Viewpoints

Attract and Retain Top Executive Talent Through Effective Deferred Compensation Planning

Paul Henry

Originally Published In:
THE ROCHESTER BUSINESS JOURNAL
February 2008
Author: Paul Henry, CPA

Attracting and retaining top executive talent within an organization can be extremely competitive. That’s why it’s critical to structure strong compensation plans that offer opportunities for additional earnings that are specific to an executive's targets and performance, and provide them on a tax-deferred basis. 

Because of significant tax penalties, enterprise management teams and executives need to understand the new tax rules affecting deferred compensation plans as outlined in Sec. 409A.  They should also realize the additional options of deferred compensation plans that are not subject to these new rules, and thus may be more effective for their specific purpose.

Organizations can take two approaches when it comes to compensation planning: qualified compensation plans or nonqualified deferred compensation (NQDC) plans. 
Qualified deferred compensation plans generally cover the majority of the workforce, have uniform benefits across all plan participants, have standardized plan features, compliance and reporting requirements, and are geared almost entirely towards retirement.  They also provide a current tax deduction for employer funding of the plan, and a deferral of income for participants until the benefits are paid. 

NQDC plans, on the other hand, can be created for a select group of executives at the discretion of the management team, and the terms of these plans can be customized to the organization's objectives.  These plans must be structured to avoid the constructive receipt of income by the participant (so there is a deferral of income), with the result that the organization cannot deduct the benefits until actually paid.

Because of their flexibility, NQDC plans offer more options for executives to accumulate deferred compensation beyond the qualified plan limits, defer performance-related bonuses, and more directly benefit from their contribution to the success of the business or enterprise; all on a tax-deferred basis. However, with the ever-changing world of tax law, organizations’ management teams must make sure to comply with the requirements as described in Sec. 409A.
 
Sec. 409A now allows the deferral of income via NQDC plans only if the plan adheres to specific timing rules for elections to defer income and take distributions, and there is now far less flexibility in changing any part of these elections at a later date.

The requirements of the Sec. 409A regulations were generally effective for income deferred after 2004, but the date for full plan compliance has now been extended for the third time to December 31, 2008.

During this transition period, NQDC plans must still be operated in "reasonable, good-faith compliance" with Sec. 409A until the full compliance date.  After three extensions, it is unlikely that there will be another, and so NQDC plan sponsors and their employees/participants should view this as a final deadline.  In fact, the IRS issued rules in December of 2007 for correcting failures of plan operation (but not plan design) occurring before 2010, so it appears they are proceeding as if there will be no more extensions.

Overview of Sec. 409A Regulations

The Sec. 409A regulations are lengthy and complex, and as with all tax law, there are numerous exceptions, definitions, and transition rules. The following is an overview of the key points of the rules to help managers gain a better understanding of how to review and structure their company’s executive-level compensation plans. 

Sec. 409A applies to all employers (commercial and not-for-profit) that provide an arrangement where an employee can, by election or agreement with the employer, defer income until a future year.  The statute itself is very broad and may affect certain types of arrangements that are not typically considered to be deferred compensation (e.g., certain severance arrangements, provisions in employment contracts, split-dollar insurance arrangements, etc.).  However, certain nonqualified deferred compensation plans are outside the scope of Sec. 409A, and can be used by employers to provide benefits to certain employees free of the Sec. 409A requirements.

Compensation methods that are subject to the Sec. 409A requirements include many of the traditional NQDC arrangements, such as phantom stock plans, advance deferral elections of cash compensation, etc.  However, plans excepted out of Sec. 409A are many plans involving "property", such as restricted stock, incentive stock options (ISOs), stock appreciation rights, even nonqualified stock options.

This is because a plan that provides no actual deferral of income is not covered by Sec. 409A.  For instance, if nonqualified stock options were issued to an employee when the exercise price was equal to the stock's value (issued "at-the-money"), there is no deferral of income (i.e. the employee has an option to pay full price for something; there is no inherent benefit at that time).  So some plans that would typically be covered under Sec. 409A could possibly be structured to avoid such coverage by using such equity instruments.

Under the Sec. 409A regulations, NQDC plans must meet specific requirements to avoid plan failure:

• Elections to defer compensation must generally be made the year before compensation is earned,
  
• Distributions may only be made at times specified in the arrangement, or upon certain events that are specified in the regulations,
  
• Once amounts have been deferred, there are substantial restrictions on the ability to change the timing and form of payment, and
  
• The time or form of payment may generally not be accelerated.

Each of these requirements must be spelled out in the compensation plan document, and the plan must be operated in accordance with them.  Practically, many NQDC plans may already have most of these features, so conformance should be expedient.

A plan covered under Sec. 409A and that fails in its compliance with the regulations, absent any relief provided by the IRS' December 2007 notice, will generally result in full taxability of future benefits years before any benefits are received (i.e., the amounts deferred), as well as a 20 percent penalty tax and additional interest.  Because the income tax, penalty tax, and additional interest component all fall on the participant, they should have as much of an interest in plan compliance as the employer.

In the future, employers should expect that requests for NQDC plan documents will become part of the initial Information Document Request (IDR) that the IRS sends to initiate an audit.  In addition, the W-2 forms of NQDC plan participants will likely be reviewed, as there are W-2 reporting requirements for annual plan deferrals and earnings, distributions from the plan, and plan-failure-related income inclusions.

Take Action: Steps for Employers & Employee/Participants to Become Sec. 409A Compliant

• Review all compensation arrangements, including any bonus policies, and employment and severance agreements to determine if they are covered under Sec. 409A.
  
• For plans that are subject to Sec. 409A, either amend the plans to come into full compliance, or amend so they clearly are not Sec. 409A plans.
  
• Create or update plan documents and ensure the plans are being administered appropriately.
  
• Perhaps give participants the option to change their timing and payment elections for pre-2008 deferrals or payments.  Plans fully in compliance with Sec. 409A for 2009 and later will no longer have these options, so 2008 is the last time participants can change these elections.

The Future of NQDC Plans

In selecting a NQDC plan, employers must now consider whether the rules found in Sec. 409A will limit their options in operating the plan.  Sec. 409A's requirements may not be onerous for employers with straightforward plan provisions and operations, and where they have determined the plan is effective.  However, even with Sec. 409A’s standardization of plan provisions, there are still ways to structure NQDC plans without subjecting the arrangement to Sec. 409A requirements.  As noted in the list above, some arrangements, such as plans that don't initially provide a deferral of income, are excluded from the scope of Sec. 409A, and thus variations of those plans may be effective for employers. In addition, the multiple NQDC arrangements involving property, such as restricted equity instruments, are also not covered under Sec. 409A. 

Because 409A plan failure will be so costly from a tax perspective, employers must review existing compensation arrangements before December 31, 2008.  Employers considering new incentive, equity-based, or deferred compensation arrangements to reward key employees should not be intimidated by the Sec. 409A requirements; there are ways to provide these benefits both within the Sec. 409A structure and via arrangements outside Sec. 409A's scope.  The best approach is for the organization to determine how they want their plan(s) to operate, and then work with their advisors to see if there are plan design alternatives that may prevent the imposition of Sec. 409A requirements.  If not, then consider the plan akin to a qualified deferred compensation plan (i.e. a 401(k) plan), and develop internal control procedures to ensure accurate and timely plan compliance and reporting.

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