November 2004 Vol. VIII, No. 1
ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the "Act"). Among its many provisions, the Act includes a major change in the income tax treatment of deferred compensation. The types of plans and arrangements affected by the new law extend beyond what has traditionally been regarded as nonqualified deferred compensation, and the Act will impact many common arrangements (such as stock appreciation rights and supplemental executive retirement plans). Since the effective date of the change in the law is close at hand, January 1, 2005, employers need to take immediate action to assess the impact of the Act upon their deferred compensation arrangements. The tax and penalties for violating the Act are steep, so care must be taken to determine a plan's compliance as soon as possible.

This Newsletter also contains a table with new cost of living adjustments affecting tax-qualified plans. Our annual, more in-depth Newsletter will be forthcoming to apprise you of other important legal changes of which you should be aware.

The Newsletter is not intended as, and cannot be considered to constitute, specific legal advice, as each individual circumstance is unique. However, we are prepared to assist our clients and business associates in reviewing their employee benefit programs and in making any necessary or desirable revisions to take into account changes in the law.

Since our last Newsletter, Marcia S. Wagner has continued to lecture and write extensively, and has been selected by her peers as one of "The Best Lawyers in America" in the ERISA/Employee Benefits field. She has also been quoted in several major news publications, and has provided numerous seminars for the American Bar Association, Society of Enrolled Actuaries, Internal Revenue Service and others. Marcia has also co-authored a Quick Reference to HIPAA Compliance and has appeared twice on "Nite Beat with Barry Nolan" for New England cable news. Ari J. Sonneberg continues his work at the Tax Section Council of the Massachusetts Bar Association. Marcia S. Wagner, Esq., Christopher J. Sowden, Esq., John R. Keegan, Esq. and Virginia Peabody are working on a book regarding compliance issues and guidance for tax-qualified and welfare benefit plan sponsors. To learn more about our team and practice, please visit our web site at www.erisa-lawyers.com.

In the event you desire legal advice or consultation, please feel free to contact Attorney Marcia S. Wagner, Attorney Christopher J. Sowden, Attorney John R. Keegan, Attorney Ari J. Sonneberg, or Attorney Jon C. Schultze. See Meet the Team Page >>


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TABLE OF CONTENTS
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I. COST OF LIVING ADJUSTMENTS
II. NONQUALIFIED DEFERRED COMPENSATION
A. INTRODUCTION
B. SUMMARY
C. DEFINITION OF NONQUALIFIED DEFERRED COMPENSATION PLAN
D. DISTRIBUTION REQUIREMENTS
E. DEFERRAL ELECTIONS
F. ACCELERATION PROVISIONS
G. FUNDING ARRANGEMENTS
H. REPORTING REQUIREMENTS
I. EFFECTS OF NONCOMPLIANCE
J. EFFECTIVE DATE
K. TRANSITION RELIEF
L. REGULATIONS
M. RECOMMENDED ACTIONS


I. COST OF LIVING ADJUSTMENTS

The 2005 index limits for qualified retirement plans are as follows:

   2004 2005
 Maximum annual payout from a defined benefit plan
at or after age 62
 $165,000*   $170,000*
 Maximum annual contribution to an individual's defined contribution account  $41,000 **  $42,000 **
Maximum Section 401(k), 403(b) and 457(b) elective deferrals  $13,000 ***   $14,000 ***
Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older  $3,000***   $4,000***
 Maximum amount of annual compensation that can be taken into account for determining benefits or contributions under
a qualified plan
 $205,000 $210,000
 Test to identify highly compensated employees, based on
compensation in preceding year
 $90,000 $95,000
Wage Base: For Social Security Tax  $87,900  $90,000
 For Medicare  No Limit  No Limit
Amount of compensation to be a key employee $130,000
$135,000

* There are late-retirement adjustments for benefits starting after reaching age 65.
** Plus "catch-up" contributions
*** These are calendar year limitations.

