The American Jobs Creation Act of 2004 included significant changes in the tax rules regarding deferred compensation. In the past, deferred compensation primarily referred to employees who postponed receiving part of their compensation until a future date and weren’t taxed on the income until it was collected. But the new Code Section 409A, in particular, represents a broad departure from prior law by classifying a host of additional benefits as deferred compensation.
“It is significantly reshaping the way that companies structure and dole out compensation and other benefits to employees and other service providers,” explains Mark Saulino, a tax partner in Alschuler Grossman Stein & Kahan LLP’s Transactional Department.
Smart Business spoke with Saulino about why these changes were enacted, how companies should make sure they are in compliance with the new law and the severity of penalties for offenders.
Why were changes made to deferred-compensation laws?
Section 409A was enacted by Congress to prevent perceived abuses by executives and companies in the area of deferred compensation. Deferred-compensation abuses are simply another one in the long list of issues that surfaced as a result of the recent corporate scandals that everyone is all too familiar with. Part of the concern was the perception that there was too much flexibility under prior law to offer benefits to employees and other service providers that had a built-in value today, but were not taxable until a later date.
How should a company determine which plans are subject to the new rules?
Companies really have to be careful about assuming that 409A will not apply to a given situation based on the notion that they’re not doing something that anyone would perceive as ‘abusive.’ 409A is broad in scope and can apply to many arrangements that would fall outside what most people would consider deferred compensation such as stock options, bonus arrangements, severance agreements and expense reimbursement plans.
My advice to companies has been to check for 409A issues whenever the company grants any type of benefit to an employee or another service provider — other than straight wages or salary that are payable at the time that the services are provided. Because the rules are so complicated and voluminous, I think it’s the safest approach until companies become familiar enough with the rules to be sure about what they can and cannot do.
If a company has a deferred-compensation plan with grandfathered benefits, should it amend the old plan or adopt a new one?
There are three requirements that must be met in order for compensation or other benefits to be grandfathered under 409A. Those three requirements are: the arrangement must have been entered into on or before October 3, 2004; the arrangement must not have been materially altered since that date; and the compensation or other benefit under that arrangement must have been earned and vested before January 1, 2005.
Companies that have outstanding arrangements where the benefits are not grandfathered should really consult their tax counsel as to how to best remedy the situation. The ability to terminate a plan that does not comply with 409A generally went by the wayside as of Dec. 31, 2005.
But companies can amend their plans to bring them in compliance with 409A before the end of 2006. Companies should be careful, however, not to take any actions before they consult with their tax counsel because they could create a situation that is more difficult, if not impossible, to fix under the new rules.
Who faces the penalty for noncompliance?
The primary consequences fall on the employee, but employers would really be shortsighted to think that it does not affect them. For one thing, there are reporting and withholding issues for the employer that flow from Section 409A. But those issues really pale in comparison to the concern with avoiding the public relations issues that would flow from saddling one or more critical employees with problems under 409A.
What types of penalties are involved?
The consequences are dire. Service providers face a 20 percent tax on any benefits that do not comply with Section 409A’s requirements for deferred compensation. This is in addition to the regular income taxes that are payable on those benefits. This means that some taxpayers will pay income tax at a rate of more than 60 percent on any benefits that are subject to 409A.
There are also possible interest charges that can be imposed on the benefits. At this point, it is not entirely clear how the additional tax and interest charges will apply in certain contexts — they’re still working on that and we’re waiting for guidance — but suffice it to say that the consequences are pretty severe.
MARK SAULINO is a tax partner in Alschuler Grossman Stein & Kahan LLP’s Transactional Department. Reach him at [email protected].
