American Jobs Creation Act

1
American Jobs Creation Act Nonqualified Plans
and Withholding on Supplemental Wages

• Presenters
• Daniel Keating, FPC
• Roger Salois, CPP

September 22, 2005
2
Agenda

• What happened ? - HR 4520, American Jobs
  Creation Act of 2004
• What is a NQDC Plan ?
• Prior to January 1, 2005
• Beginning January 1, 2005
• New requirements of NQDC Plans
• New requirements on taxation of Supplemental
  Wages

3
What Happened ?

• October 2004, Senate passes HR 4520, American
  Jobs Creation Act of 2004
• Most sweeping revisions in the tax code since
  1986
• Seen as a response to the corporate scandals over
  the last few years i.e. Enron
• Changes made impact over 600 sections of IRC
• Repeal of extraterritorial income (ETI) exclusion
• Reform the foreign tax credit regime
• Fundamentally changes the rules that govern NQDC
  plans
• Significant changes in the tax shelter reporting
  and penalty area

4
NQDC Plans Prior to January 1, 2005

• What is deferred compensation ?
• Qualified Plan v. Nonqualified Plan
• Types of NQ Plans
• Funded Plan v. Unfunded Plan
• NQ Plan Tax Issues
• W-2 Reporting Issues

5
NQDC Plans Prior to January 1, 2005

• What is deferred compensation ?
• The postponement of a wage payment to a future
  date
• Compensation the employee would have a current
  right to receive because they have a right to
  receive it or they will perform future services
  to receive the right to it
• Plan document contains the rules the employer and
  employee need to follow

6
NQDC Plans Prior to January 1, 2005

• Qualified Plan v. Nonqualified Plan
• Qualified plans
• Required to be broad in its coverage
• Contributions subject to several limits
• Distributions subject to certain rules
• Periodic reporting requirements (IRS, DOL,
  individual)
• Examples 401(k), 403(b), ESOPs, 457(b)
• Nonqualified plans
• Very few rules are set by federal law
• Contributions not subject to government limits
• DOL reporting required for most plans, but only
  once a year
• Plan rules govern

7
NQDC Plans Prior to January 1, 2005

• Types of NQ Plans
• Nonqualified deferred compensation plans
  (for-profit organizations)
• Section 457(f) plans (government and
  not-for-profit organizations)
• Deferred Bonus Arrangements
• Executive deferred compensation arrangements
• Long-term incentive pay arrangements
• Phantom stock arrangements

8
NQDC Plans Prior to January 1, 2005

• Funded Plan v. Unfunded Plan
• Funded Plan
• Money is legally protected for the employee by
  the creation of a trust or an escrow account
• EE contributions from wage payments are legally
  protected so they are considered being deferred
  into a funded plan
• Unfunded Plan
• Employer promise the deferred compensation to the
  employee at a later date

9
NQDC Plans Prior to January 1, 2005

• NQ Plan Tax Issues
• FIT and SIT
• Based upon rule of constructive receipt
• Deferrals to NQDC plan are exempt from tax
• Distributions from NQDC plan are taxable
• FICA, FUTA and SUI
• Based upon lapse of substantial risk of
  forfeiture
• Taxation can occur at one of three times
• At time of deferral (most common)
• At different points based upon a vesting schedule
• At time of distribution
• FUTA and SUI will follow FICA taxation

10
NQDC Plans Prior to January 1, 2005

• W-2 Reporting Issues
• Deferrals
• Not reported in Box 1 (Federal) or 16 (state)
• Reported in Box 3 (SS) and 5 (MEDC) when
  substantial risk of forfeiture lapses
• Not reported in Box 11 unless deferrals became
  taxable for SS and Medicare taxes during the year
  but were for prior year services
• Vesting occurs after a stated number of years
• Vesting occurs at time of termination/retirement

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Examples - Reporting Deferrals

