Compliance Extended For New IRS Rule

November 9, 2007
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GRAND RAPIDS — Bowing to pressure from corporate tax attorneys, the U.S. Department of Treasury and the Internal Revenue Service have extended the deadline for documentary compliance with new rules governing deferred compensation. Corporate America now has until Dec. 31, 2008, to plan for the change.

Section 409A of the Internal Revenue Code was issued in April in response to the devastation Enron and WorldCom executives left behind when they tapped their deferred compensation plans early and bailed out as their companies were imploding.

Section 409A will put new restrictions on a wide variety of nonqualified deferred compensation plans and arrangements in which an employee elects to defer a certain amount of his current salary and bonus compensation to a future tax year. The statute sets tougher guidelines on when and how the money is set aside and when it can be cashed out, explained Attorney Andrew Stumpff, a private practitioner and a lecturer at the University of Michigan Law School. The rules apply to bonuses, severance packages, stock options and employment agreements.

Excluded are certain qualified retirement plans, vacation leave, sick leave, disability pay and death penalty plans.

A coalition of 92 law firms petitioned the IRS for a one-year reprieve on Sec. 409A because they believed the length and complexity of the final regulations would be too much for most companies to handle within the limited time period, Stumpff said. The law was written broadly and interpreted even more expansively by the IRS, creating some uncertainty as to how to apply the new rules to compensation practices, he said.

Stumpff said the impending law seems to have flown under the radar of many small- to mid-sized businesses in Michigan, and many of them would now be in crisis mode if the law had been implemented at the end of this year as originally intended.

"The law requires that employers — pretty much without exception — review, put into writing and, probably, amend every incentive or deferred compensation arrangement they maintain. Any new deferred compensation arrangements they enter into have to comply with this law right now. The tax penalties for not complying are severe and fall on employees."

Section 409A was actually passed in 2004 and became effective in January 2005, observed Attorney James Bruinsma, who specializes in employee benefits at Miller, Johnson, Snell & Commisky. He said the compensation plans that were probably the most targeted by 409A were the nonqualified deferred compensation plans that are typically maintained for executives of large companies.

The law was aimed at the big public companies that offer their executives huge compensation payments, but it's not restricted to any size of employer, explained Attorney Cynthia Moore, member of Dickinson Wright PLLC.

"If you have a small nonprofit with a nonqualified deferred comp for your CEO, you're affected," Moore said. "It potentially affects every single employer in this country, and they really need to pay attention to this. It's hard when the IRS keeps extending the deadline because it takes the pressure off, and you kind of put it off until next year."

There are three basic components to the law, Moore pointed out: Employees must make their elections in a timely manner and they must be documented properly; payments can only be made upon good triggering events; and deferred comp plans cannot include accelerated payment or even the potential for them.

"What the IRS has done is create all these technical rules that govern how these nonqualified deferred comp plans are going to operate, which takes away a lot of the flexibility that previously existed in these arrangements," Bruinsma remarked.    

If an employee compensation agreement doesn't satisfy new statute requirements, the employee will suffer two major consequences. First, the deferral will not work, and the employee will have to pay a 20 percent excise tax on the amount of the deferred compensation, plus an interest penalty, Stumpff explained.

"Say I've earned income in 2007 and have attempted to defer it until 2010, but I've run afoul of Section 409A," he said. "Normally, I wouldn't get taxed until 2010 when I get the pay out, but if I'm not in compliance, I will be taxed as if I get the money this year." 

Furthermore, under the new statute, no discount employee stock options may be granted: The exercise price must be at least equal to the stock's fair market value on the date granted, and an IRS-approved expert must determine the fair value, Stumpff noted.

Bruinsma said employers that have not yet done so should identify which of their employee compensation plans and agreements are subject to Section 409A requirements and then determine how those plans need to be revised to comply with 409A. Sometimes severance agreements, split-dollar life insurance agreements and long-term incentive plans, for instance, are subject to 409A and sometimes they're exempt. That's part of the challenge, he said. Because the new rules are more restrictive on distributions, employees potentially have a one-shot opportunity to change the date(s) they elect to receive compensation, noted Bruinsma.

As Moore sees it, the expertise is really going to lie with employers because they're the ones monitoring the law and best aware of it, but the hammer will fall on the employee. Though employees are the ones at risk, employers that value their employees will do what they can to help reduce those risks.      

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