Even With 409A Limits, Deferred Comp Plans Have A Vital Role

An increasingly popular form of executive compensation is restricted stock. A grant of restricted stock will not be subject to 409A as long as the stock is both nontransferable and not vested. It is important to note that once it vests, restricted stock becomes taxable income. Deferred stock units are subject to 409A. Despite this, they are gaining in popularity as the right to payment can vest, while the actual receipt of income can be deferred to a later year.

In addition to considering whether to implement new plans, employers must review all of their existing executive compensation arrangements for 409A compliance. This review should cover employment agreements and severance arrangements; stock-based arrangements for public and private companies, including options; phantom stock plans and deferred stock unit plans; supplemental executive retirement plans; plus executive deferred compensation arrangements.

The good news is that amendments to make existing plans comply with 409A are allowed through 2006. To the extent a pre-2005 arrangement had non-vested benefits as of Dec. 31, 2004, the employer has two choices. The first is to apply the pre-2005 rules that violate 409A to pre-2005 vested balances or benefits and then apply the 409A rules to the rest. The other is to amend the arrangement to meet 409A requirements for all years.

Whether it is better to preserve the pre-409A rules for pre-2005 vested balances depends on the employer’s goals. A single set of rules promotes administrative simplicity and uniformity, but conforming pre-2005 plans to 409A requirements could eliminate some of the popular features of the plan, such as the ability to take an unscheduled withdrawal with only a small “haircut” or the ability to elect subsequent year-to-year deferrals of deferral account balances.

One fact is certain: 409A covers many arrangements that are not automatically associated with deferred compensation. To avoid significant penalties for noncompliance, all employment contracts, severance packages and other arrangements must be reviewed by counsel with expertise in 409A compliance to determine whether 409A applies.

How should nonqualified deferred compensation proposals be presented to current or prospective clients? First, the financial consultant must determine what objectives the client seeks to achieve and which cannot be achieved through qualified plans. Then, the consultant should identify nonqualified plan solutions to achieve the client’s objectives.

The consultant should emphasize that nonqualified plans may be the most effective and flexible way to meet the company’s objectives, not the least of which is the need to attract and retain top executive talent. Although all existing arrangements must be reviewed to avoid penalties, the IRS guidance eliminates uncertainty in tax treatment and provides templates for plans that clearly withstand IRS challenge, such as participant-directed investment options.