• FICA occurs at time of deferral and EE defers
  10,000 from a 30,000 bonus to a NQDC plan.
• Box 1 20,000
• Box 3 and 5 30,000
• Box 11 0
• There is a vesting schedule and substantial risk
  of forfeiture end after 3 years of service.
  Employee defers 10,000 each year the first 3
  years and in 4th year defers 10,000 from a
  60,000 bonus.
• Year 1 -3
• Box 3, 5, 11 - 0
• Year 4
• Box 1 50,000
• Box 3 and 5 60,000 plus 30,000 for last 3
  years and the applicable earnings
• Box 11 - 30,000 plus applicable earnings
• Substantial risk of forfeiture ends at time of
  retirement and in the year of retirement the EE
  deferred 10,000 from a 40,000 bonus.
• Box 1 30,000
• Box 3 and 5 Account balance
• Box 11 Account balance less 10,000

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NQDC Plans Prior to January 1, 2005

• W-2 Reporting Issues
• Distributions
• Reported in Box 1 (Federal) or 16 (state)
• Reported in Box 3 (SS) and 5 (MEDC) when
  substantial risk of forfeiture lapses
• This will not occur that often
• Reported in Box 11
• If reporting a distribution and also reporting
  prior year deferrals in box 3 and box 5, do not
  report anything in Box 11

13
Examples Reporting Distributions

• FICA occurs at time of deferral and EE takes a
  distribution of 50,000
• Box 1 50,000
• Box 3 and 5 0
• Box 11 50,000
• There is a vesting schedule and substantial risk
  of forfeiture ends after 3 years of service. EE
  takes a distribution of 40,000 and the EE worked
  for 10 years
• Box 1 - 40,000
• Box 3 and 5 - 0
• Box 11 - 40,000
• Substantial risk of forfeiture ends at retirement
  and in the 1st year of retirement the EE takes a
  distribution 70,000 from a account that has a
  balance of 2,000,000
• Box 1 70,000
• Box 3 and 5 2,000,000 (up to applicable
  limits)
• Box 11 0
• Subsequent years 70,000 in Box 1 and 11 only

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NQDC Plans Beginning January 1, 2005

• New IRC 409A
• New requirements on the timing of employees
  deferral election
• New distributions restrictions
• New restrictions on funding arrangements
• New penalties for failure to meet new
  requirements
• New W-2 reporting requirements
• Taxation remains the same

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New Requirements of NQDC Plans

• These are not all the new requirements but are
  the ones applicable to HRPR
• Additional W-2 Reporting requirements
• Report deferrals to a Section 409A NQDC plan
  using Code Y in Box 12
• Report income under Section 409A using Code Z in
  Box 12. There is subject to an additional 20 tax
  plus interest which will not be withheld by HRPR
• What is income under Section 409A? When a plan
  fails to meet Section 409A requirements.
• Deferrals can be grandfathered in under the old
  rules
• New rules on taxation of supplemental earnings

16
New Requirements on Taxation of Supplemental
Earnings

• Once supplemental earnings exceed 1 million,
  supplemental earnings are withheld at the highest
  rate (i.e. 35 for 2005) for the remainder of the
  year
• All employers treated as a single employer under
  IRC 52 (a) or (b) will be treated as a single
  employer for purposes of determining the 1
  million threshold

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New Requirements on Taxation of Supplemental
Earnings

• IRS introduced proposed regulations to assist
  employers in administering this new requirement
• Increased mandatory withholding rate once YTD
  supplemental wages exceed 1 million
• Definition of supplemental wages
• Definition of supplemental wages not counted
  towards 1 million threshold
• All employers treated as single employer in
  determining 1 million threshold
• Payments made by third parties on behalf of
  employer considered when determining 1 million
  threshold
• Gross-ups of supplemental wages

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What do you need to do ?

1. Review all wage/earning codes
2. Update payroll system with new rules
3. Determine if you have FEINs that are treated as a
   single employer under IRC 52(a) or (b)
4. Determine if your company makes supplemental wage
   payments that are not processed through the
   payroll system
5. Develop a process to share information with third
   parties to accurately withhold on supplemental
   wages
6. Modify any manual tax calculations
7. Communicate changes to impacted employees

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• Questions ?