By Jeffrey P. Hart, Esq. and Perry Ganz, Esq.
Nobody wants to pay income taxes on compensation they have not yet received. But many executives who are entitled to receive deferred compensation from their employers may soon have to do just that. The problem was created by new Section 409A which was added to the tax law by the American Jobs Creation Act of 2004. The law dramatically changes the taxation of so-called nonqualified deferred compensation (NDC) plans. NDC is compensation that is deferred (i.e., earned in one year but paid in a later year) under an arrangement other than pursuant to traditional pension, profit sharing or 401(k) plans or vacation, sick or disability plans. Compensation is considered deferred under these new rules if the service provider (e.g., an employee, independent contractor, or consultant) has a legally binding right to receive the payment in the current year and elects to receive the payment in a later year. Companies have until December 31, 2006 to amend their plans to comply with the new law. Failure to comply will result in severe tax penalties.
It used to be relatively easy to defer income taxes on compensation promised to be paid in the future. The rules required that promises to pay compensation in the future had to be unfunded and unsecured or there had to be a "substantial risk of forfeiture." For example, if an executive was promised a bonus in 2006 equal to 5% of the company's 2006 profits, but the bonus was not payable unless the executive remained a full time employee until 2009, the risk that the executive would not be paid was sufficiently "substantial" for the IRS to permit deferral of the taxes on that income until 2009, because if the executive quit or was fired before 2009, the deferred bonus was forfeited. It was very common for such arrangements to include special circumstances under which the executive could take his or her money sooner or even decide to defer the payment (and the income taxes) still further.
Congress has now decided that too much income tax was being deferred without any real risk that the income would actually be forfeited by the service provider. The House Committee Report explaining the new law states that Congress was concerned that "Executives often use arrangements that allow deferral of income, but also provide security for future payment and control over amounts deferred." In other words, to no one's surprise, executives were postponing the payment of income taxes on deferred compensation under arrangements that made it virtually certain that the compensation would be paid.
Under the new law, all income deferred under a NDC plan will now be currently taxable unless the compensation may be paid only upon one of the following six events: (1) termination of employment, (2) death, (3) disability (a real medical disability expected to last more than one year or result in death, not just the flu), (4) a specific date specified at the time of the deferral, (5) an unforeseen emergency (such as a severe financial hardship resulting from an illness or accident), or (6) a change in ownership of the company. If the compensation can be paid sooner for any other reason (except as provided in new tax regulations not yet finalized), it will be taxable when earned even though not yet paid. For example, if a plan allows deferred compensation to be paid if the participant's child enters college, the income taxes on this compensation may not be deferred. The new rules apply only if the compensation is not subject to a substantial risk of forfeiture and was not previously included in the service performer's income. Proposed Regulations issued in September provide that the new law does not apply to "short-term deferrals," where the income is paid by the fifteenth day of the third month after the end of the service performer's or the employer's taxable year in which the amount is no longer subject to a substantial risk of forfeiture, whichever is later.
Section 409A also requires that the initial election to defer compensation be made either in the tax year before the services are performed or within thirty days of initial eligibility to participate in the NDC plan. This period is extended for performance-based compensation plans which may permit participants to make the deferral election within the first six months of the service year. Performance based compensation is contingent on the satisfaction of preestablished organizational or individual performance criteria.
Employees receiving stock options may also face accelerated income taxes under Section 409A. While "incentive stock options" are exempt from the new rules, nonqualified stock options and similar plans will be subject to the new rules if the options are granted at a strike price which is less than the fair market value of the stock. A company must use a reasonable valuation method to determine the fair market value.
The penalties for violating Section 409A will be painful. The unpaid tax liability will subject to interest at the IRS underpayment rate plus 1%, plus an additional 20% income tax on the amount of the deferred compensation included in income on account of the new rules. The new rules apply to all compensation deferred on or after January 1, 2005. Compensation benefits which were both accrued and vested as of that date are grandfathered. All deferred compensation plans will have to be reviewed to determine if amendments are needed to comply with the new law. The IRS initially set December 31, 2005 as the deadline by which plans must be in compliance, but this date, for most purposes, has been extended to the end of 2006. Until then, plans must be operated in good faith compliance with the new rules. Considering the complexity of the new rules and the penalties for failure to comply, employers should review all of their deferred compensation plans immediately.
Jeffrey P. Hart is a member of the law firm of Tarlow, Breed, Hart & Rodgers, P.C. in Boston. Perry Ganz is an associate attorney at the firm.