Articles

Is your company's deferred compensation plan at risk?

Katherine E. David

San Antonio Business Journal (July 13, 2007)

Does your company have deferred compensation plans? Do your employees receive stock options or bonuses? If so, changes to the Internal Revenue Code and Regulations may change the way you compensate your employees.

In the early part of this decade, corporate scandals seemed to plague the United States. In response, Congress passed a number of legislative measures (including the Sarbanes-Oxley Act of 2002) in an attempt to improve accountability and transparency in corporate America. The American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Like other legislation of that time period, Section 409A was designed to promote corporate accountability and transparency. The statute focuses on deferred compensation plans whereby an employee receives compensation in one year for services rendered in a prior year.

Starting Jan. 1, 2008, if a deferred compensation plan subject to Section 409A fails to comply with the applicable rules, employees who deferred compensation under the plan face severe tax consequences. If a plan is not compliant, all vested compensation deferred under the plan for the taxable year – and all preceding taxable years – is immediately included in the employee’s gross income. The tax imposed is subject to interest, and the entire amount deferred is subject to a 20 percent penalty.

Thus, if your employees receive deferred compensation through plans subject to Section 409A and your plan is not compliant, your employees could face penalties of more than 20 percent on taxable income not only for this year, but for any year from 2004 (when the legislation was passed) to the present day.

In addition, the statute casts a wide net. Section 409A can apply to any employer, of any size, including privately held companies and partnerships.

Employers and employees need to be aware of this change in our tax code and revise deferred compensation plans accordingly. All plans must be in compliance with the new 409A rules by Dec. 31, 2007.

Getting ready

So, what is an employer to do to prepare?

Take an inventory of all of your deferred compensation agreements. This could include employment agreements, severance agreements, offer letters, consulting agreements, bonuses, stock options, reimbursement arrangements and any compensation agreements with employees, consultants, directors and others.

Determine whether your deferred compensation agreements are subject to Section 409A. Many common deferred compensation plans fall under Section 409A, and if yours does, you must make sure that your plan complies with the new rules. Conversely, your plans may be excluded or exempt, and it is important to know whether you need to make changes or not.

Make the necessary changes. If a deferred compensation arrangement is subject to Section 409A, you must have your plan in compliance prior to Dec. 31, 2007, and there are a multitude of compliance issues you must consider.

For example, one of the most significant changes brought by 409A involves the timing of a deferred payment. If an employee wants to defer compensation for one taxable year, he or she must elect to do so by Dec. 31 of the prior taxable year. So if an employee wants to defer compensation for 2008 into a future pay period, he must elect to do so prior to the end of 2007.

Making changes

These changes are best handled by your attorney, who can assist you in ensuring your plan complies. Another option may be to revise your deferred compensation plans so that your plan falls outside the scope of Section 409A.

If revisions are required, you should allow time for all the necessary corporate actions such as notice periods and approvals from your shareholders or board of directors. Because this can be a lengthy process, it is imperative to begin the process now. It is important to communicate with your affected employees so that they understand the changes in any deferred compensation agreement and so that they know your company is doing its part to protect them from tax penalties.

Finally, be sure that all of your plans are compliant, in writing, and approved pursuant to your corporate standards on or before Dec. 31, 2007.

The implications of 409A are significant, and to be fully prepared and protected from the possible penalties of noncompliance, you need to begin the process today.

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Katy E. David is an Associate in the Tax practice of Oppenheimer, Blend, Harrison and Tate, Inc. She has been recognized as a Texas Rising Star and one of San Antonio's Best Lawyers. Katy can be reached at 210.224.2000 or kdavid@obht.com

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