II. NONQUALIFIED DEFERRED COMPENSATION

A. Introduction

On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the "Act"). Among its many provisions, the Act includes a major change in the income tax (but not Social Security tax) treatment of deferred compensation payable under employer plans or arrangements, other than tax-qualified plans and similar tax-favored arrangements (such as 403(b) annuities and 457(b) eligible deferred compensation plans maintained by tax exempt organizations).

The types of plans and arrangements affected by the new law extend beyond what has traditionally been regarded as nonqualified deferred compensation, and the Act will impact many common arrangements (such as stock appreciation rights and supplemental executive retirement plans). Since the effective date of the change in the law is January 1, 2005, employers need to take immediate action to assess the impact of the Act upon their deferred compensation arrangements and, where appropriate, to adjust those arrangements to conform to the new requirements imposed by the Act.

At the end of this Section of the Newsletter, we list the actions that we believe clients affected by this significant legislation ought now to be taking. In an upcoming firm Newsletter, we will be providing further guidance on the Act, including the Treasury regulations implementing the Act that can be expected in the near future.

B. Summary

Under current law, amounts deferred under a nonqualified deferred compensation plan maintained by a taxable employer are generally taxable when actually or constructively received by the employee. Amounts deferred under a nonqualified deferred compensation plan maintained by a tax exempt employer are not taxable when they are actually or constructively received but when they are no longer subject to a substantial risk of forfeiture, i.e., as they become vested.

Under the Act, the current law treatment for nonqualified deferred compensation plans of taxable employers continues to apply to amounts deferred after 2004 under a nonqualified deferred compensation plan that meets the Act's requirements, as well as to amounts deferred before 2005. Starting in 2005, amounts deferred under a nonqualified deferred compensation plan that fails to meet the new requirements will be subject to income tax not when they are received (actually or constructively) but when they are no longer subject to a substantial risk of forfeiture, i.e., as they become vested.

The Act also applies to nonqualified deferred compensation plans maintained by tax exempt employers. It does not, however, change the current law treatment of amounts deferred under such plans, so that deferrals under these plans will continue to be taxable as they become vested.

The Act does, however, make two major changes to all nonqualified deferred compensation plans regardless of whether they are maintained by a taxable or tax exempt employer. First, if the plan does not satisfy the Act's requirements, when benefits become taxable there is an additional interest charge and a 20% tax penalty. Thus, even though the rules regarding when benefits are taxable under a nonqualified deferred compensation plan maintained by a tax exempt employer have not changed, it is important for such plans to satisfy the Act's requirements in order to avoid the new interest charge and 20% penalty tax. Second, employer deferrals under a nonqualified deferred compensation plan, whether or not vested, must be reported on IRS Form W-2 or the appropriate Form 1099 for the year in which amounts are deferred even if they are not currently includible in income. Form W-2 (or Form 1099) reporting is also required for the year in which deferred amounts become taxable.

C. Definition of Nonqualified Deferred Compensation Plan

The Act, which adds a new Section 409A to the Internal Revenue Code of 1986, as amended (the "Code"), defines a nonqualified deferred compensation plan as "any plan, agreement or arrangement that provides for the deferral of compensation," other than:

1. a tax-qualified plan (Section 401(a) of the Code), a tax deferred annuity (Section 403(a) or (b)), a SEP (Section 408(k)) or a SIMPLE plan (Section 408(p));

2. a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan;

3. an eligible deferred compensation plan (Section 457(b));

4. certain non-elective deferred compensation plan for non-employees (Section 457(e)(12)); and

5. qualified governmental excess benefit arrangements (Section 415(m)).

Since the definition of a nonqualified deferred compensation plan is not limited to arrangements between an employer and an employee, deferral arrangements affecting partners and independent contractors, such as directors, consultants and sales representatives, would also be included. Nor need there be a plan: deferral arrangements contained in an individual employment contract would be included in the Act's definition.

