When it was signed into law nearly two years ago, the American Jobs Creation Act of 2004 was described by tax specialists as the first major piece of tax-related legislation since the Internal Revenue code was revised in 1986. At the core of the legislation are measures designed to stimulate job creation in the manufacturing sector. But the so-called 2004 Jobs Act also contains provisions with significant tax implications for corporations in all economic sectors.
Internal Revenue Code (IRC) Section 409A establishes rules governing corporate deferred-compensation plans, including traditional elective deferral plans, equity-based compensation arrangements such as stock appreciation rights and restricted stock, supplemental executive retirement benefits, and individual employment and severance agreements. Failure to comply with the new rules carries significant tax implications for covered employees.
In light of the new rules and their tax-related implications, many corporate decision-makers are reviewing their deferred-compensation plans and policies, says Scott Mayfield, tax partner in Whitley Penn LLP, a regional accounting and consulting firm with offices in Dallas and Fort Worth.
Smart Business spoke with Mayfield to discover how corporate managers can evaluate their deferred-compensation plans to ensure 409A compliance.
How does Section 409A affect deferred-compensation agreements?
IRC Section 409A was enacted as part of the 2004 Jobs Act. The Treasury Department has enforcement jurisdiction of the law that covers all deferred-compensation agreements, including individual agreements such as executive contracts that contain a deferred-compensation clause.
Beginning in 2005, all deferred-compensation agreements that provide for future payment of current compensation must comply with tax rules relative to 409A. If the agreements are not in compliance, the individual receiving the compensation is liable for penalties. Non-compliance eliminates the deferral benefit and changes deferred income to current income, subjecting the income to a 20 percent excise tax on the amount deferred, along with an IRS underpayment penalty plus one point.
Penalties are imposed for each year beyond 2005. For example, if the deferred income is not to be paid until 2007, a noncomplying agreement would subject the individual to taxes and penalties for 2006.
State and local noncompliance penalties may be applied if those entities follow the federal legislation regarding deferred compensation.
How can managers ensure their deferred compensation agreements comply with Section 409A?
Most big companies will have already complied, but it’s still important to review every arrangement for each individual who has a legal binding right to compensation paid in a subsequent tax year.
How can managers evaluate agreements?
Each contract must be in compliance in the areas of distribution of benefits, acceleration of benefits and election of benefits.
Under Section 409A, a deferral election must be made before the beginning of the tax year or, for first-time participants, within 30 days after they become eligible to participate in the plan. If the deferred compensation is performance based for services of a period of 12 months or more, the election must be made within six months of the time the services begin.
Also, the time schedule of benefits cannot be accelerated except if specified by the IRS. Compensation cannot be distributed earlier than separation of service, disability, death, unforeseeable emergency and a date irrevocably determined at the time of at the deferral election. Compensation may be generally deferred only if the deferred election is made prior to the year during which the compensation is earned.
However, companies may continue to offer short-term deferred-compensation plans, as these still qualify for compliance under Section 409A — so long as the compensation is paid within 2.5 months after the current tax year.
How should reviews be carried out?
Managers of human resources departments in larger companies will be familiar with Section 409A and its noncompliance consequences, and larger companies may have internal controls for reviewing deferred-compensation agreements. Companies that do not have in-house human resource specialists should start with the tax advisers and their attorneys.
How do managers bring plans into compliance?
If agreements are not in compliance, they may not be terminated. They must be renegotiated. Tax advisers and attorneys should review renegotiated agreements.
How are companies changing their compensation policies as a result of the new rules?
As a result of the new rules established in Section 409A of the 2004 Jobs Act, many companies are replacing deferred-compensation plans with other programs such as qualified retirement plans such as 401(k)s, vacation pay, sick leave, disability and death benefits, incentive stock offerings and medical Health Savings Accounts (HSAs).
The cost of administering deferred-compensation agreements under Section 409A rules is driving this change. Overall, the new rules are encouraging companies to rethink their compensation policies to include diverse benefits packages.
SCOTT MAYFIELD is a tax partner in the Fort Worth, Texas, office of Whitley Penn LLP. Reach him at (817) 258-9173 or [email protected]
