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Home > Financial Press Releases > Defuse the Non Qualified Deferred Compensation “Time Bomb”
Defuse the Non-Qualified Deferred Compensation “Time-Bomb”
The American Jobs Creation Act of 2004 makes dramatic changes to the tax rules impacting virtually all Non-Qualified Deferred Compensation (or NQDC) arrangements. DO NOTHING is NOT an option
(PRWEB) November 18, 2005 -- On 10/22/04, the President signed the American Jobs Creation Act of 2004. The Act makes dramatic changes to the tax rules impacting virtually all Non-Qualified Deferred Compensation (or NQDC) arrangements for all amounts deferred on or after 1/1/05. The Act mandates that all current and prior deferrals of compensation of any sort, by anyone, will be taxed, if the terms of the plan under which the deferrals were made do not comply with the new rules. The new law creates limitations on payout elections, and imposes substantive restrictions in the event of death, disability, termination, and hardship. Early withdrawals, early distributions, benefits restructures, and plan terminations are expressly prohibited. The new rules do not apply to vested, deferred balances as of 12/31/04 unless the plan has been “materially modified”.
Bottom line: few companies or executives will want to use traditional NQDC going forward. Companies have until year-end 2005 to freeze or terminate their current plans, or fall victim to the negative tax implications of the new law. DO NOTHING is NOT an option! Penalties for those who don’t take action before 12/31/05 include accelerated inclusion of the employee’s income, a 20 % excise tax, and payment of an interest penalty (at the Applicable Federal Rate) looking back to the time of deferral.
Employers - understand that current NQDC Plans are now considerably less attractive to key executives. Internal Revenue Service reporting requirements, shareholder scrutiny, and Directors’ and Officers’ liability potential have increased. Further, until the last participant’s retirement is paid, there is no ability to terminate the plan.
Executives must harbor concerns regarding the long-term financial security of their employer. Management might discontinue the plan, given the new regulatory environment. Retirement planning flexibility has been substantially reduced. Early access is no longer an option.
What are the alternatives? The so-called §162 Double Bonus Plan is one. The company agrees to make an annual bonus of the after-tax amount necessary to pay the premium on an executive-owned life insurance policy. The company also makes a “double bonus” to cover the taxes the employee must pay on the bonus(es). Because the participant is paying taxes on the bonuses, the regulations otherwise applicable to traditional NQDC (and, in particular, the Act) are irrelevant. However, since the employer is expected to “gross up” the bonus to cover taxes, this concept is expensive and tax-inefficient. Assuming a 40 % marginal tax rate, the gross cost to a Company is $166,667 to yield an after-tax bonus to the employee of $100,000.
Another strategy is conceptually similar to the §162 Double Bonus. However, the company doesn’t make a second bonus to cover the entire cost of taxes on the bonuses. Instead, the company makes a much smaller second bonus to cover the interest cost of borrowing an amount that replaces the taxes lost on the first bonus. For example, the company makes a $100,000 (tax-deductible) bonus to the employee. The employee borrows $35,000 to pay his/her taxes using an (assumed) 7 % interest-only loan. A second bonus in the amount of $2,450 covers the interest cost. Net cost to the company [($100,000 + $2,450) x (1-0.4)] is $61,470.
Employers should recognize that this strategy is not subject to deferred compensation-related regulation or the Act. Importantly, this option uses funds that are currently deductible, thus substantially reducing costs.
Employees appreciate owning the retirement plan outright. Moreover, unlike traditional NQDC, planned retirement benefits are tax-free. Lastly, this strategy provides a current death benefit, and may be designed to provide asset protection and/or estate tax planning flexibility when used in conjunction with an Irrevocable Life Insurance Trust.
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