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Deferred Compensation Under the American Jobs Creation Act of 2004


November 2, 2004

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3 minutes


On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004. The Act adds a new section 409A to the Internal Revenue Code, which significantly alters the treatment of nonqualified deferred compensation arrangements for deferrals that occur on or after January 1, 2005.

Deferred Compensation Arrangements Subject to the Act

The Act applies to all nonqualified deferred compensation arrangements including elective and non-elective deferrals of base pay or incentives, supplemental executive retirement plans, discounted stock options, phantom stock plans, stock appreciation rights, excess benefit plans and deferrals under individual employment contracts. Additionally, the Act applies to plans for non-employees such as directors or independent contractors.

Deferral Elections

Under the Act, participants under a plan must make any deferral election prior to the beginning of the calendar year during which the compensation is deferred. New participants have a 30-day window after becoming eligible in which to make a deferral election, and the election is only effective for compensation earned after the election is made. A special rule is applicable to deferrals of certain types of incentive compensation. Specifically, if the incentive compensation is paid under a performance-based plan that covers services performed over at least 12 months, the election may be made up to six months before the end of the service period.

Limits on Distributions

Under the Act, a plan must specify the time and form of distribution of deferred compensation or, alternatively, the participant may elect a distribution method at the time of deferral. The Act limits the events that may trigger distributions to separation from service, death, disability, a specified time, a change in control, or an unforeseeable financial emergency. Additionally, except as provided in IRS regulations, no acceleration of benefit payments, such as “haircut provisions” in which the employee pays a penalty for early withdrawal or premature distributions at the election of the employer, are permitted.

The Act also places limits on distributions to key employees of publicly held companies. Such distributions cannot begin until six months after the termination of employment unless the termination results from death or disability.

Although elections to further defer distributions are permitted, the Act places severe limits on such elections. Such elections can only become effective 12 months after the date of the election. Furthermore, participants that desire to further defer a payment that was to be made at a specified time must make the subsequent election at least 12 months in advance of the scheduled payment date. Finally, the new election must defer the payment for at least five years from the originally scheduled payment.

Limits on Funding

The Act prohibits the use of an offshore trust for deferred compensation arrangements even if the trust is a “rabbi” trust that is available to satisfy claims of general creditors. Furthermore, the Act also prohibits springing rabbi trusts that are funded upon a decline in an employer’s financial health.

Consequences for Violating the Act

Failure to comply with Act with respect to an individual will result in all deferred compensation under the plan for the individual to be taxed when it is earned (or vested, if later). In addition, the Act imposes an additional penalty tax of 20% of the taxable amount.

Effective Date and Grandfathering Rules

The Act applies to amounts deferred after December 31, 2004. For this purpose, “deferred” means both earned and vested. Thus, only vested amounts will be grandfathered under existing law. Furthermore, if a plan is materially modified after October 3, 2004, amounts previously deferred under the plan will be subject to the Act.

Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.

Filed under: Corporate

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