On the July 12 Webcast of Tax Talk Today, an expert panel discussed nonqualified deferred compensation (NQDC)
plans – which can include stock options, performance-based bonuses, etc. – and the recent legislative changes that affect them.

The provisions of Section 409A of the American Jobs Creation Act of 2004 made sweeping changes to what does and does not qualify as deferred compensation, a critical distinction for tax returns. The IRS has given taxpayers until December of this year to amend NQDC plans to meet the new requirements without incurring penalties and has provided other transitional relief for 2005.

As summarized by the IRS official and tax expert on the July Tax Talk Today panel, Section 409A includes four key provisions for deferred compensation. They are:

Timing of elections – The election to defer compensation must be made during the year before the year in which the services will be provided to which the compensation relates. Two exceptions are newly eligible participants and performance-based compensation.

Permissible distributions – Under the law, distributions are allowed no earlier than six specified events: death, disability, separation from service, fixed time or schedule of payments specified in the plan, unforeseeable emergency and change of control.

Accelerating benefits – Except as provided in guidance from the IRS, no acceleration of benefits is allowed. Exceptions are few and include distributions to satisfy a domestic relations order, to satisfy federal conflict of interest requirements and to pay withholding taxes.

Securing payment obligations – Two types of funding arrangements for NQDC can violate section 409A: offshore trusts, including “rabbi” trusts and trusts or other arrangements funded as a result of an adverse change in the financial condition of the service recipient.

The Tax Talk Today panel acknowledged that the penalty for failure to comply with the new law is steep. The cost of non-compliance with Section 409A is three-fold: taxation on the income, a 20 percent additional tax plus applicable interest. But, as the experts noted, the diligent tax practitioner can help clients avoid NQDC pitfalls and penalties.

“If you use the transition rules and keep your wits about you, you will not incur the 20 percent tax penalty this year,” said Elizabeth E. Drigotas, principal, Deloitte Tax LLP. “But, that does require you to know what you're working with, and to be aware of the transition guidance.”

Notice 2005-1 from the IRS provides guidelines to help tax practitioners transition their clients to full compliance by the end of this year. The trick to following the transition rules, however, is keeping tabs on additional guidance expected from the IRS.

In the meantime, tax practitioners can take action right away to evaluate clients’ deferred compensation plans. Tax practitioners should:

• Understand what compensation arrangements the client offers.
• Determine whether the client's deferred compensation plans can be brought into compliance with Section 409A of the American Jobs Creation Act, or if those plans should be cashed out during 2005 (which requires payment of the regular income tax, but can avoid the additional 20 percent tax).
• Identify which deferred compensation plans are "grandfathered in" and can remain unchanged.
• Explain to the client what types of deferred compensation plans can be offered under the new legislation.
• Watch for additional notices and guidance, expected from the IRS.

For additional information on Section 409A of the American Jobs Creation Act and Notice 2005-1, visit www.taxtalktoday.tv and click on “Resources.” A full transcript of the Webcast – “What You and Your Clients Need to Know about Deferred Comp Plans” – can be accessed online.

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