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7 steps to cope with new deferred-comp rules

by on October 1, 2007 11:00pm
in Compensation and Benefits,Human Resources

In 2004, Congress overhauled the tax rules for nonqualified deferred-compensation plans (see related article). The new rules took effect in 2005, but the IRS only recently issued final regulations.

Follow these seven steps to ensure full compliance under the final regs:

Step 1: Identify arrangements that provide a deferral of compensation. This requires employers to:
  • Identify service providers covered by the rules (e.g., staff, independent contractors, board members).

  • Identify arrangements that are deferrals of compensation.
Although certain “grandfathered arrangements” are exempt, the new rules apply to all other arrangements unless the IRS grants an exception.

Caution: Grandfathered status is lost if the arrangement is materially modified after Oct. 3, 2004.

Step 2: For each arrangement, decide between removing the deferral of compensation feature and complying with the rules. The deadline for making and documenting this decision is Dec. 31, 2007.

Tip: Weigh the benefits of providing deferred compensation against the costs of compliance and exposure to penalties.

Step 3: Design each arrangement to comply with the basic rules (i.e., restrictions on deferral elections, funding and distributions). Decide whether to adopt various special exceptions to the rules, which provide certain advantages but make plan administration more complex.

Step 4: Develop and implement policies and administrative procedures.

Tip: Designate someone to have ultimate responsibility for developing policies and procedures and for ensuring that they are followed.

Step 5: Prepare a written plan by Dec. 31, 2007. Under the final regs, the written plan must specify the terms as of Jan. 1, 2008, but is not required to specify the terms for the period prior to Jan. 1.

Step 6: Obtain service-provider elections as to time and form of payment by Dec. 31, 2007. But be aware that some elections result in noncompliance with the rules. Examples:
  • An election in 2007 to postpone a payment that would otherwise be received in 2007.

  • An election in 2007 that would cause a payment to be made in 2007 that would otherwise not be made in 2007.
Step 7: Evaluate compliance for the period between Jan. 1, 2005, and Jan. 1, 2008. The final regulations are effective for tax years beginning after 2007. Until then, the law requires good-faith compliance with the statute and earlier guidance in Notice 2005-1.

Tip: Review the plan operations to determine whether violations have occurred and take appropriate actions.

Contact your tax pro for assistance.

—Adapted from AccountingWeb, Inc., www.accountingweb.com.
What do the new deferred-compensation rules cover?
The new deferred-comp rules apply to a plan if any legally binding right is created in one year and payable in a later year (including written and oral agreements and arrangements that cover only one person). What’s covered:
  • Deferred compensation provisions in various types of agreements, including offer letters and employment, noncompete and consulting agreements.

  • Intercompany agreements with a personal service corporation.

  • Bonus plans.

  • 401(k) mirror plans.

  • Supplemental executive retirement plans.

  • 457(f) plans.

  • Severance agreements (some exceptions for 2005 only).

  • Phantom stock.

  • Stock appreciation rights.

  • Discounted stock options.

Initial deferral election

The election to defer compensation must be made by the last day of the tax year preceding the year in which services are performed. But there are two key exceptions:
  1. In an employee’s first year of plan eligibility, the election may be made as late as 30 days after the date the employee becomes eligible.

  2. For performance-based compensation, the election may be made as late as six months before the end of the performance period, at least 12 months in length.
Note: Additional exceptions are included in the final regulations.


Distributions

Distributions may not occur earlier than:
  • Separation from service.

  • Disability.

  • Death.

  • A specified date or schedule of dates.

  • Change in ownership or effective control of employer, or in ownership of a substantial portion of employer’s assets (only if employer is a corporation).

  • Unforeseeable emergency.
Tip: Other circumstances are set forth in the final regulations.
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