United States: Countdown for Deferred Compensation: Why 2004 is the Year for Updating Distribution Elections and Deferring Stock Plan Gains

The U.S. Congress is poised to pass legislation that will dramatically tighten the tax rules applicable to deferred compensation. The second half of 2004 nevertheless presents a window of opportunity for those in the U.S. who want—

• To update individual elections establishing the time or manner in which benefits are paid from deferred compensation plans, supplemental retirement plans, restricted stock and phantom stock plans, and other nonqualified plans (collectively, "Plans").

• To make a special election that will control payment of their benefits in the event of a change in corporate control—or other special trigger events.

• To defer the income that would otherwise arise either from their exercise of stock options or from the vesting of their restricted stock.

• To convert deferred compensation or supplemental retirement benefits into deferred shares.

• To expand the investment alternatives from which participants may choose to measure the rate of return to be credited on their deferred compensation.

At this juncture, both the House and the Senate have passed bills that would change the deferred compensation laws as part of broadly-supported legislation to repeal of the Extraterritorial Income Exclusion Act ("ETI"). The tax provisions within the Senate bill¹ would apply only to amounts deferred after 2004. The House bill² proposes, however, to apply retroactively to amounts deferred after June 3, 2004. The American Bar Association’s tax section and leading tax lobbyists have been arguing persuasively that it is infeasible for the IRS—and a tax disaster for employers and employees—to amend the deferred compensation laws retroactively.

Because Congress has now recessed until September without appointing a joint committee to reconcile the two ETI bills, it seems likely that any tax legislation will only apply to deferrals occurring after 2004. As a result, those Plan sponsors, executives, and directors who act before the tax legislation becomes effective should be well-positioned to secure any grandfathering treatment that becomes available. In the unlikely event that the tax legislation takes effect retroactively, careful drafting should protect Plan sponsors and participants by voiding any actions they take now. Overall, the second half of 2004 presents what could be a last chance to make Plan amendments and special elections of the kind listed above (and described further below).

Many nonqualified plans restrict participants to payment alternatives such as the following:

• Requiring irrevocable distribution elections before participants begin to earn the compensation being deferred.

• Limiting payment forms to lump sums or to installments for a set number of years.

• Pre-ordaining the benefit commencement date, usually based on termination of service.

• Triggering automatic lump sum cash-outs when a change in control occurs.

Current U.S. tax laws generally permit broader choices for participants, including second elections to defer or to accelerate payment if participants make them at least a year in advance of their effectiveness (or on shorter notice if the participant forfeits some benefits through what is know as a "haircut"). The tax proposals that Congress is now considering would severely limit second elections, and would generally prohibit the accelerated payments that occur routinely under current tax laws.

Even though any new tax legislation will likely apply on a prospective basis to new deferrals, new distribution elections (as to form or timing) with respect to past deferrals may convert them into new deferrals for purposes of the new laws. The current bills do not address this point. However, the change could come in the form of a conference agreement or afterward through implementing Treasury Department regulations. These risks are not without precedent relating to deferred compensation.³

Consequently, plan sponsors and participants would be wise to get their plans and their deferral elections in the best possible form before the end of 2004 (and ideally, as soon as possible in case legislation passes earlier with an immediate effective date). A simple plan amendment should be sufficient to broaden distribution election rights —and protections—for executives and directors. The same amendment could amend or allow a stock gain deferral program of the type described below. The sooner these rights and protections are in place in 2004, the better for executives and directors who want to make elections before the year ends.

Whenever the proposed tax legislation passes, plan sponsors will likely want (1) to freeze their existing Plans, perhaps designating them as separate plans for each participant, and (2) to adopt new Plans that conform with the new law and cover post-effective date deferrals. This may prove the best approach for conforming with the new law in a manner that preserves maximum flexibility for grandfathered amounts.

What we describe below as "Stock Gain Deferral Programs" could take the form of any or all of the following alternatives that a Plan sponsor could offer to executives and corporate directors:

• With respect to restricted stock or restricted stock units, the ability to defer taxation from vesting to some future date within the award holder’s control.

• With respect to non-qualified stock options that are in-the-money, the ability to convert the gain into deferred compensation. This alternative is ordinarily of particular interest when nonqualified stock options are within a few years of expiring—and thereby generating taxable income if exercised.

• Converting supplemental retirement benefits or cash-based deferred compensation into a right to receive shares of employer stock at a future date. See Part 2(c) below.

For plan sponsors, a Stock Gain Deferral Program has several potential advantages that go well beyond the goodwill that executives may feel. A plan sponsor could, for example, impose conditions on an executive’s participation in the program. One condition could take the form of a forfeiture-for-competition rule that attaches to all or some of the executive’s deferred compensation. Other conditions could relate to transfer restrictions, holding period requirements for employer stock, and corporate or individual performance conditions.

