New Deferred Compensation Rules: The Law of Unintended Consequences

 by Deborah Lush

July 2005

Congress recently passed a sweeping deferred compensation law. While intended to target only abusive schemes, the ambit of the law not only catches legitimate compensation packages but also threatens an onerous 20% penalty on them. The law applies not just to "top hat" executives and corporate directors, but also to rank-and-file employees. This article reviews the requirements of the new law and what it can mean for small businesses in the Willamette Valley .

The Rule

The new law is a constructive receipt rule codified at § 409A of the tax code. The law imposes a number of election, funding, and distribution requirements. If these requirements are not met, all amounts deferred for all taxable years under the plan are immediately included in the taxpayer's gross income and taxed at ordinary income rates. In addition, the tax imposed shall include interest and a penalty equal to 20% of the compensation included in gross income.

Application

The new law applies to amounts deferred after December 31, 2004 under any plan that loosely provides for the deferral of compensation. Amounts deferred prior to that time are grand fathered unless the plan is "materially modified" after October 3, 2004. Application of the law includes plans that are not typically thought of as "deferred compensation," such as nonqualified stock options (except when issued "at the money," i.e., the strike price is equal to the underlying stock's market value) and stock appreciation rights. The law applies regardless of whether the participant is an employee, an executive, or an independent contractor. It also applies equally to arrangements for a single individual as for a group of employees.

The law does not apply to qualified retirement plans or bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans. It also does not apply to statutory stock options or options issued at the money. The usual practice of deferring the payment of bonuses within 2½ months after the end of the year does not come within the scope of the law, but arrangements to defer bonuses beyond that time do.

Thus, the law might apply to a struggling manufacturer in a small town that, when unable to meet current payroll, makes a wage concession with the union and promises to make it up later. In another example, it applies to a phantom stock or stock appreciation rights arrangement under which an employee receives a grant of phantom stock if the stock is fully vested, even though the stock may not be payable until after the employee reaches age 65. Conversely, the law does not apply if the stock does not vest until 65, even if payout occurs at the same time.

Distributions

Section 409A eliminates any discretion in the timing of distributions and instead requires that the plan make distributions only upon the following events: separation from service, disability, death, a change of control, an unforeseeable emergency, or at a specified time or under a fixed schedule set out by the plan. With regard to the latter, the legislative history seems to distinguish distributions based on a "time" versus an "event," and apparently prohibits all event-based distributions (except for those specifically named, e.g., separation from service). The purpose for this distinction is unclear.

A participant may make a "second" election under § 409A to defer a distribution, but must do so at least twelve months in advance of the distribution and generally must delay the distribution for at least five years.

The law also prohibits any acceleration of a distribution. Future guidance may allow some acceleration when beyond the participant's control, as for example, a court-approved divorce settlement. Some commentary suggests the government might allow acceleration upon an unintended tax inclusion in order to facilitate the payment of taxes.

Deferral Elections

Section 409A generally requires that elections to defer compensation (if applicable) must be made prior to the taxable year in which the compensation will be earned. Newly-eligible participants have a 30-day grace period to make their first election. Elections to defer "performance-based" compensation earned over a period of at least one year must be made six months before the end of that period. Future guidance should flush out what constitutes "performance based" compensation.

Funding

Section 409A also prohibits securing a deferred compensation obligation with an off-shore trust. The government is to identify and target arrangements that shield assets from creditors while also deferring compensation, and it has the authority to exempt schemes without this effect.

Recommendation

In light of the new rules and their unintended-and arguably, harsh-consequences, we invite you to carefully examine any policies, practices, procedures, letters, memoranda, e-mails or other document that might promise someone a benefit payable in the future. If you have such an arrangement, we advise you to refrain from making any further deferrals under your plan until it is evaluated under the new law. Even though the extent of the guidance remains limited at present, compliance is critical. We anticipate more guidance will be forthcoming, and we will continue to monitor it as it comes.