Financial Planning for November 2004

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The Third Time is a Charm
(Washington's October Surprise Part 3)

In our tax and general business articles this month, we discussed in very general terms the fact that Congress passed three major bills in 2004 that the President signed into law. In varying degrees, these laws substantially affected some aspect of tax law. While the Working Families Tax Relief Act of 2004 ("WFTRA") mainly affected individuals, the American Jobs Creation Act of 2004 ("AJCA") was geared more toward business entities, with the exception of several provisions designed to impact individuals.

As luck would have it, the third major law was one affecting pension plans, their funding and taxability. Combined with the provisions of AJCA, changes to compensation, deferred compensation and pension plan funding rules will be substantial in 2004 and forward.

Let's first deal with the provisions of AJCA related to non-qualified deferred compensation plans. Non-qualified deferred compensation plans basically are plans that provide for taxation to the employee when the right to receive the income becomes nonforfeitable. These plans generally allowed for an employee to elect having a certain portion of income earned, generally bonus income, deferred and paid years after the income is earned.

Nonqualified deferred compensation plans include any plan (unless excluded by Treasury Regulations) that provides for deferral of compensation to future periods. Any plan that is designed to be a "qualified plan" under the Internal Revenue Code would not be subject to the new definition. Plans providing vacation, sick leave, disability income, compensatory time and death benefits are not covered under AJCA.

Some examples of nonqualified deferred compensation plans are:

    • Account-based plans that allow an employee to defer salary or bonus;
    • Supplemental Executive Retirement Plans that provide retirement benefits based on some formula;
    • Stock Appreciation Rights;
    • Restricted stock of Phantom stock arrangements where benefits are tied to employer stock;
    • Nonqualified Stock Option plans;
    • Numerous other plans that are designed to defer income to later years.

The first significant change in the structure of these plans is the requirement that the form of distribution be elected at the time of the deferral of income. Employees must also elect the percentage or amount of deferral before the end of the year preceding the year in which the deferred income is earned, except for newly eligible employees. Newly eligible employees have thirty days from the date of eligibility to make the deferral election.

In addition, performance based compensation for services over a period of at least 12 months. In this situation, the election must be made six months before the end of the period in which the bonus is earned. This exception can be extremely valuable for companies that pay executives based on 12 month or longer service periods. For example, if performance based pay is based on operational results over a period from January 1, 2008 to December 31, 2010, and payable on January 31, 2011, the employee could make the deferral election no later than June 30, 2010.

As previously stated, the form and manner of distributions must be elected at the time of deferral of the income. If it becomes necessary, a "redeferral" of compensation can be elected, if it is elected 12 months before the payment is due. If the employee chooses to do this, the money so deferred will basically be unavailable for five years.

The ability of key employees to control distributions is curtailed in ACJA. Except for unforeseen emergencies, payment can be made only upon death, separation from service, disability or pursuant to a fixed schedule. This will eliminate the ability of the employer to claim that the right to receive payments from the plan is subject to a substantial risk of forfeiture. This is the clause that many employers use to avoid current taxation on such plans. Accordingly, all plans should be reviewed and compared with sample plans to be certain the plans meet the standards to continue deferral of income.

Failure to comply with the new rules for funding and deferral will subject the employee to an additional twenty percent tax on the deferred amount plus interest at 1 percentage point above the underpayment rate.

The new rules are effective for deferrals applicable to periods that begin after December 31, 2004.

The new law requires the deferral amount to be included on Form W-2 for employees and 1099 for independent contractors regardless of whether or not included in the recipient's wages. This reporting requirement is applicable to deferrals December 31, 2004 and deferrals before 2004 if they are treated as post-2004 deferrals.

The Pension Funding Equity Act of 2004 ("PFEA") essentially changed certain assumptions to be used in determining the funding amount for defined benefit pension plans in tax years 2004 and 2005. The importance to the employee is that the new law allows for lower deferrals in these two years, which will affect assets available to pay benefits. Given the relatively short period of time for which the higher expected rates of return will be allowed, the potential impact should not be a significant factor in your financial planning if your retirement date is far in the future. Even for those with retirement looming in the near future, if the plan has been properly funded in the past, you should not have a significant impact from the changes in PFEA.

One of the main points to proper financial planning is providing sufficient income for your retirement years. Changes made in 2004 to the types and funding of retirement and deferred compensation plans could have an impact on your decision-making process. This article is designed to simply alert those who have benefits due under any of these plans that changes are imminent and a thorough review of the plans should be initiated immediately to maintain the integrity and effectiveness of plans currently in place or scheduled to be introduced in the near future. Since this article is only a cursory overview of some changes made in 2004, it is not an extensive review of new deferred compensation and pension plan law. We strongly advise you to seek counsel from your current tax adviser if you have questions. If you don't currently have a tax adviser, give us a call if you are involved in any plans that may be affected by the new tax and pension law.

Have a great November and please remember to vote on November 2.


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