An executive’s ability to defer taxation on stock gains could save an employer from the poor market reaction that may result from public disclosure that insiders have sold shares (often, in these cases, in order to raise the cash with which to pay applicable income taxes). Shareholders and stock analysts generally prefer arrangements that encourage executives and directors to hold their shares.

A Stock Gain Deferral Program may also enable an employer to minimize the financial expense that could arise in 2005 from future stock option grants or the vesting of past grants. Partly because FASB is proposing to base the expense on the stock option’s fair market value (as determined under a Black-Scholes, binomial, or similar model), many employers are considering alternatives that replace future or unvested stock options with other incentives that are by comparison less dilutive and more fairly valued from a benefit and expense perspective.

From a tax perspective, an employer’s accommodation of longer periods for deferral comes with a tax cost, because an employer’s deduction for deferred compensation must coincide with the executive’s recognition of income. In other words, deferral of income tax will defer the time for the employer’s tax deduction.

Suppose that an executive holds stock options to purchase 100,000 shares of employer stock for $30 per share. If the fair market value of those shares is $50, then the executive has built-up gain equal to $2,000,000 (calculated as 100,000 times $20 per share of in-the-money value). A deferred compensation program could permit the executive to surrender those stock options in exchange for deferred compensation tracked as 40,000 deferred share units. See Item 2(c) below.

This exchange reduces the executive’s downside —and upside—risk from fluctuations in the value of employer stock. For example, a 20% reduction in the value of the employer’s stock (to $40 per share) would reduce the executive’s stock option gains by 50% to $1,000,000 but would only reduce the value of the executive’s deferred share units by 20%, to $1,600,000.

For executives and directors who want greater opportunities to diversify their investment risk, an employer could permit the conversion of stock option gains into deferred compensation having an investment return that the executive selects from measures other than employer stock (e.g., a mutual fund). These programs have the potential to create trailing financial expense for employers, based on increases in the deferred compensation liability. Employers should also be sensitive to how stockholders will react to public disclosure of the program, because most stockholders prefer to have executives heavily invested in employer stock.

If an executive converts stock option gains into deferred share units, the employer will generally incur a financial expense equal to the deferred gain. Current FASB rules require this, and provide for amortization of the expense over any expected vesting period. An employer may, however, structure this type of program to avoid any expense. It takes careful navigation of applicable tax and accounting rules. The key is having the executive pay the exercise price by surrendering shares that the executive has owned for at least six months.

The term "deferred share units" refers to a liability that an employer tracks as a future obligation to deliver shares of its common stock. In contrast to deferred compensation that may be settled in cash, no financial expense results from increases in the value of shares that are deliverable in the future. This is not expected to change if FASB implements its proposed changes to the accounting rules applicable to stock options.

Employers may use deferred share units as an alternative form of deferred compensation. They may also provide executives and directors with an election to convert cash-based deferred compensation or supplemental retirement benefits into deferred share units. This type of conversion usually appeals to shareholders and stock analysts because the conversion—

• is possible without triggering current financial expense for the employer,

• will avoid future expense that would have occurred for cash-based deferrals, and

• will align executive and director interests more closely with those of shareholders (because cash-based benefits convert to stock-based benefits).

Under current U.S. tax laws, the same distribution alternatives that are available for cash-based deferred compensation are generally available for the shares that settle deferred share units. Ordinary income occurs at the time an executive or director receives unrestricted shares, with the income equaling the fair market value of the shares received.

Our Washington insiders report that the political climate nationwide is ripe for eliminating special tax deferral strategies for executives and directors. Included among these are Stock Gain Deferral Programs. Also targeted for elimination are the following design features that presently appear in many Plans:

• "haircut" provisions that provide immediate withdrawal rights for Plan benefits (through forfeiture of a portion, e.g., 10 percent, of the withdrawn benefits),

• the immediate distribution of benefits upon a change in control,

• Plan investment alternatives that differ from those generally available under the employer’s most flexible 401(k) or similar plan, and

• (in a 2003 proposal but not the current ones) the use of a rabbi trust to enhance the likelihood that executives and directors will collect their nonqualified plan benefits.

Legislation aimed at deferred compensation has another appeal that those in Washington may find irresistible—the legislation would raise significant revenue, estimated last year to be above $800 million.

Because Congress recessed for the summer without appointing a joint committee to move the ETI legislation, tax legislation will not occur before September at the earliest. The prospect of legislation passing before November will dim with each passing day after Congress returns. Nevertheless, there is no denying that radical new limitations on deferred compensation appear inevitable.

For those inclined to act, there may be sound business reasons for plan amendments and participant elections that take effect in 2004—and may thereby qualify for any grandfathering treatment that accompanies the tax legislation when it passes.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.