United States: Legislation Cuts Executive Pay Perks

Nonqualified deferred compensation plans have long been a staple for senior management and officers of both for-profit and tax exempt organizations. They are typically used to supplement the retirement income of their participants due to limitations imposed on the contributions available under qualified retirement plans, such as 401(k) plans.

The new American Jobs Creation Act of 2004 is part of a larger package aimed at curtailing abuses that occurred at Enron and other companies in recent years. It was well documented that many of those executives were permitted to withdraw their deferred compensation as their employers were sliding into bankruptcy. That will soon be prohibited.

In general, nonqualified deferred compensation plans offer a variety of tax savings to their participants. Participants may delay the receipt of their compensation or bonuses for specific periods of time, typically until retirement or termination of employment, while their deferred compensation grows on a tax-deferred basis as income taxes are not collected until the distributions are made. Under the new legislation, deferrals of benefits will still be possible but under much more restrictive rules.

Failure to comply with the new rules will have onerous consequences for the executive; there are no sanctions imposed on the employer. First, noncompliance means inclusion of income of all deferred amounts regardless of whether a distribution is then permitted under the terms of the plan. Therefore, there may not be a source of cash available to the executive from which to pay the taxes. Second, the executive will pay interest at the underpayment rate plus one percentage point calculated from the time when the income was first deferred. Finally, the amount required to be included in income is also subject to a 20 percent additional tax. These sanctions only apply with respect to the participants for whom the requirements of the new rules are not met. They have no effect on other participants.

The new law covers any plan or arrangement providing for the deferral of compensation other than a qualified retirement plan such as a pension or 401(k), 457(b) or 403(b) plan. Although bona fide vacation, sick leave, and paid time off benefits have the characteristics of deferred compensation, they are specifically excluded from the reach of the new law. Similarly, stock option plans are not subject to the new law, provided the exercise price is at least equal to the value of the underlying stock at the time the option is granted. Similarly, the rules are equally applicable to independent contractors and employees, and a plan or arrangement may cover many individuals or just one person.

The scope of the new legislation as it applies to nonqualified arrangements sponsored by tax exempt organizations (so-called .457(f) plans.) is somewhat unclear. Although regulatory guidance is anticipated in the near future, it appears that participants in these plans will not be subject to the new legislation, so long as plan benefits remain subject to a substantial risk of forfeiture.

Under the new law, a plan permitting voluntary deferrals of compensation earned during a taxable year must require the participant to decide how much to defer, not later than the end of the preceding taxable year. An exception is made, however, for the participant’s initial year of eligibility, provided the deferral election is made within 30 days following the date of initial eligibility. Many existing deferred compensation plans authorize participants to make their deferral elections during the same year, provided the election is made prior to performing the services. The new law eliminates that practice.

The flexibility now found in many plans which delays the timing or form of distributions is severely curbed under the new law. A subsequent election to delay the timing or modify the form of distribution will be permitted only if (i) that election cannot be effective for at least 12 months after the date on which the election is made; (ii) except for distributions payable upon death, disability, or unforeseeable emergency, the new deferral period must be extended for at least five years from the date the distribution would otherwise have been paid; and (iii) the election must be made at least 12 months prior to the date of the first scheduled payment.

Distributions may only be payable upon the occurrence of certain specified events. Although separation from service is such an event, executives of publicly traded companies may not receive their distributions until at least six months following their termination.

Distributions attributable to disability are also permitted. However, the definition of disability is narrow and is generally limited to conditions expected to last at least 12 months or to result in death. Distributions are also permitted upon death, an unforeseeable emergency, upon a specified time, or pursuant to a fixed schedule. Amounts payable upon a specified event, i.e., when the participant’s child begins college, are not permitted. Finally, distributions may be made upon a change in ownership or effective control of the organization or a change in ownership of a substantial portion of the assets of the organization.

Benefits may not be accelerated. However, the rule against acceleration is not violated merely because a plan provides a choice between cash and taxable property if the timing and amount of includable income are equal. Plans that allow a choice between a lump sum payment and an annuity providing installment payments are also permitted. In a significant departure from existing law, a new provision prohibits assets from being restricted to the payment of deferred compensation in the event of a change in the employer’s financial condition, even if the assets remain available to satisfy the claims of general creditors. For example, income would be triggered if assets were transferred to a rabbi trust upon a deterioration in the financial health of the employer.

The new law offers little flexibility to those participating in nonqualified deferred compensation arrangements. The potential for income recognition, without receiving any cash, will make these arrangements much less attractive in the future. Most importantly, those already benefiting under deferred compensation plans should review their arrangements to determine whether they might, inadvertently, trigger these new rules since there are measures that can be taken to avoid those adverse consequences.

As a result of the broad scope of the legislation, it is recommended that all compensation arrangements, including those not normally viewed as providing for the deferral of compensation (e.g., employment agreements), should be reviewed for compliance with the new law.

If you have questions regarding the new legislation, please contact Robert Goldstein in our San Diego/Del Mar office, Mike Woolever in our Chicago office, Terri Wagner Cammarano in our Los Angeles office, Chris Berry in our Madison office, Greg Renz, Lloyd Dickinson, Harvey Kurtz, or Leigh Riley in our Milwaukee office, Sam Hoffman in our San Diego office, or the member of the firm who normally handles your legal matters.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.