. Act § [885[f].
8. Other Provisions
The statute directs the Treasury to issue regulations in a number of areas, including definitions [e.g., a "change in control" [as used in Code § [409A[a][A][v]] and "financial health" of a corporation [as used in Code § [409A[b]].13 The statute also provides for aggregation of affiliated employers for certain purposes and not for others. Code § [409A[d]. As a new reporting requirement, Act § [885[b] amends Code § [6051[a] to require "the total amount of deferrals for the year under a nonqualified deferred compensation plan [within the meaning of Code § [409A[d]]" to be reported on an individual form W-2 [or Form 1099].14
 In a 1980 Private Letter Ruling [PLR],
the Internal Revenue Service [IRS] held that such a trust did not constitute a funding
of the deferred compensation that it was intended to secure. PLR 8113107 [
 Apart from ordinary income tax rules, compensation that has been "earned" [i.e., is not subject to future performance or other substantial conditions to its becoming an entitlement of the employee] is subject to Social Security and Medicare taxes. This is so whether or not its receipt is deferred. These rules continue. [For most executives, Social Security taxability is not relevant because their current income levels already exceed the taxable wage base for Social Security taxes.]
 The Conference Report indicates that the new rules are not applicable "to annual bonuses or other annual compensation amounts paid within two and one-half months after the close of the taxable year in which the relevant services required for payment have been performed." Conf. Rep. at 525.
 In Revenue Ruling 80-300, 1980-2 C.B. 165, the IRS held that a taxpayer is not in constructive receipt under a stock appreciation right, reasoning that the exercise is the equivalent of surrendering a valuable right [the loss of all further appreciation].
 See Code § [409A[a][B][i], which defines a "specified employee" as a key employee as defined under Code § [416[i]. Code § [416[i] generally defines a key employee as an officer having annual compensation greater than $130,000 [adjusted for inflation and limited to no more than 50 employees], five percent owners and one percent owners having annual compensation from the employer greater than $150,000.
 Code § [409A[a][B][ii] defines "unforeseeable emergency" as "a severe financial hardship to the participant resulting from illness or accident of the participant, the participant's spouse or a dependent [as defined in [Code] § [152[a]] of the participant, loss of the participant's property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant." Code § [409A[a][B][ii][II] provides that offsetting reimbursements such as those attributable to insurance must be taken into account.
 The Conference Report provides examples of circumstances, in addition to those set out in Code § [409A[a], in which it intends that the Treasury permit acceleration of distributions. See Conf. Rep. at 521.
 For this purpose, the Conference Report
indicates that the Treasury is to define the meaning of "performance-based
compensation" to include compensation that is " variable and
contingent on the satisfaction of pre-established organizational or individual
performance criteria and  not readily ascertainable at the time of the
election." Conf. Rep. at 522. The Conference
Report indicates that performance-based compensation may be required to meet
certain requirements similar to Code § [162[m]. For example, the Conference
Report states that performance criteria will be deemed pre-established,
"if it is established in writing no later than 90 days after the
commencement of the service period, but the requirement of determination by the
compensation committee of the board of directors would not be required."
 The statute provides, however, that it "shall not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualified deferred compensation relates are performed in such jurisdiction." Code § [409A[b].
 The statute provides that the deemed "transfer" attributable to a covered "restriction" will occur on the earlier of the date the NQDCP provides for the restriction or the date on which the assets are so restricted. Code § [409A[b].
 Examples of exceptions to the new rule given in the Conference Report are transfers, or other restrictions, as a result of a change in control of the employer or other events unrelated to a change in the employer's financial health. Also excluded are transfers, or other restrictions, occurring based on a predetermined schedule having nothing to do with a change in the employer's financial health. Discussion of the "financial health" triggers, and intended exceptions, are contained in pages 523 and 524 of the Conference Report.
 The Conference Report states that the "addition of any benefit, right or feature is a material modification." On the other hand, the exercise or reduction of an existing "benefit, right or feature" is not a material modification. Conf. Rep. at 526. The Conference Report provides a few examples of what is or is not a "material modification" at page 526. The Conference Report also states that
Operating under the terms of a deferred
compensation arrangement that complies with current law and is not materially
 The act also requires the Treasury to adopt regulations as to when a "substantial risk of forfeiture" is to be disregarded. Code § [409A[e]. The Conference Report suggests disregarding a substantial risk of forfeiture if it is "illusory" or otherwise inconsistent with the purposes of the new rules. Conf. Rep. at 525.
 In the year in which such amounts are required to be includible income they are required to be reported on an individual's Form W-2 [or Form 1099] for that year. Provision is made for the Treasury's excluding from the requirements amounts below a minimum threshold. Wage withholding and other reporting requirements reflecting the new rules are contained in Act § [885[b] and .