Article by Maureen Gorman, Debra Hoffman, Herbert Krueger, Wayne Luepker, Donald Norman and Anna O’Meara.

The House and Senate have each passed a tax bill that includes significant changes to the tax treatment of nonqualified deferred compensation, and the bills are being referred to conference. If enacted, this legislation would require every business to do a thorough review of its employee and director compensation arrangements and its executive employment agreements and, in most cases, will require substantial revisions of these arrangements. Although the provisions of the bills are generally prospective, the new rules might also apply to amounts deferred after June 3, 2004, as well as to certain amounts deferred before that date.

Severe Penalties on All Participants. The new rules would impose severe tax penalties on all participants in a deferred compensation arrangement if any of the technical requirements are violated with respect to the design or operation of the arrangement. In other words, a violation as to one participant may result in significant penalties on all participants.

Likely New Rules. The new rules would generally apply to all nonqualified deferred compensation, broadly defined. The rules would apply, at a minimum, to arrangements covering a single individual and groups, elective and non-elective arrangements, defined contribution and defined benefit arrangements, and various forms of incentive compensation. In its current form, the legislation: (1) would require all deferral elections to be made before the year in which the services are performed; (2) may limit the available types of investment alternatives permitted under defined contribution plans; (3) would require that assets could not be held outside the U.S.; (4) would permit distributions to be made only under one of the following circumstances: a specified date (but not the occurrence of an event) designated by the plan or elected by the participant as of the date of initial deferral, death, disability, unforeseeable emergency, or separation from service or, to the extent permitted by regulations, upon a change in control. For a key employee of a public company, distribution on separation from service would be delayed six months (1 year under the Senate bill for payments to insiders following a change in control). Distribution could not be accelerated for any reason, including by reason of the deteriorating financial health of the employer. Further deferrals would be severely limited.

Effective Date. As written, the Senate bill would be effective for amounts deferred in taxable years beginning after December 31, 2004. The House bill would be effective for amounts deferred after June 3, 2004 (other than amounts deferred in 2004 pursuant to an irrevocable election or binding arrangement in effect before June 4, 2004). The House Report and the explanation prepared by the Joint Committee on Taxation staff provide that the new rules are also intended to be applicable to amounts that were deferred on or before the effective date if they are further deferred after that date. Under such an approach, the new rules could apply to certain existing deferred compensation. For example, under this approach, the new rules might apply to supplemental pension benefits accrued prior to the effective date that are subject to a future election to have the benefits paid in the form of a lump sum or as an annuity, or to preeffective date elective deferred compensation under an arrangement where subsequent elections affect the form and timing of the pre-effective date deferrals. Under both bills, the IRS is authorized to issue rules permitting termination of deferred compensation arrangements that would otherwise become taxable under the new rules. 

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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