The following types of arrangement will be subject to the new rules:

1. deferred compensation plans of tax exempt and governmental employers that are not eligible deferred compensation plans under Section 457(b) of the Code ­ i.e., Section 457(f) plans;
2. stock options with an option price less than the fair market value at the time of grant;
3. stock appreciation rights;
4. phantom stock plans;
5. restricted stock units;
6. supplemental executive retirement plans ("SERPs"), both defined benefit and defined contribution plans and regardless of whether they are elective;
7. excess benefit plans;
8. severance plans and agreements payable in a later taxable year; and
9. any other arrangement that defers the receipt of income.

The following arrangements are specifically exempted from the new rules:

1. payment of annual compensation, such as bonuses, within 2 _ months after the end of the year in which the services are performed;
2. incentive stock options (Code Section 422);
3. employee stock purchase plans (Code Section 423); and
4. eligible deferred compensation plans of tax exempt and governmental employers (Code Section 457(b)).

D. Distribution Requirements

The Act requires that a nonqualified deferred compensation plan permit distributions no earlier than:

1. Separation from service ­ In the case of a key employee of a publicly traded corporation, however, a date six months after separation from service (or death, if earlier) is the earliest date on which distribution may be made. For all employees, whether a separation from service has occurred will be determined (under Treasury regulations to be issued) on a controlled group basis.

Comment: The required delay in payments to key employees of public corporations may require amendments to the plans of those employers if they provide for distribution upon separation from service.

2. Disability ­The Act defines disability as inability to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment that is expected to result in death or to last for a continuous period of at least 12 months, or receipt of income replacement benefits by reason of any such physical or mental impairment for a period of at least three months under an accident and health plan.

3. Death.

4. A specified time or pursuant to a fixed schedule ­ The time or schedule must be established by the plan of deferred compensation at the time of deferral. The occurrence of an event, such as a child's beginning college, is not a specified time, but the participant's attainment of age 65 is.

Comment: Defined benefit SERPs generally contain distribution provisions that track those of the underlying qualified retirement plan. As a result, the participant is generally permitted to choose the date of distribution when he or she retires or terminates employment, rather than when the deferral occurs. Such plans may need to be amended to eliminate or modify such provisions with respect to accruals after the effective date of the Act.

5. Change in control ­ A change in the ownership or effective control of a corporation, or in the ownership of a substantial portion of the assets of a corporation, will be a permissible distribution event. The Treasury has been directed to issue regulations defining a change in control within 90 days after the enactment of the Act. This definition will be similar to, but more restrictive than, the change in control definition used for purposes of the golden parachute provisions of Section 280G of the Code.

6. Unforeseeable emergency ­ For this purpose, an unforeseeable emergency is a severe financial hardship of the participant resulting from:

an illness or accident of the participant, his or her spouse or dependent;
loss of the participant's property due to casualty; or
other similar extraordinary and unforeseeable circumstances resulting from events beyond the control of the participant.

The amount distributed must be limited to the amount needed to satisfy the emergency plus taxes reasonably anticipated as a result of the distribution. Distributions are not permitted if the hardship may be relieved through reimbursement or compensation, or by liquidation of the participant's assets.

Plan documents must be specific as to the events permitting distributions, either by requiring participants to make elections at the time of deferral or by default rules that specify the time of distribution.

E. Deferral Elections

Where compensation is deferred under a nonqualified deferred compensation plan at the election of the employee, the Act contains new requirements that generally accelerate the time by which an election to defer must be made. Under current law constructive receipt rules, an election to defer may generally be made at any time before amounts are due and payable to the employee. Under the Act, elections must generally be made before the services giving rise to the compensation are performed.

Initial election ­ The initial election to defer compensation for services generally must be made no later than the end of the taxable year preceding the taxable year in which the services are performed (or at such other time as may be provided in Treasury regulations). Newly eligible participants may make the election within 30 days of eligibility, but only with respect to compensation for services to be performed after the election.

In the case of "performance-based compensation", an election may be made up to six months before the end of the period during which the services are performed, provided that the period of performance lasts at least 12 months. Compensation is performance-based if it 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 to defer.

