Guest Article

(From the June 21, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

House Approves International Tax Bill with Changes to Nonqualified Deferred Compensation Rules

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The House Ways and Means Committee late on June 14 reported an international tax bill (H.R. 4520, the American Jobs Creation Act) that would repeal the extraterritorial income (ETI) exclusion and make significant changes to current rules for taxing nonqualified deferred compensation arrangements. Just three days later the full House approved the bill, which also includes a package of tax relief for manufacturers and small corporations, among other things.

According to a press release by Ways and Means Committee Chairman Bill Thomas (R-CA), H.R. 4520 includes some provisions that are identical to counterparts in the Senate companion bill, S. 1637, "so that the bills can be quickly reconciled when they are considered in a House- Senate conference." The nonqualified deferred compensation provisions in H.R. 4520 are not identical to those in S. 1637, but they are similar. However, there are other significant differences between the two bills.

House and Senate negotiators will have to work quickly to resolve these differences if they hope to produce a final bill this year. Congress will be out of session from June 28 through July 5 for the Independence Day holiday, and then will work only three weeks before embarking on a sixweek summer recess. After that there will be only four legislative weeks left before the October 1 target adjournment date.

Taxation of Nonqualified Deferred Compensation

The House bill would amend the Internal Revenue Code to add a new section 409A to provide specific rules for taxing compensation deferred under nonqualified deferred compensation plans. In general, participants would be required to include such compensation in gross income when deferred (or when no longer subject to a substantial risk of forfeiture, if later) unless the plan at all times satisfied specific requirements. Among other things, plans generally would have to provide deferrals that could not be distributed earlier than--

• separation from service (or 6 months after the date of separation in the case of certain officers and owner-employees of publicly-traded companies),
• disability,
• death,
• a specified time (or pursuant to a fixed schedule) specified under the plan as of the date of the deferral of such compensation,
• to the extent provided by Treasury regulations, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation's assets (the bill would direct the Treasury Secretary to issue regulations on what constitutes a change in ownership or control not more than 90 days after the date of enactment), or
• occurrence of an unforeseeable emergency.

Plans would not be allowed to include acceleration clauses with respect to the time or schedule of any payment, except as permitted by regulations. Other requirements relating to the timing of the initial deferral election and changes in time and form of distribution also would apply.

Funding

The proposed IRC section 409A also would regulate the use of trusts to fund nonqualified deferred compensation plans. Under current IRS rules, employers can set aside executives' deferred compensation in grantor (or "Rabbi") trusts without causing them to immediately recognize income.

Some employers set up these trusts outside of the U.S. ("offshore Rabbi trusts"). Under the proposed section 409A, assets set aside in an offshore Rabbi trust would be treated as transferred in connection with the performance of services (and thus subject to the section 83 rules) when set aside even if still technically available to satisfy claims by the company's general creditors. (In cases where the assets are initially set aside in the United States and later transferred offshore, the section 83 rules would apply at the time of transfer.)

In some cases, nonqualified deferred compensation plans include contingency provisions that will automatically make a Rabbi trust's assets unavailable for any purpose other than paying benefits if the company's financial health deteriorates. The proposed section 409A would subject a participant's deferrals under such a plan to the section 83 rules.

Effective Dates

The nonqualified deferred compensation provisions generally would apply to amounts deferred after June 3, 2004. However, the changes would not apply to amounts deferred after June 3, 2004, and before January 1, 2005, pursuant to an irrevocable election or binding arrangement made before June 4, 2004. (The Senate bill's nonqualified deferred compensation provisions would apply only to amounts deferred after December 31, 2004.)

The bill would direct the Treasury Secretary to issue guidance on how an individual participating in a nonqualified deferred compensation plan adopted before June 4, 2004, could terminate participation or cancel an outstanding deferral election with regard to amounts earned after June 3, 2004, if such amounts would be includible in income as earned. This guidance would have to be issued not more than 90 days after the date of enactment.

Other Employment and Employee Benefit-Related Provisions

The bill also would clarify that exercising an incentive stock option, purchasing stock under an employee stock purchase plan, or selling stock so acquired does not generate "wages" subject to federal employment taxes (i.e., FICA and FUTA). Furthermore, it would clarify that federal income tax withholding is not required in the event of a disqualifying disposition of stock acquired with a statutory stock option, or in connection with an employee stock purchase plan discount. This same provision has appeared in several bills over the past few years.

Additionally, H.R. 4520 would reinstate the mental health parity excise tax effective as of the date of enactment and continue it through December 31, 2005. The excise tax expired on December 31, 2003, but the ERISA provision remains in effect until December 31, 2004.

Finally, the bill would extend retroactively the welfare-to-work and work opportunity tax credits through December 31, 2005. Both expired at the end of last year.

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The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Tom Brisendine 202.879.5365, Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5324, Tom Veal 312.946.2595, or Deborah Walker 202.879.4955. Copyright 2004, Deloitte.

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