August 2007 - Issue XX, Volume 8

The Impending “Sea Change” in Deferred Compensation
By Bruce A. Campbell and Robert G Chadwick, Jr.
 

ARE YOU READY FOR JANUARY 1, 2008?  
 
As part of the continuing fallout from Enron and other corporate scandals, the IRS recently adopted final regulations regarding Section 409A of the Internal Revenue Code, which governs the taxation of non-qualified deferred compensation for “service providers.” An IRS official has said that Section 409A marks a “sea change” in deferred compensation; the breadth of the new regulations shows this statement was an understatement.
 
Whose Compensation is Affected?   Section 409A governs compensation to “service providers” who are broadly defined as individuals and entities that provide services. Although bona fide independent contractors are excluded by the statute, the following are among those included:
 
What is a Deferred Compensation Plan? A plan provides for the deferral of compensation, if, under its terms and relevant circumstances, a service provider has a legally binding right during a tax year to compensation that, pursuant to its terms, is or may be payable in a later tax year. Compensation may be in any form having value, such as equity interests.  
 
What Arrangements Are affected? Some obvious compensation arrangements, amongst others, that are impacted by the new regulations are:
 
Less obvious arrangements also potentially impacted by Section 409A, however, are:
 
What has Changed? Section 409A generally provides that, unless certain requirements are met, all amounts deferred under a deferred compensation plan which are not subject to a substantial risk of forfeiture must be included in a recipient’s current gross income for tax purposes.  
 
What are the Stakes for Recipients of Deferred Compensation? The tax consequences of a deferred compensation plan which does not comply with Section 409A are borne entirely by the recipient. The recipient can be subjected to income taxes before compensation is received plus interest and a 20% penalty. For highly compensated individuals, this financial toll can be substantial. 
 
What are the Stakes for Providers of Deferred Compensation? Disgruntled recipients forced to pay harsh taxes and penalties under a flawed deferred compensation plan will likely turn to plan providers for answers and money. Suits alleging a variety of claims are unavoidable. Companies will not be the only defendants in such suits. Individuals who design, recommend, approve or administer flawed plans will also likely be sued.
 
What is Required Under the New Regulations?   To avoid taxation and penalties, deferred compensation plans must condition future payment upon fixed dates or events. Generally, acceleration of payment is impermissible.   The only permitted payment dates and events are:
 
Are There Additional Requirements for Public Companies?Yes. For instance, severance pay to “key employees” cannot commence until six months and a day after separation.
 
Are There Exemptions? Yes. Although too numerous to list here, there are exemptions to the Section 409A requirements. Certain arrangements, such as qualified retirement plans, welfare plans and collective bargaining agreements are completely exempted. Other arrangements, including those which provide severance pay, are exempt only if they contain certain provisions.    
 
What about Older Deferred Compensation Plans? Deferred compensation which was vested or deferred before December 31, 2004, is not affected by Section 409A as long as the plan under which the compensation was granted was not materially modified after October 3, 2004. 
 
Can Existing Deferred Compensation Plans Be Fixed or Amended? Many existing plans can be amended to bring them in compliance with Section 409A. The catch is that these amendments must be completed by December 31, 2007. On January 1, 2008, taxes and penalties will ensue for non-conforming plans.
 
What is Recommended For Providers of Deferred Compensation Plans?    Act now. Arrangements with service providers should be reviewed with legal counsel to determine whether they are subject to Section 409A. If so, an action plan should be devised and implemented, with the assistance of legal counsel, to ensure timely compliance.
 
WHAT LOOMS BEYOND JANUARY 1, 2008?
 
The terrain for deferred compensation will become daunting on January 1, 2008, when the final regulations adopted by the IRS become effective. The tax consequences of noncompliant plans are harsh and are not limited to the high-level executives who were Congress’ originally intended target. 
 
How Will Unsuspecting Recipients be Affected? The tax burden and penalties of Section 409A are not limited to officers and directors who may have been complicit in the negotiation or design of an ill-conceived deferred compensation plan. All recipients under a noncompliant plan can be subjected to income taxes before compensation is received plus interest and a 20% penalty. The regulations do not spare persons who may have little or no choice about the method of their compensation or little knowledge about the tax consequences of an election of deferred compensation.
 