Comment: The Act will end the practice of soliciting deferral elections for bonuses until late in the period for which the bonus is paid.

The Treasury is directed to issue guidance on performance-based compensation which will be similar to the requirements under Code Section 162(m) (which limits deductible compensation for publicly traded corporations). This guidance will require that performance criteria be established in writing no later than 90 days after the beginning of the performance period, but there will be no requirement that the compensation committee of the board of directors establish the performance criteria. The guidance will also address the timing of elections where the fiscal year of the employer and the taxable year of the employee differ.

Note that the new rules could affect 2004 annual bonuses and long-term bonuses where the performance period is ongoing, since these will be subject to the new rules if not vested by the end of 2004. Transition relief for these amounts may be provided.

Comment: Bonus plans that use a non-calendar fiscal year will be more severely affected than calendar year plans. For example, for a plan year beginning on July 1, 2006, where the bonus payment will occur in 2007, elections may have to be made by the end of 2005 unless the plan meets the requirements for performance-based compensation (in which case the six-month election rule would apply) or the Treasury provides relief for fiscal year plans.

The time and form of distributions must be specified at the time of initial deferral. This can be done either by the plan itself (for example, a plan could state that payments at separation from service will be made in a lump sum within 30 days of separation) or participants could be permitted to elect the time and form of payment when the initial deferral election is made. Multiple payout events (for example, 25% of the account balance at age 50 and the remainder at age 65) and different forms of distribution at different payout events will be permitted.

Subsequent elections ­ A later election by a participant to delay the timing or change the form of distributions will be permitted only if the plan provides that:

1. The election cannot be effective for at least 12 months after it is made;

2. Except for elections relating to distributions on death, disability or unforeseeable emergency, any additional deferral will be for a period of at least five years from the originally applicable distribution date; and

3. An election changing a distribution to be made at a specified time or pursuant to a fixed schedule must to be made no later than 12 months before the first scheduled payment.

F. Acceleration Provisions

Under the Act, the acceleration of the time or schedule of payments may only be made in accordance with Treasury regulations. Changes in the form of distribution that have the effect of accelerating payments are also prohibited, although the Treasury regulations will provide that the choice between different forms of actuarially equivalent life annuities will be permissible.

Comment: The Act will end "haircut" provisions under which a participant may receive distribution, if a portion, typically 10% to 15% of the distribution, is forfeited.

The Treasury regulations will permit acceleration of distributions for reasons beyond the control of the participant if the accelerated distribution is not elective on the part of the participant, such as a distribution to comply with a court-approved divorce settlement. In addition, employment tax withholding and some distributions to participants to pay income taxes due upon a vesting event would be permitted.

Finally, the Treasury regulations will permit a plan to provide for automatic distributions of minimal amounts ($10,000 is mentioned in the Conference Report on the Act) upon the occurrence of permissible distribution events.

Plan termination is not an exception to the prohibition on acceleration of distributions.

G. Funding Arrangements

Foreign Trusts ­ Under the Act, vested participants will be taxable if assets are transferred to a foreign trust (or other arrangement designated by the Treasury) unless substantially all of the services to which the nonqualified deferred compensation relates are performed in the foreign jurisdiction where the trust (or other arrangement) is located. Taxability occurs at the time of the transfer. Subsequent increases in value of the foreign assets, as well as earnings on those assets, are treated as additional transfers subjecting the participant to tax.

Transfers to domestic rabbi trusts are not affected unless, as described below, the assets in the trust become restricted as a result of a change in the employer's financial health.

Financial health triggers ­ If assets are or will become restricted to the payment of nonqualified deferred compensation (even if the assets will remain available to satisfy the claims of general creditors), a vested participant will recognize taxable income on the earlier of the date on which the assets become restricted or when the plan provides that assets will be restricted. A change in control of the employer is not for this purpose treated as a change in financial health, a term that will be defined in Treasury regulations.

