The Senate Finance Committee recently approved a change in the effective date of the nonqualififed deferred compensation legislation it approved last September, the "National Employee Savings and Trust Equity Guarantee Act ("NESTEG"). The House Ways and Means Committee approved the American Jobs Creation Act of 2003 ("AJCA") on October 28, 2003, which contains proposed new deferred compensation rules that are similar to NESTEG. Both bills were originally effective for amounts deferred in taxable years beginning after December 31, 2003, but the Senate has just approved a change that would make the Senate version applicable to amounts deferred in taxable years beginning after December 31, 2004. Although the deferred compensation rules in AJCA and NESTEG are similar in many respects, there are a number of significant differences. The Finance Committee’s action indicates that the deferred compensation bills are not dead, but will be on the congressional agenda this year. The Finance Committee action was taken in conjunction with the approval of a revised version of the proposed bill on corporate owned life insurance which is also discussed herein. Finally, IRS officials have announced their intent to expand audit efforts with respect to executive compensation, which is also discussed at the end of this ALERT.
Common Provisions of Proposed Legislation
New Tax Code Provision: Both bills would create a new section of the Internal Revenue Code which would tax nonqualified deferred compensation in the year of deferral unless specified requirements are satisfied.
Timing of Elections: Both bills require that the election to defer take place in the year prior to the year in which "the services are performed" (AJCA) or "the compensation is earned" (NESTEG"). Both bills also allow deferrals within 30 days of eligibility in the case of newly eligible participants applicable to services performed only after the election.
Limitations on Distributions: Both versions would require that the deferral arrangement provide that the deferred compensation cannot be distributed earlier than (a) separation from service, (b) disability, (c) death, (d) a specified date or pursuant to a specified schedule specified as of the date of the deferral, (e) to the extent provided by Treasury regulations, following a change in control or (f) the occurrence of an unforeseeable emergency. However, under NESTEG distribution after a change in control could not be made to officers, directors or 10% owners of public companies before one year after the change in control and even then, such distributions would be treated as "excess parachute payments" under Section 280G (even if they do not violate applicable 280G limits) and thus would be subject to a 20% excise tax and no corporate deduction.
No Acceleration: Both versions provide that the arrangement cannot allow the timing of payment of deferred compensation to be accelerated (except as provided in regulations), thus prohibiting provisions which allow unscheduled withdrawals by paying a penalty, often called "haircut provisions."
Limited Delays or Changes in Form: Both proposals permit a subsequent election to delay a distribution payment or change the form of payment, but only if the subsequent election is made at least 12 months before the first scheduled payment and only if the plan requires the payments to be delayed at least 5 years. AJCA would permit only one such election to delay distributions and would not allow changes to take effect for 12 months from the date of elections. NESTEG would permit more than one such election with respect to an amount deferred.
No Offshore Rabbi Trusts: Both versions would prohibit the use of offshore rabbi trusts by taxing assets set aside outside the United States.
Penalty For Failure To Comply: Finally, if any of the requirements are not met, each bill includes a penalty provision, AJCA an interest change and NESTEG an excise tax on deferred amounts in addition to the inclusion of the deferred compensation in income.
Reporting Requirements: The provisions would also mandate W-2 reporting on compensation deferrals.
Significant Differences In Proposals
Investment Alternatives: NESTEG would impose substantial restrictions on the investment alternatives which could be offered through a nonqualified plan. Investment alternatives made available to executives under a nonqualified plan would be required to be comparable to (or more limited than) those investments offered under the qualified plan sponsored by the same employer having the fewest investment options. The bill would prohibit open brokerage windows, hedge funds, and investments in which the employer guarantees an above market rate of return. Treasury would be directed to issue guidance where there was no qualified plan for comparison.
No Deferral of Option Gains: NESTEG would prohibit executives from deferring the recognition of stock option gains and other equity-based gains by exchanging such arrangements for nonqualified deferred compensation benefits.
Removal of Regulation Moratorium: NESTEG includes a provision which would repeal the moratorium on nonqualified deferred compensation guidance that was included in Section 132 of the Revenue Act of 1978. That act essentially prohibits the Treasury from issuing guidance which changes the tax treatment of nonqualified deferred compensation arrangements for taxable businesses. If Section 132 is repealed, the Treasury would have broad discretion to begin issuing guidance that could significantly change the current rules applicable to nonqualified deferred compensation.
The proposals originally applied to amounts deferred in taxable years beginning after December 31, 2003. As discussed above, the Senate Finance Committee recently changed the effective date of NESTEG to December 31, 2004. Thus, the new rules would not apply to existing account balances but to new deferrals made after the ultimate effective date. AJCA also provides further transition relief as follows: (a) irrevocable deferral elections made before October 24, 2003 (for compensation payable in 2004 - which will probably be changed to 2005) would be grandfathered (that is subject to prior law) and (b) a brief period after enactment would be provided for participant to cancel existing deferral elections or terminate participation in a deferred compensation plan in place before the effective date of the new rules. While we can expect to also see a later effective date for any new House proposal such new legislation will most likely follow the pattern of the prior proposal with respect to implementation and transitional relief.
Expected Addition of COLI Proposal
The Senate Finance Committee recently approved proposed modifications to its prior proposal regarding corporate owned life insurance (“COLI”). The proposed changes were circulated by Senator Charles Grassley. Last fall, legislation was proposed that would have made death benefits received by corporations taxable unless the insured has been employed by the corporation within the 12 months prior to death. Under the Grassley discussion draft, benefits paid under a COLI contract would not be taxable if any of the following were true:
- the insured was an employee within 12 months of death;
- the benefits were payable to the employee’s family, beneficiary, trust or estate, or were used to purchase an equity interest in the employer, such as a buy-sell agreement; or
- the employee was a "key person," defined as a "highly compensated employee" under Section 414(q) or the Internal Revenue Code, or a "highly compensated individual" under Section 105(h)(5) with a salary in the top 35% of employees of the company or is a director of the company.
The proposal would impose notice, consent, and reporting requirements. In all cases the employee must receive written notice of the insurance coverage, including that the coverage may continue after the insured terminates employment and that the employer will be the beneficiary of the proceeds. The Finance Committee added to the approved proposal that the employee notice must include the maximum face amount of the coverage at the time of issuance. The employee must consent in writing.
In terms of reporting requirements the employer would be required to submit the following information to the IRS as of the end of each year:
- the total number of its employees
- the number of employees insured under the COLI program
- the total amount of insurance in force
- the name, address, and TIN of the employer and a description of its business
The Finance Committee also added the requirement that the IRS notice include a statement that all of the employees on which the employer has life insurance have consented or, if not, the number of employees who have not consented.
IRS Audit Focus on Executive Compenation
A senior IRS official speaking before a meeting of the American Bar Association’s Tax Section stated that the Service plans to expand its audit efforts with respect to executive compensation. The IRS will focus on eight issues: (1) split dollar life insurance arrangements; (2) loans to executives; (3) nonqualified deferred compensation; (4) golden parachutes; (5) equity compensation arrangements; (6) fringe benefits; (7) asset protection schemes such as sales of compensatory options to family limited partnerships and off-shore (so called “Irish”) leasing arrangements; and (8) compliance with the million dollar deduction limit under IRC Section 162(m). The official also said that the IRS intends to examine executive’s individual tax returns to ensure that they include income that matches the deductions being claimed by the employers.
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