HAVE YOUR DEFERRED COMPENSATION PLANS BEEN UPDATED TO AVOID CURRENT TAXATION?

By: David L. Musser, CPA, CFP®

During the Enron scandals, Congress was upset by highly paid executives who controlled their expensive deferred compensation benefits, while avoiding taxation and at the same time avoiding the reach of Enron’s creditors. In response, Congress placed stronger restrictions on nonqualified deferred compensation plans. These restrictions are designed to prevent high-ranking employees from manipulating their deferred compensation to maximize their tax and financial benefits, while protecting them from their employer’s creditors.

Deferred compensation is an amount earned in one year and payable in a subsequent year. Nonqualified deferred compensation is labeled in contrast to qualified pension plans, which are much more protected and do give employees some control over the distribution of their benefits. Qualified plan benefits are usually for rank-and-file employees, while nonqualified benefits tend to be for highly-paid executives.

Congress enacted Code Sec. 409A in 2004 to place limits on deferred compensation. The IRS issued final regulations in April 2007. These regulations have been controversial because they are extensive and complex. There have also been complaints that the IRS is not providing enough time for plans to comply with the regulations. The deadline for compliance with the regulations is December 31, 2007. The IRS extended the compliance deadline for the terms of the written plan to December 31, 2008. In the interim, plan sponsors may continue to operate plans in good faith compliance with the proposed regulations, or may choose to rely on the final regulations. Selected highlights of the provisions are discussed below:

Deferral Elections
§ 409A generally requires deferral elections to be submitted before the end of the participant’s taxable year (i.e., 12/31) preceding the service period, subject to limited exceptions provided in the regulations. Exceptions to this general rule include elections to defer “performance-based compensation” (as defined in the regulations) and deferral elections made during the first year in which an individual is eligible to participate in the plan.

Distribution Elections
The regulations provide guidance regarding (i) the deadline by which the form and/or timing of benefit payments under a nonqualified deferred compensation plan must initially be elected by the participant or designated by the plan sponsor, and (ii) the application of the rules of §409A regarding any subsequent changes in the form or timing of payment.

Permissible Distributions
§ 409A generally provides that payments may only be made at certain times or upon certain events specified in the statute (e.g., separation from service, disability, death, a specified time or pursuant to fixed schedule, upon a change in control, and upon an unforeseeable emergency). In addition, the statute provides that a plan may not permit any acceleration of the specified time or fixed schedule for paying benefits, except as provided by Treasury guidance. The regulations incorporate these rules and provide additional guidance on the requirements for a payment to be made in compliance with §409A.

Effective Date and Grandfathered Amounts
The requirements of §409A generally apply to any amounts deferred into a nonqualified deferred compensation plan on or after January 1, 2005. The regulations provide that an amount is considered deferred before January 1, 2005 if prior to that date (i) the participant had a legally binding right to be paid the amount, and (ii) the right to the amount was earned and vested.

Reporting Requirements
§ 409A generally requires that plan sponsors report on Form W-2 (for employees) and Form 1099-MISC (for non-employees) all amounts deferred under a nonqualified deferred compensation plan during the year (plus earnings for that year). In December 2005, the IRS suspended these reporting requirements for the 2005 calendar year. Note 2006-100 (released by the IRS on November 30, 2006) further suspended these reporting requirements for amounts deferred during the 2006 calendar year under a nonqualified deferred compensation plan that has been operated in compliance with the requirements of §409A.

The regulations do not address the reporting requirements for amounts deferred under a nonqualified deferred compensation plan; however, additional guidance is anticipated that will address this topic.

Guidance on Whether Certain Arrangements are Beyond the Scope of §409A
The requirements of §409A generally apply to any amounts deferred into a nonqualified deferred compensation plan on or after January 1, 2005. The term “nonqualified deferred compensation plan” is broadly defined in §409A as any plan or arrangement that provides for the “deferral of compensation,” subject to certain limited exceptions. In general, a plan provides for the “deferral of compensation” if, under the terms of the plan and the relevant facts and circumstances, the participant has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the participant in a later taxable year.

The regulations provide guidance describing which arrangements are excluded from §409A, and address the circumstances under which §409A applies to specific arrangements, such as severance plans, stock options and stock appreciation rights, and arrangements with independent contractors.

Short-Term Deferrals – (Generally within 2 ½ months): In general, an arrangement that only provides for “short-term deferrals” is not subject to §409A. The regulations provide guidance on what is required for an arrangement to fall within this exception.

Separation Pay Arrangements: Severance pay arrangement (referred to in the regulations as “separation pay” arrangements) are not categorically excluded from §409A. However, the regulations do provide limited exceptions from §409A for certain types of separation pay arrangements.

Arrangements with Independent Contractors: The regulations provide guidance on the application of §409A to arrangements involving independent contractors when they provide “significant services”. Directors are not considered as independent contractors under this exclusion.

Stock Options and Stock Appreciation Rights: The regulations generally provide that stock options and stock appreciation rights (SARS) for employer stock issued at an exercise price at least equal to fair market value on the date of grant are excluded from coverage under §409A. However, note that if the stock right contains a feature for deferral of compensation, the stock right will be subject to §409A.

Split-Dollar Life Insurance Arrangements: Split-dollar life insurance arrangements that provide for the deferral of compensation (by providing the executive with deferred policy cash values) are subject to the requirements of §409A. However, split-dollar life insurance arrangements that provide only death benefit payments fall outside of §409A. Notice 2007-34, which was issued at the same time as the final regulations, allows plan sponsors to modify their grandfathered split-dollar arrangements to bring them into compliance with §409A without violating the grandfathering provisions with the split-dollar regulations.

Action List

• Prepare a listing of all deferred compensation and/or benefit plans that may be subject to §490A.
• Obtain plan documents for each type of compensation/benefit, if any.
• Consult with your attorney and/or tax accountant concerning the necessary changes and applicability.

If you have any questions about these changes, please call us. Proper planning is important to avoid current inclusion of taxable income for failure to comply with these provisions.

Contact Nichols, Cauley & Associates by Email, phone, or online form with your questions.

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