The Treasury has been authorized to provide exceptions to the above funding rules for arrangements that do not result in an improper deferral of tax and in assets being effectively beyond the reach of creditors.

H. Reporting Requirements

Employee deferrals under a nonqualified deferred compensation plan, whether or not vested, must be reported on IRS Form W-2 or the appropriate Form 1099 for the year in which amounts are deferred even if they are not then currently includible in income. According to the Conference Report, one purpose of this reporting is to enable the IRS to identify arrangements that "should be examined and challenged." The Treasury may establish a minimum amount of deferrals below which reporting is not required, and may except from the reporting requirement deferred amounts that are not reasonably ascertainable (but only in the case of non-account balance plans) which would have to be reported when they first become reasonably ascertainable. Form W-2 (or Form 1099) reporting is also required for the year in which deferred amounts become taxable.

I. Effects of Noncompliance

If a nonqualified deferred compensation plan fails to meet any of the Act's requirements, the participant affected by the failure will be subject to current taxation on all amounts deferred for the taxable year in which the failure occurs and for all prior years that are not subject to a substantial risk of forfeiture and have not previously been included in income. In addition, the Act imposes the following interest charge and penalty tax:

Interest, at the IRS underpayment rate plus 1%, for the period from the date of deferral or, if later, the date of vesting, on the underpayments of tax that would have occurred if the deferred compensation had been included in income for the taxable year in which it was deferred or, if later, became vested; and

A penalty tax of 20% of the taxable amount.

Comment: If a nonqualified deferred compensation plan is not drafted correctly, all participants may be "affected" by the failure and owe penalty taxes and interest as a result.

J. Effective Date

The requirements for nonqualified deferred compensation plans introduced by the Act generally apply to amounts deferred after December 31, 2004. The new rules do not apply to amounts deferred before January 1, 2005, or earnings on those amounts that are credited before or after that date, unless the plan is materially modified after October 3, 2004. For purposes of the effective date provision, amounts are considered deferred before January 1, 2005, only if both earned and vested before that date.

Amounts deferred before January 1, 2005 and earnings on those amounts will be subject to the new rules if the plan under which the deferrals occurred is materially modified after October 3, 2004, except to the extent permitted by Treasury regulations giving transition relief (see below). The addition of any benefit, right or feature to an existing plan, such as accelerating vesting to a date before the effective date of the Act or adding a haircut feature, is a material modification, but the elimination or reduction of an existing benefit, right or feature (such as eliminating a haircut feature) is not.

Subsequent deferrals of amounts deferred before January 1, 2005, under a plan that is not materially modified after October 3, 2004, would not be subject to the new rules.

Under the effective date provisions of the Act, 2004 annual bonuses and longer-term bonuses that are not vested at December 31, 2004, as well as other outstanding awards (such as restricted stock units, phantom stock, stock appreciation rights and discounted options) that will not vest by that date, would be subject to the new rules, unless transition relief is provided. Accelerating vesting to avoid the new rules does not appear to be a solution.

K. Transition Relief

The Treasury will issue guidance within 60 days after the enactment of the Act that will provide a limited period of time during which nonqualified deferred compensation plans and arrangements adopted before December 31, 2004, may be amended:

To permit a participant to terminate participation in the plan or cancel an outstanding deferral election with respect to amounts deferred after 2004 without violating the new requirements, but only if amounts subject to the plan termination or election cancellation are includible in income as earned or, if later, when vested; and

To conform the plan to the new rules for post-2004 deferrals.

The Conference Report states that the Treasury is expected to provide exceptions to certain of the new rules (such as the rule regarding the timing of elections) for plans that are amended to comply with the new rules, and to provide a reasonable period of time after guidance is issued in which plans may be amended. It is currently unclear what, if any, amendments will need to be adopted by the end of 2004.

L. Regulations

In addition to the regulations implementing the transition rules described above, the following Treasury regulations are either required or permitted by the Act, or expected as a result of statements in the Conference Report:

1. To provide for determining the amount deferred in the case of a nonqualified deferred compensation plan that is a defined benefit plan.

