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Change of Plan?

New tax laws require a new look at deferred compensation plans.

A new federal law governing deferred compensation plans could mean substantially higher taxes and penalties if companies and their employees aren't paying attention.

The American Jobs Creation Act of 2004 dramatically changed these types of plans, which businesses use to retain and reward key employees. With nonqualified deferred compensation plans, business owners promise to pay employees a sum of money at a future date. The new law defines plans so broadly that it applies not only to traditional plans, but also to equity-based plans, such as discounted stock options, stock appreciation rights and phantom stock plans.

The law covers amounts deferred in 2005 and beyond, as well as amounts that were not vested as of January 1, 2005, in three areas: distributions of plan monies, elections employees make, and plan funding. For example, under the new law, a company can't make a distribution until one of six scenarios occurs: the reaching of a specific deferral date, a change in corporate ownership or control, an unforeseeable emergency, separation from service, disability, or death. In addition, employees must meet a prescribed deadline for electing to defer compensation, and offshore funding of nonqualified deferred compensation plans is not allowed.

Employees who don't comply face a substantial tax penalty. Those employees may come to you to reimburse them for the taxes if you are responsible for noncompliance, says Eddie Adkins, compensation and benefits tax practice leader for accounting firm Grant Thornton LLP in Washington, DC. "Plans are created and managed by the employer. This means the employer bears the major responsibility for keeping plans in compliance with the new law. But the employee faces the penalty for noncompliance, [so] don't be surprised to see employees turning to employers to recover the taxes that are due if the employer causes noncompliance," says Adkins.

Changes and amendments in plans can be made until December 31, so get on the phone to your accountant now if you haven't already done so. Start by determining which of your plans are subject to the new rules, then modify payroll systems to reflect changes in the plans' accounting and reporting requirements. Keep in mind that starting this year, companies must report nonqualified deferral compensation plans on W-2 or 1099 tax forms for the year deferred, even if the amount cannot currently be included in income for that taxable year.

In light of the changes, Adkins says deferred compensation plans may no longer be as attractive as they were in the past to companies and their employees. But only time will tell.


Great Falls, Virginia, writer Joan Szabo has reported on tax issues for 18 years.

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This article was originally published in the July 2005 print edition of Entrepreneur with the headline: Change of Plan?.

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