Tax and Employee Benefits Alert
Companies that maintain deferred compensation arrangements are bracing for the upcoming release of IRS guidance that will dictate the necessary amendments for these arrangements to comply with recent changes in federal tax law.
The release of this guidance is likely to unleash a flurry of activity, as companies will need to review and revise their nonqualified deferred compensation arrangements to comply with these changes. Although no formal release date has been set, informal comments from Government personnel suggest that its release may be imminent perhaps within the next few weeks.
The anticipated IRS guidance is in response to last year’s changes in federal tax law (namely, the enactment of section 409A) that impose a significant penalty on any executive or employee participating in a deferred compensation arrangement that does not meet the new tax requirements.
Given the amount of work that will be required once the guidance is released, companies should make sure they have a game plan in place for reviewing and revising all of their affected deferred compensation arrangements. In particular, in view of the stakes involved, companies will want to have their tax departments involved at the start of this process (rather than merely having the tax department review the final product) since the plan amendments could have a direct impact on the tax consequences to executives and employees participating in these arrangements.
Specifically, nonqualified deferred compensation arrangements will need to be redesigned to reflect the new law’s requirements concerning deferral elections, distributions, and plan funding. Generally, only amounts deferred after 2004 are subject to these requirements. Deferrals which vested prior to 2005 (often referred to as “grandfathered deferrals”) are generally not subject to the new law.
The IRS views section 409A as covering a wide variety of arrangements including not only the more typical nonqualified salary deferral plans and supplemental executive retirement plans (SERPs) but also potentially executive employment agreements, severance arrangements, nonqualified stock options, certain stock appreciation rights, executive reimbursement plans, and other compensatory arrangements.
If a company fails to amend its deferred compensation arrangements to comply with these changes, executives and employees who participate in these arrangements may be subject to current federal income tax on any vested deferrals, plus an interest charge, plus an excise tax equal to 20% of the amount of the deferrals.
Current IRS guidance provides that companies will need to redesign their arrangements by December 31, 2005, although the forthcoming guidance may extend this deadline into 2006. Even with an extension, we anticipate that many companies will want to review and revise their plans and arrangements as soon as possible so that they can have legal documents in place and communicate the changes to their executives and employees without delay.
To address the upcoming IRS guidance, a company should consider taking the following action steps:
- Create the right in-house team to handle the job. Because the changes are tax-driven, the tax department should take a lead role in the process from the outset. Companies should also involve their payroll department so that the revised arrangements are properly administered and reported.
- Review an inventory of potentially affected arrangements. It is possible that some arrangements may not need to be revised in light of the forthcoming guidance.
- Determine how to calculate and treat grandfathered deferrals.
- Review plan design options in light of the guidance.
- Review procedures for implementing any changes, e.g., procedures for obtaining corporate governance (and, if applicable, participant) approval, for notifying participants of changes, for soliciting and processing any participant elections, and for handling the payroll consequences, etc. We intend to send out an email alert as soon as the guidance is issued. We plan to follow that up shortly with a written analysis of the guidance and also with a teleconference during which we will discuss the new rules.
For additional information, please contact any of the following lawyers:
Fred Oliphant, email@example.com, 202-626-5834
Anthony Provenzano, firstname.lastname@example.org, 202-626-1463
Gary Quintiere, email@example.com, 202-626-1491