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DEFERRED COMP - SOME IMPORTANT DEADLINES FROM NEW TREASURY GUIDANCE

December 22, 2004

This week the IRS issued its first guidance on the non-qualified deferred compensation restrictions signed into law October 22. The guidance (Notice 2005-1) covers some key effective dates. These are very helpful, as many of these provisions take effect January 1, 2005.

WHY THIS IS IMPORTANT

The new deferred compensation rules (New Code Section 409A) require employees to take "deferred" amounts into income unless the deferral meets new requirements. For example, all deferral elections must be made prior to the year in which the income would otherwise be paid, and new restrictions apply to early withdrawals of deferred amounts. For a more complete rundown on the new rules, go here.

If the new rules are violated, the employee gets a double whammy:

-they have to include all amounts they are owed under the plan in income, whether or not they actually receive them, and

-they have to pay a 20% excise tax on top of the income tax on the deferral.

Notice 2005-1 gives employers and employees a little breathing space for dealing with these plans. Some questions, and answers, on the deadlines:

EMPLOYEE DEFERRAL ELECTIONS FOR 2005

Q. I have elected to defer $50,000 in salary I would otherwise be paid in 2005. The new rules take away the option I thought I would have to withdraw amounts early by taking a 10% "haircut." Now that I can't get the money out early, can I undo the election and take the money in 2005?

A. If your plan is amended by the employer to so allow, you may undo your 2005 deferral election and get paid that amount in 2005 without penalty before the end of 2005. (Notice 2005-1, Q&A 20)

Q. Can I just reduce my 2005 deferral, rather than eliminate it completely?

A. Yes. (Notice 2005-1, Q&A 20)

EMPLOYER PLANS: DEADLINES FOR CHANGES

Amounts that are deferred through 2004 under plans that aren't "materially modified" after October 3, 2004 are excluded from the new deferred compensation rules. Maintaining this "grandfather status" is important; if a plan is materially modified after 2004 and fails to comply with the new rules, all pre-2005 deferrals could be subject to tax and penalty. Notice 2005-1 answers some questions relating to "grandfathered" plans.

Q. We have a plan that allows employees to elect each quarter to defer income for the next quarter. Can we continue doing this for 2005?

A. No; all amounts deferred under elections made after 2004 under this circumstance would be subject to tax and penalty in 2005.

Q. Other than the quarterly elections, it appears our plan is otherwise in compliance with the new rules. If we amend the plan to require all deferral elections for 2005 to be made by the end of 2004, we will be in compliance. Will such a post 10/3/04 election blow our "grandfather"status for old deferrals?

A. No. "The amendment of a plan to bring the plan into compliance with the provisions of Section 409A will not be treated as a material modification." (Q&A 18) In fact, you can allow employees until March 15, 2005 to make elections that apply for compensation payable starting March 16, 2005. (Notice 2005-1, Q&A 21)

Q. We want to suspend our deferred compensation plan until the new rules get sorted out. Is that a "material modification" that jeopordizes our grandfather status?

A. No, as long as you don't do anything in 2005 that is otherwise out of compliance with the new rules. (Notice 2005-1, Q&A 18(c))

Q. This plan is a hassle. Can we just terminate it? Can we wait until next year to do so?

A. Yes. "Amending an arrangement on or before December 31, 2005 to
terminate the arrangement and distribute the amounts of deferred compensation
thereunder will not be treated as a material modification, provided that all
amounts deferred under the plan are included in income in the taxable year in
which the termination occurs." (Notice 2005-1, Q&A 18(c)).

OTHER ISSUES

For most operational purposes, the next big deadline is March 15 - the date that participants can alter elections under existing plans, if the plans so permit. You can put a hold on current plans without getting into trouble, and you can cancel plans until 2005. It is not certain to us, but it appears that you can freeze an existing plan as of December 31, 2004 and begin operating under a new plan in 2005, while protecting the grandfathered status of the pre-2005 deferrals.

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