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Non-Qualified Deferred Compensation and COLI Legislation Moves Forward

The Senate recently approved a slightly revised version of the deferred compensation bill passed last year in the so-called “FSC/ETI tax bill” (S. 1637), which was passed by the Senate on May 11, 2004. An updated version of the American Jobs Creation Act ("AJCA -2004") (H.R. 4520) was introduced June 4, 2004 in the House of Representatives. Although the deferred compensation rules in the FSC/ETI and AJCA-2004 tax bills are similar in many respects, there are a number of significant differences. The most significant change this year is the effective date. The Senate bill is effective for deferred amounts earned after December 31, 2004 while the House bill would be effective June 4, 2004 but would grandfather deferrals earned between June 4 and December 31, 2004 deferred pursuant to a binding commitment in existence on or before June 3, 2004. The purpose of the immediate effective date proposed in the House is to avoid a flood of deferrals taking advantage of an end of year effective date. The Senate bill has conformed to the House bill in two significant ways. The Senate has changed its timing provision to require deferral elections to take place in the year prior to the year in which “the services are performed,” and has taken out the provision removing the moratorium on non-qualified deferred compensation guidance by Treasury. A discussion of the details of the two bills follows.

Common Provisions

New Tax Code Provision: Both bills would create a new section of the Internal Revenue Code which would tax non-qualified deferred compensation in the year of deferral unless specified requirements are satisfied.

Bills Conform on Timing of Elections: The FSC/ETI bill changed its timing rule to conform to AJCA so that both bills now require that the election to defer take place in the year prior to the year in which “the services are performed.” The prior standard focused on the year in which amounts were “earned.” 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 the Senate bill 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 month 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. FSC/ETI 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 FSC/ETI 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: FSC/ETI would impose substantial restrictions on the investment alternatives which could be offered through a non-qualified plan. Investment alternatives made available to executives under a non-qualified 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: The Senate bill would also prohibit executives from deferring the recognition of stock option gains and other equity-based gains by exchanging such arrangements for non-qualified deferred compensation benefits.

No Removal of Regulation Moratorium: The new Senate bill does not include the prior provision which would have repealed the moratorium on non-qualified deferred compensation guidance by Treasury.

COLI Provision Approve by Senate

Last February, the Senate Finance Committee approved the corporate owned life insurance (“COLI”) proposal that had previously been circulated, by Senator Charles Grassley. Last year legislation was proposed that would have made death benefits received by corporations taxable unless the insured has been employed by the corporation within the last 12 months prior to death. Under the Grassley proposal, 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 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
  • that all employees have consented to purchase of insurance or the number who have not

This client alert is a publication of Loeb & Loeb and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations. We will continue to monitor and keep you informed of further developments regarding this legislation. If you have further questions, please contact either Marla Aspinwall at (310) 282-2377.

Circular 230 Disclosure: To assure compliance with Treasury Department rules governing tax practice, we inform you that any advice (including in any attachment) (1) was not written and is not intended to be used, and cannot be used, for the purpose of avoiding any federal tax penalty that may be imposed on the taxpayer, and (2) may not be used in connection with promoting, marketing or recommending to another person any transaction or matter addressed herein.