The Treasury Department is clamping down on tax regulations for deferred compensation plans. Are you in compliance?
Executive compensation plans frequently involve what are known as nonqualified deferred compensation plans, or NDCPs. These plans allow executives and their employers to enter into agreements that essentially defer compensation from the year it was earned to a later tax year, allowing them to spread out tax liabilities over a period of time.
While beneficial for employees and employers alike, it's the kind of tax flexibility that's frowned upon by the Treasury Department. Recently, it adopted stricter regulations on NDCP requirements contained in IRS Code Section 409A that both reduces this flexibility and creates many a trap for unsuspecting employers. After Dec. 31, 2007, plans that don't comply in writing with these new requirements could face costly penalties. Yet, a few important exemptions still remain.
For starters, let's review some key details of 409A. Deferred compensation can only be paid out upon certain "trigger" events, such as separation from service, death, an unforeseeable emergency, or pursuant to a predetermined fixed payment schedule. There are also time limits on when an employee has to elect to defer the compensation. An employee must choose deferral of the compensation during the year prior to the year when the compensation is earned. If the employee is in the first year of deferral eligibility, the election to defer must be made within 30 days of becoming eligible. If the compensation is performance based, the deferral election must be made no later than six months before the end of the performance period, or as soon as the performance bonus amount is "readily ascertainable." Of course, there are also rules and time lines that must be strictly followed if the deferral elections are to be changed at some point after they're initially made.
The penalties for 409A violations are harsh. If the rules are not followed, there is immediate taxation of all vested deferred amounts of all NDCPs in the same category, plus an additional 20 percent penalty. Interest also accrues on the taxes and penalties from the date of deferral or vesting at the normal federal rate plus one percent. If the compensation was deferred prior to 2005, it may be "grandfathered" and escape the 409A requirements, so long as the NDCP hasn't been materially modified after Oct. 3, 2004. If the "grandfathering" treatment is lost as a result of material modifications to the NDCP, all the deferred compensation -- even compensation deferred prior to 2005 -- is subject to 409A.
That said, there are a few exemptions to consider, such as short-term deferrals. These include deferrals where the compensation is paid within two and one-half months of the year in which it became vested. Also exempt are severance payments for involuntary separations or voluntary terminations under "window" programs, so long as the benefits don't exceed the lesser of twice the annual compensation or $450,000 and the payments occur before the end of the second year following the separation of service. Tax "gross-up" payments are allowed, provided they are paid by the end of the year following payment of the taxes.
Under 409A, there are nine categories of NDCPs, and a violation of 409A by any one plan causes all other plans within the same category to be subject to the taxes, penalties, and interest described above. However, a violation in one category of plans will not necessarily cause violations in plans under other categories. These "category aggregation" risks can be minimized by splitting plans up -- that is, creating separate plans for each executive, for each year of deferrals, or both. However, this approach will increase administration costs.
Given the year-end deadline to comply, employers should meet with their tax advisers sooner rather than later in order to:
* Identify and review all plans and arrangements that defer compensation (including oral agreements, employment offer letters, and promises made in e-mails) to determine which plans are subject to 409A.
* Determine which grandfathered plans to freeze.
* Draft written plan documents for any existing oral agreements.
* Amend other existing plans to comply with 409A.
* Communicate all changes to participants using summaries and detailed disclosures.
Publicly traded companies should also prepare and file any SEC filings related to the plan amendments. All revised plan documents should also allow employers to unilaterally amend the plan in the future.
Nobody expects the new 409A regulations to trigger companies to abandon NDCPs. But the new regulations are vast, the penalties for noncompliance are severe, and based upon the Treasury's dislike of such plans, look for the IRS to aggressively review these plans on audit. If you participate in or if your firm provides an NDCP, you should consult with your tax adviser immediately.