Proposed Legislation Makes Further Significant Changes To Taxation Of Deferred Compensation

Employee Benefits Alert
01.19.07

The Senate Committee on Finance has approved proposed legislation which if enacted into law would (1) impose arbitrary annual limits on the amount of deferrals that could be made under nonqualified deferred compensation plans and (2) expand the definition of “covered employee” for section 162(m) purposes to include former employees who previously were covered employees. As described below, these proposals have the potential for serious tax consequences to both employees and employers.

Deferred Compensation Changes

Under present law, section 409A does not limit the amount that may be deferred under a nonqualified deferred compensation plan. Under the proposal, however, the annual aggregate amount of deferral would be capped at $1 million, or if less, the amount of the individual’s average annual compensation for services performed for the employer for the preceding 5-year period. If the amount deferred exceeds the applicable limitation, the employee would apparently be required to include all amounts deferred under the deferred compensation plan (and any other aggregated arrangement) as current taxable income, plus pay interest if the tax is paid after the year that the compensation was first deferred or became vested, and also pay a 20-percent additional tax. Complicating matters even further, the proposal would treat earnings attributable to deferred compensation after 2006 as additional deferred compensation subject to the annual deferral cap. The proposal is effective for amounts deferred in taxable years beginning after December 31, 2006.

A hint of the significant tax consequences that would be generated by this proposal is illustrated by the following example: Assume a public company’s CEO earns a salary of $4 million for 2007, of which $3 million is deferred until a future year in accordance with the provisions of section 409A in its present form. If the new proposal is enacted and the CEO’s deferral election is not modified, the $3 million deferral would not satisfy the requirements of section 409A. Therefore, in addition to the regular tax and perhaps interest, the CEO would be required to pay a 20-percent additional tax on not just the excess $2 million, but on the entire $3 million.

Assume however, that the CEO modifies his deferral election and defers only $1 million, thereby agreeing to accept the remaining $3 million in current salary in 2007. Although the
modified deferral would comply with the new annual cap under section 409A, if the CEO’s salary does not qualify as “performance-based compensation,” it is likely that $2 million of the $3 million salary paid in 2007 would not be deductible by the company because it exceeds the $1 million salary cap imposed by section 162(m). This example takes on even greater complexity when one factors in the potential impact of the current 409A aggregation rules and the proposal’s treatment of earnings as additional deferrals.

Changes to Section 162(m)

Under present law, the $1 million limitation on compensation deductions imposed by section 162(m) applies to compensation paid by a public company to one of its covered employees. Covered employees are the CEO and the four other most highly compensated officers of the company as reported in the company’s proxy statement. The proposal would modify the definition of covered employees to include any individual who previously was a covered employee for any preceding taxable year beginning after December 31, 2006. Under present law, if the CEO, a covered employee in 2007, retired in November 2008, and received deferred compensation in 2010, the deferred compensation when paid would not be subject to the $1 million deduction limitation under section 162(m) because the former CEO would not be a covered employee in 2010. If the proposal were enacted, the deferred compensation paid to the former CEO in 2010 would be subject to the $1 million deduction limitation in that year because the CEO was a covered employee in a prior taxable year after 2006.

Prospects for Proposed Legislation

These new restrictions on executive compensation were approved by the Senate Finance Committee as part of the Small Business and Work Opportunity Act of 2007. The legislation is expected to be added as an amendment to House-passed legislation to increase the minimum wage. The timing of the legislation is unclear, although it could come to the Senate floor as early as the week of January 22nd. While we anticipate that there will be efforts to have these new restrictions removed from the legislation, we believe that it will be equally important to undertake efforts to provide a complete policy and technical analysis to members and staff. Such analysis will be essential not only with respect to this legislation but also with respect to future legislation as Congress continues to examine and express concern regarding executive compensation issues. We believe that our government affairs group, in combination with our employee benefits group, is well-positioned to provide this type of analysis to interested organizations and taxpayers affected by these new restrictions.

For further information, please contact any of the following lawyers:

Fred Oliphant, foliphant@milchev.com, 202-626-5834

Anthony Provenzano, aprovenzano@milchev.com, 202-626-1463

Gary Quintiere, gquintiere@milchev.com, 202-626-1491

Lee Spence, lspence@milchev.com, 202-626-5965

Adrian Morchower

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