When President George W. Bush signed the American Jobs Creation Act of 2004 late last fall, one component of the sweeping tax legislation included major changes in the rules governing non-qualified deferred-compensation plans typically offered to corporate managers, senior executives and directors. As a result, all U.S. companies — public or private, large or mid-sized — need to review and revise these plans to ensure they are in compliance with the new law.

The AJCA invokes penalties on those who take money out of the plans early, except in certain circumstances; makes it tougher to put off taking the payout beyond the originally intended date; and requires decisions about whether to postpone taking a bonus payment.

The new law also more broadly defines deferred compensation. As a result, many non-qualified deferred-compensation plans, which often provide extra retirement benefits for senior management with pre-tax contributions, could start looking more like qualified plans, such as 401(k) plans, which are frequently funded with pre-tax contributions.

Specifically, deferred compensation is now defined as any plan under which income is paid out to an employee at a date at least 2 1/2 months after the end of the tax year when the income is earned. Some examples include non-qualified stock options with deferral features; stock appreciation rights (SARs); discounted stock options; severance pay; or a bonus.

Previously, many deferred-compensation plans were flexible — perhaps too flexible. Now, companies not in compliance with these new rules risk exposing plan participants to several adverse tax consequences:

Immediate taxation of compensation deferred under the plan. All compensation deferred in all previous taxable years and the current taxable year is subject to immediate federal income taxation.

A 20 percent penalty on all compensation deferred under the plan.

An IRS-imposed interest charge dating to the year in which the amounts were initially deferred or the year they became vested, whichever is later.

Though the Treasury Department is expected to further clarify the issue in June, guidance issued last December should provide a good framework to begin revising plans. First and foremost, a company should have a tracking system in place. Pre-2005 deferrals are grandfathered under the law, but amending these plans to add additional benefits, rights or features will cause them to lose their grandfathered status.

If they haven’t done so already, companies should consider freezing old plans and putting a new, compliant plan in place. Tracking systems separating pre-2005 and post-2005 deferrals can be as simple as an Excel spreadsheet, or extremely sophisticated, depending on the size of the company and complexity of the plan.

Also, clear employee communication is crucial, because the tax burden ultimately rests with executives or directors if they make a withdrawal in violation of the AJCA. Employees should understand which deferrals are grandfathered and which are not, so that they can avoid triggering taxes.

Perhaps the most arduous task facing executives and human resources departments will be deciding how to design their new plans so that they continue to motivate and reward employees. For example, some publicly traded companies are considering eliminating discounted stock options and are weighing alternatives, including SARs. Based on the guidance the Treasury Department provided last December, some SARs are generally not considered deferred compensation, and are almost identical to stock options in terms of what an employee receives.

As long as plans are operated in good-faith compliance during calendar year 2005, and in a manner consistent with the AJCA, employers have until Dec. 31, 2005, to amend their plans to conform to the new rules. However, executives should explore alternatives to their deferred compensation plans while they wait for the Treasury Department to shed more light on the subject.

Nancy Mossman is a senior manager for compensation and benefits at KPMG LLP.