From the March 2006 issue of Wealth Manager Web • Subscribe!

TAMING THE WILD WEST

FOR DECADES, VARIOUS EXECUTIVE COMPENSATION strategies have been as wild and creative as gunslingers and gold miners in 19th century America. But a new sheriff just came to town; actually, it's an old sheriff with new ammunition.

Over many, many years, the IRS (aka the sheriff) lost every single case it brought to court challenging deferred compensation plans. In fact, since 1978 the IRS has been prohibited from issuing new rules on deferred comp. Congress has generally been silent on the issue. But because of corporate scandals including Enron and MCI World-Com, the IRS has successfully obtained through legislation what it could not obtain through the courts.

The American Jobs Creation Act of 2004 added a new section to the Internal Revenue Code. It is Section 409A, and guidance from the Treasury Department in the form of Proposed Regulations became effective on September 29, 2005. The new rules apply to any amount deferred after December 31, 2004. This is not the future; this is now!

And it's the biggest thing since the ERISA legislation began governing qualified retirement plans in the mid-1970s. Section 409 A will have far-reaching--and expensive--ramifications to two specific groups:

High level employees

Business owners

The new rules cover plans with any agreement or arrangement that provides for a deferral of compensation. There are limited statutory exceptions: qualified retirement plans and such items as vacation leave, sick leave, compensatory time, disability pay or death benefit plans. In addition, Incentive Stock Option plans are exempt, and Non-Qualified Stock Option plans may be exempt under certain circumstances. More on that later.

The rules in Sec. 409A are an addition to existing rules for deferred comp; they do not eliminate or replace the old rules. The cost of failure to comply with Sec. 409A is extremely high--you could call it "compelling compliance persuasion"--because it means automatic inclusion in current income, a 20 percent penalty tax, and interest from the beginning of the deferral (which could go back 10, 20 or more years). Because this last item effectively overcomes the normal statute of limitations, it could result in an exorbitant penalty.

Under Sec. 409A, compensation earned in one year and paid in another (a "legally binding right") must either be 1) statutorily excluded from Sec. 409A, or 2) compliant. If not, see penalties above. And take note: The penalties are imposed on the employee, not on the corporation. Keep in mind, under virtually all non-qualified deferred compensation arrangements, the corporation takes no tax deduction until the amount is paid to the employee. Thus, there is no tax advantage to the corporation that can be penalized. The Treasury Department has scored Sec. 409A at $800 million of revenue over 10 years.

If there is no "legally binding right" to the compensation, then Sec. 409A does not apply.

Let's take a look at how this affects both high level employees and business owners, whether their corporations are small, medium, or large:

The term "high level employee" could include anyone from the owner of a small business to a mid-level manager to an executive in a large corporation. The real issue is whether an employee has any kind of deferred compensation arrangement other than a qualified retirement plan.

There are two important times in any deferred compensation situation: the beginning--that is, the election to defer--and the end--the timing of the distributions. The new Sec. 409A has quite a bit to say about both.

One of the issues the IRS continually lost in court was their position that an election to defer income should be made in the calendar year prior to deferral. Well, the IRS finally got what it was fighting for. The new rule states:

The initial deferral election must be made before the beginning of the year in which the services are performed, except in the case of a new participant or with respect to performance-based compensation (such as a salesperson's bonus for exceeding a certain level of production).

In the case of performance-based compensation, the initial deferral election can be made at least six months before the end of the performance period, provided that the performance period is at least 12 months.

There is an exception for short-term deferrals, and according to one Treasury official, this is the most important exclusion: Statutorily, there will be no deferral of income if the employee actually or constructively receives the income within two and a half months of the end of the taxable year. That would generally be March 15. To avoid problems or penalties, you must take the income by that deadline.

Stock options may be exempt from the rules. Incentive stock options are excluded. Non-qualified stock options are only excluded if they have a fair market value exercise price; if there is any discount or other deferral feature, they will not be exempt.

Stock appreciation rights (SARs) with a fair market value exercise price and no other

deferral feature are also exempt. In addition, restricted stock subject to a Sec. 83(b) election is not subject to the Sec. 409A rules. However, there is a less utilized arrangement known as Restricted Stock Units (RSUs) that is subject to the rules. Be careful.

Severance or separation pay is excluded if the amount does not exceed two-times compensation and is completely paid out within two years of termination. Generally, the employee and the company must agree on a specified date or year when the payment will be made. In addition, the distribution date cannot be changed unless: 1) it is elected at least one year before it is payable, and 2) it is pushed back at least five years.

There is a special rule for key employees of publicly traded corporations under Sec. 416(i): These are the top 50 employees by compensation. A distribution on account of separation from service must be delayed by at least six months.

A plan may not distribute amounts earlier than for separation from service, disability, death, a specified time or pursuant to a fixed schedule (but not an event, such as a child going to college), a change in control, or an unforeseeable emergency.

The new rules prohibit an early distribution with a reduction ("haircut"). This is the tactic many Enron and MCI Worldcom executives took advantage of.

From the company perspective, there are many issues. First, the owners should identify all of the various deferred compensation arrangements that presently exist.

Old plans are grandfathered, unless they are changed. Be very cautious about making modifications of any kind to existing plans.

If a benefit or right existing as of October 3, 2004 is enhanced, or a new benefit or right is added, that constitutes a modification.

The company should consider whether to freeze all existing plans and issue new plans for the future. Conversely, the company could choose to amend their existing arrangements to conform to the new rules.

A deferred compensation arrangement must be a written plan. The company should make sure there are no verbal or "handshake" agreements. All plans must be put in writing.

Next, the company should clearly inform employees of the restrictions detailed above, both with respect to initial deferral elections and to distribution choices and changes.

Also, the new law requires annual reporting on W-2s and 1099s of the amounts deferred. Companies should consider how to measure and track the amounts, and they should notify employees that these amounts will be appearing on their W-2s and 1099s.

Finally, there are limited opportunities to terminate and pay out a Sec. 409A plan with specific rules to follow.

The new section regulates the timing, but not the amounts of the payment of compensation. The penalties for non-compliance are severe.

There are some exceptions available so that certain plans or situations may not be subject to Sec. 409A. Employers and employees should be aware of plans that are exempt and plans that are subject to the rules. Exclusions were tailored carefully to target certain types of abuse.

This legislation for non-qualified plans closely mirrors ERISA legislation for qualified plans. The vast territory of deferred compensation is no longer the "wild west"; it has become civilized. Outlaws will pay a terrible price. Law-abiding citizens will continue to enjoy the benefits of deferred compensation. There will simply be less flexibility and more reporting.

Cal Brown, CFP, is Vice President of Planning at The Monitor Group in McLean, Va. He is pursuing his Masters of Science in Taxation at American University in Washington, D.C. and would like to thank Washington attorneys Norma Sharara and Keith Mong, adjunct professors there, for providing invaluable information on Sec. 409A in their class on employee benefits.

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