For some recipients, a tax bill from the IRS before receipt of the deferred income can mean financial insolvency. Homesteads are not exempt from IRS foreclosure. Claims by disgruntled recipients who are caught off guard by the tax burden and penalty are therefore almost a certainty. 
 
What Claims Against Employers Will Likely be Brought by Disgruntled Recipients? Deferred compensation arrangements have already been the subject of claims under a variety of legal theories. These theories can be tapped to address the taxes and penalties of Section 409A.
 
Breach of Contract: Where participation in a deferred compensation plan is provided as part of a contract with the service provider, the failure to pay the promised compensation can be the basis of a claim for breach of contract. A tax burden which diminishes or erases (at least in the short term) promised compensation may also be tantamount to a contractual breach.
 
Pay Day Laws. Full and timely payment of employee compensation is required by many state statutes. Saddling employees with an early and exorbitant tax burden may violate such statutes. 
 
ERISA: For deferred compensation plans which are also ERISA plans (e.g., severance pay plans, 401(k) wrap plans, etc.), claims may be brought under the terms of the plan itself or under statutory provisions establishing fiduciary duties for plan sponsors, administrators or trustees. A claim based upon a disabling tax burden could be pursued in a similar manner.
 
State Tort Theories: Among the state tort theories which may be asserted by a deferred compensation claimant, depending upon the particular state, are negligence, breach of fiduciary duty, breach of covenant of good faith and fair dealing, fraud, and possibly a variety of statutory claims that could vary from state to state. Some of these tort theories may allow for punitive damages.  
 
Is a Grossed-Up-For-Tax Payment an Alternative to Litigation? Some commentators have suggested that potential litigation can be avoided if the company reimburses the tax bills of recipients of deferred compensation. Since a tax reimbursement is itself taxable income, the amount which must ultimately be paid by a company is actually substantially more than the tax bill incurred. A grossed-up-for-tax payment is permitted by Section 409A, but still would need to be paid earlier than intended under a deferred compensation plan to avoid (1) a lawsuit, and (2) treatment as yet another deferred compensation plan which creates only greater damage and potential liability.
 
Will Third-Party Claims Be Far Behind? Even companies who elect to provide a disgruntled recipient with a grossed-up-for-tax payment rather than face the prospect of a costly lawsuit will likely turn for answers and money to third parties who were involved in the design or negotiation of a flawed deferred compensation plan. Possible third-party claims include professional negligence, contribution and indemnity, breach of contract and breach of fiduciary duty, among others.   
 
 
Circular 230 Notice. The following disclaimer is included to comply with and in response to U.S. Treasury Department Circular 230 Regulations.
 
ANY STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN BY THE WRITER TO BE USED, AND NOTHING CONTAINED HEREIN CAN BE USED BY YOU OR ANY OTHER PERSON, FOR THE PURPOSE OF (1) AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW, OR (2) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TAX-RELATED TRANSACTION OR MATTER ADDRESSED HEREIN.
 
Who Should be Concerned About Possible Claims? Concern about possible claims by disgruntled recipients should not be limited to the companies who provide or administer noncompliant, deferred compensation plans.   Many of the legal theories for third-party claims should be of concern to others as well: 
 
Insurers: Companies who provide EPLI, ERISA fiduciary, D&O and E&O liability lines should begin to manage this risk arising out of claims on deferred compensation plans.
 
Trustees: Trustees of ERISA plans which provide deferred compensation are subject to being sued for breach of fiduciary duties.
 
Directors and Officers: Corporate directors and officers who recommend and approve deferred compensation plans may also have liability exposure.
 
Legal and Accounting Professionals: Attorneys, accountants and tax advisors who provide advice regarding deferred compensation plans may be vulnerable to third-party actions alleging professional malpractice.
 
Employees and Consultants: Employees and consultants who recommend, design and administer flawed, deferred compensation plans should be concerned about personal liability.
 
What Else Looms Beyond January 1, 2008? The unknown. Although adopted with the intent to give meaning and enforcement authority to Section 409A, the IRS regulations are still vulnerable to interpretation. How the IRS and tax courts will construe the provisions is unknown.    While it is anticipated that claims will be brought by disgruntled recipients, the full array of claims which will be brought by creative plaintiffs’ attorneys or desperate claimants is unknown.       
 
A “Sea Change”? The IRS official who called Section 409A a “sea change” in deferred compensation understated its likely effect. Instead, the ripple effect of the law will likely extend far and wide.