Deferred Compensation Changes Approved by Senate; Proposals under Consideration by House

Employee Benefits Alert

Yesterday, the Senate approved a legislative package that includes dramatic changes to the tax rules governing deferred compensation. By a vote of 94-3, the Senate approved its version of the minimum wage bill (H.R. 2) containing a tax relief package for small businesses funded in part by changes to the rules governing the taxation of deferred compensation.

Impact of Proposed Legislation. These proposed changes to the tax rules applicable to deferred compensation are summarized in our prior alert of January 19, 2007 and would (1) impose arbitrary limits on the dollar amount of compensation that could be deferred by an individual without incurring severe tax consequences and (2) expand the definition of “covered employees” under section 162(m) to include former covered employees.

The proposed limits on the dollar amount of deferred compensation have the potential for imposing punitive taxes not only on deferrals by top executives but also deferrals by middle managers. We have prepared a set of examples to illustrate the broad reach of the proposed legislation (click here to download). While there is some talk that the legislation might be modified to exclude middle managers, it seems quite likely that any such modified legislation will still target top executives.

Because of the draconian nature of the taxes imposed on excess deferrals under these rules and the potential administrative problems in designing compliant plans under the legislation as proposed, the enactment of the legislation may have the effect of eliminating deferred compensation as a viable compensation option for many employers. Moreover, for publicly held employers subject to section 162(m), the inability to defer compensation for top executives will make it more likely that such compensation, to the extent it is not performance-based compensation, will not be deductible when paid out currently because of the deduction limits of that section.

While the tax policy basis for the proposed deferred compensation changes is questionable from our perspective, there appears to be significant political interest in legislation of this sort that would be touted as a means of curbing executive compensation, and we think that these proposed changes should be taken seriously by the employer community. Moreover, the fact that these changes, when coupled with the changes to section 162(m), are projected by the Joint Committee revenue estimators to raise almost $1 billion in the 2007-2016 period makes the changes very attractive to a Congress in search of revenue raisers (i.e., additional taxes) to pay for other tax relief.

Next Steps for Proposed Legislation. Because the House previously approved minimum wage legislation in January without any tax relief package, the House and Senate will now have to work out their differences with regard to the minimum wage legislation. Democrats in Congress are very anxious to see minimum wage legislation passed in the very near future as part of their new legislative agenda, and it appears that informal discussions are underway between the House and Senate leaders to determine whether a compromise version of the minimum wage legislation can be found which will satisfy the Democratic majority and the Republican minority in the Senate. While it is possible that the deferred compensation proposals might be stripped out of a compromise minimum wage bill, they may be held in reserve to pay for future tax legislation.

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