United States: Special Report: Executive Compensation - Radical New Rules Adopted And Increased IRS Scrutiny Announced

This article focuses on two recent changes in the executive compensation area, one legislative and one administrative, which will effect most employers and executives.

The press coverage of the American Jobs Creation Act, which was signed into law by President Bush on October 22, 2004, has for the most part focused on the "corporate give backs" included in the legislation. However, the new law takes some things away as well – especially in the executive compensation area.

Specifically, the new law makes radical changes in the rules which have governed executive compensation arrangements for more than thirty years. As a result of the new law, employers will need to review all of their current executive compensation arrangements and to change how such arrangements are structured in the future.

Almost simultaneously, the Internal Revenue Service announced that it was wrapping up its comprehensive executive compensation audit initiative and that, as a result of this initiative, it has created a new executive compensation audit program which will now be part of all routine audits of large and midsize employers. The new audit program focuses on seven specific executive compensation issues.

Key Aspects of the New Law. The substantive rules governing executive compensation arrangements had not changed much in the past thirty years. This was due in part to legislation passed by Congress in 1978 which significantly limited the right of the Internal Revenue Service to issue guidance in the executive compensation area. That has all changed with the new law’s addition of new section 409A to the Internal Revenue Code of 1986.

Section 409A is noteworthy in a number of respects. First, for the first time, there are now specific, objective requirements which all executive compensation arrangements which have the effect of deferring compensation must satisfy in order for the deferral to be respected for tax purposes. Covered arrangements must comply with the new requirements both in form and in operation.

In order to comply with these new requirements, (i) deferral elections may have to be made earlier and will have to specify both the timing and manner of payment, (ii) deferral extensions will be severely restricted, (iii) acceleration of payment must be prohibited, (iv) the events which may trigger a payment will have to be limited to the specific events listed in Section 409A, and (v) certain asset protection strategies will have to be avoided.

Many existing arrangements will not meet these new requirements and compliance with the new requirements may make traditional elective deferred compensation arrangements less attractive to executives. Popular arrangements which will not longer work under Section 409A include (i) "hair cut" provisions or any other techniques designed to allow the participant to accelerate payment of the deferred amounts, (ii) certain funding arrangements which are designed to protect the amounts deferred from the claims of the employer’s creditors, and (iii) deferral extensions (other than extensions which meet express new limitations imposed by Section 409A).

Second, Section 409A applies to a much broader set of arrangements than the arrangements which most people think of as deferred compensation arrangements. Section 409A applies to most arrangements which have the effect of deferring the compensation other than (i) qualified retirement programs, (ii) certain specified fringe benefit programs, such as vacation pay plans, (iii) options on employer stock which are not "in the money when granted", (iv) Section 423 stock plans, and (v) incentive compensation and bonus plans that do not delay payout more than 2-1/2 months after the end of the performance period. In other words, Section 409A applies not only to traditional elective deferred compensation arrangements, but also non-elective arrangements, SERPS and other excess benefit plans, 457(f) plans, stock appreciation rights plans, phantom stock plans, and many other equity-based compensation arrangements, split dollar life insurance arrangements, and severance pay arrangements. What is less clear is how Section 409A will apply to such arrangements.

Third, Section 409A imposes significant sanctions on executives whose compensation arrangements violate its requirements. These sanctions include a 20% penalty tax 20%, statutory interest from the date of the original deferral, and acceleration of all deferrals, not just the problem deferral.

Fourth, Section 409A applies both to employees and independent contractors.

Section 409A is effective January 1, 2005 and may apply to all amounts which are not earned and vested prior to that date. As result, Section 409A may apply to amounts deferred prior to January 1, 2005 if the amounts are not vested on that date. Pre-2005 deferrals may also be subject to the new act when the arrangement under which the deferral was made is "materially modified" after October 3, 2004.

• It is imperative that employers identify all compensation arrangements which they currently maintain and determine whether or not the arrangement may be subject to Section 409A. This should be done as soon as possible.

• If an employer has an arrangement which may be subject to the new act, but some rights under the arrangement are currently earned and vested rights and, therefore, covered under the grandfather provisions of Section 409A, employers will need to exercise great care not to do anything which could be considered a material modification of the grandfathered benefits.

• Guidance is expected in the near future from the Internal Revenue Service about several aspects of Section 409A, particularly with respect to the impact of the new law on 2004 and 2005 deferrals and how the new law applies to certain types of arrangements. Employers will need to carefully monitor the issuance of such guidance and its impact on their existing arrangements.

• Ultimately, employers will need to amend all of their existing arrangements which fall under Section 409A to incorporate the requirements of the new law.

In the spring of 2003, the Internal Revenue Service commenced an executive compensation audit initiative. The initiative involved twenty-three special comprehensive audits of selected larger employers to determine if there were areas of material non-compliance on which Internal Revenue Service examiners should be told to focus their efforts. In early November, the Internal Revenue Service announced that the initiative was wrapping up, although most of the special audits are still open.

The result of the audit initiative is a new "package audit" program which identifies seven key executive compensation related issues and provides specific guidance as to how to audit those issues. The issues identified were ones where a material lack of compliance was identified during the audit initiative and it is the expectation of the Internal Revenue Service that the "package audit" will become part of all routine audits of large and mid-sized employers.

The issues targeted for examination are:

• Non-Qualified Deferred Compensation. The audit focus will be on the matching of the employer deduction and the inclusion of income by the employee under non-qualified deferred compensation arrangements. The Internal Revenue Service believes that a large number of employers are taking deductions earlier than allowed by law.

• Stock-Based Compensation. The focus will be on whether or not various stock option, stock appreciation rights, and other equity compensation arrangements are being administered in accordance with their terms and applicable law.

• Section 162(m). The focus will be on compliance with the performance based compensation exception from Section 162(m).

• Fringe Benefits. The focus is on benefits provided to executives, including the use of company aircraft, spousal travel, and executive loans.

• Stock Option Transfers. The Internal Revenue Service has attempted to shut down tax shelters based on the transfer of stock options to a family limited partnership, but believes such transfers are still being entered into.

• Split Dollar Life Insurance. Recent guidance from the Internal Revenue Service has made these types of arrangements less attractive, but the Internal Revenue Service is concerned that existing arrangements are not in compliance with the law.

• Section 280G. The focus of future audits will be on compliance with the provisions of 280G.

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.