2. Defining what constitutes a change in ownership or effective control of a corporation or in the ownership of a substantial portion of the assets of a corporation.

3. Defining "financial health" for purposes of the new rules regarding offshore assets and restrictions on assets based upon a change in the employer's financial health, and exempting from those rules arrangements that do not result in an improper deferral of U.S. tax and in assets being effectively beyond the reach of creditors.

4. Disregarding a substantial risk of forfeiture where necessary to effectuate the new rules.

5. Providing a limited number of exceptions to the prohibition on acceleration of the time or form of payments.

6. Providing for deferral elections later than the end of the taxable year preceding the taxable year in which services are performed.

7. Permitting automatic distributions of small account balances.

8. Defining "performance-based compensation."

9. Coordinating the timing of elections for employees of fiscal year employers.

10. Permitting, in limited cases, an election to change a stream of payments.

11. Addressing elections for payment under nonelective, supplemental retirement plans.

12. Identifying the deferrals to which assets set aside are attributable when the value of the assets set aside is less than the full amount of the deferrals.

13. Addressing the application of the controlled group rules.

14. Establishing a minimum amount of deferral below which the reporting requirements do not apply, and exempting deferrals from these requirements where the amount is not reasonably ascertainable.

Comment: In some cases, the grant of rulemaking authority to the Treasury is permissive, not mandatory. Moreover, even when the Treasury is required to issue regulations, in many cases no time limit is specified. It is unlikely therefore that all of the above regulations will be issued in the foreseeable future.

M. Recommended Actions

1. Any employer that currently has a plan or arrangement that may be subject to the new rules should immediately identify those plans and arrangements (which may include individual employment contracts and severance agreements) that may be affected by the Act, and have them reviewed to determine which will be subject to the new rules in 2005 and the latitude the employer has to change the arrangement unilaterally.

2. With respect to plans that will be subject to the new rules, employers should now be considering how they will react to the new legislation: by amending existing plans to the extent necessary to comply with the Act or by freezing current plans and adopting new plans that satisfy the Act for post-2004 deferrals. The latter course may be preferable in certain instances for ease of administration and to ensure that future deferrals are not administered in a way that violates the new requirements.

3. In certain cases, consideration might be given to deferring plan amendments until the Treasury issues guidance, particularly in light of the adverse consequences that could result from materially modifying an existing nonqualified deferred compensation plan.

4. Employees covered by plans and agreements subject to the Act should be made aware of the changes to the law and their impact on both existing and future deferrals, so that they may make informed decisions as to the treatment of past deferrals and their continuation of plan participation.

5. Bonuses payable in 2005 for services rendered in 2004 will be subject to the new rules. To the extent that deferral elections have not been made, employers should proceed with the process of obtaining elections, although care should be taken to utilize forms for this purpose that adequately reflect the new requirements. Employees should be advised that the deferrals will be subject to the new rules but that they should be able to rescind elections once the Treasury issues guidance on this subject. Deferral elections already made for 2004 bonuses should be reviewed for compliance with the new rules, and amended or voided as appropriate.

6. As to bonuses payable with respect to 2005, employers should obtain deferral elections in 2004 in order to comply with the new requirements as to the timing of initial elections unless it is certain that the bonus plan will meet the new requirements for performance-based compensation.

7. To prepare for possible amendments to existing plans and the possible adoption of replacement plans, employers should be considering the mechanics of plan amendment and adoption. For example, should a board of directors or trustees meeting be scheduled before the end of 2004, or could an officer of the employer be delegated authority to take actions necessary to comply with the Act?

Comment: We will be monitoring the upcoming regulations implementing the Act and will be analyzing their impact on those existing plans and arrangements of which we are currently aware and with respect to which we have been engaged to maintain on an on-going basis. If so requested, we would be pleased to do this also for those clients whose nonqualified deferred compensation plans or arrangements we do not presently maintain.