As featured in the April 1, 2005 issue of Portland Business Journal in their special section Law Today, titled "Specialties and Practice Areas"

Creative Executive Compensation Under IRS Scrutiny

By Thomas B. Eriksen

This past October, Congress passed the American Jobs Creation Act of 2004. Buried in the lengthy legislation was a new provision of the Internal Revenue Code. Little noticed at the time, it appears that the new tax law will have a significant impact on the ability of employers to creatively structure executive compensation packages for top employees.

In December, the IRS issued its first round of guidance interpreting the new law. Unfortunately, this did little to clarify many of the questions surrounding the Act. Additional IRS guidance is anticipated later this year.

The impetus for the new tax law was perceived abuses of existing deferred compensation arrangements of publicly-held companies. Unfortunately, as is often the case with remedial legislation, the correction has far reaching and unintended consequences impacting common deferred compensation techniques and tools used to attract and retain quality management personnel. Caught up in the new tax law is every type of nonqualified, deferred compensation plan, such as Supplemental Executive Retirement Plans (SERPs) (including 457(f) Plans), severance pay plans, discounted non-qualified stock options, phantom stock plans and stock appreciation rights plans. The new law does not apply to qualified plans such as 401(k) plans, profit sharing plans, and the like.

The new law has a unique grandfathering provision. Only deferrals made prior to January 1, 2005, are grandfathered under the old rules. The old plans themselves are not grandfathered. Thus contributions and deferrals to old plans after December 31, 2004, must comply with the new law. This may cause many employees to decide to freeze existing plans in order to avoid having the new law apply to older plans and contributions.

The new tax law requires an additional level of complexity for these arrangements. Now, a plan must contain specific provisions with respect to the timing and form of deferral elections and limitations on the acceleration of distribution. These new requirements significantly limit flexibility in designing plans to meet the needs of employers and employees.

The new tax law generally took effect January 1, 2005. However, the IRS has generously permitted employers until December 31, 2005, to bring existing plans into compliance with the new law. One condition the IRS has placed on this grace period is that during 2005, plans must be operated in accordance with the new law, even if the plan document is not consistent with the new law. Accordingly, employers must be aware of the intricacies of the new law even if they have not yet determined how best to update their executive compensation plans to bring them into compliance with the new tax law.

Failure to bring the plan into compliance or to follow the new tax law during 2005 carries significant financial consequences to the executive employees participating in the plans. In addition to the immediate recognition of all deferred compensation as taxable income, an additional 20-percent penalty is imposed. That is to say, the penalty is 20 percent of the deferred compensation benefit, not 20 percent of the early tax bill. In a worst case scenario, the participant may face a total bill from the IRS exceeding 50 percent of the plan benefit. It is even possible to receive such a bill from the IRS prior to the time the employee receives payment of the plan benefit.

It is important that all employers with creative compensation arrangements for executive employees take prompt action to bring the plans into compliance during 2005. These steps should include:

• Taking an inventory of all plans and individual arrangements affected by the new legislation.
• Reviewing the plans to determine compliance with the new legislation.
• Determining changes necessary to bring plans into compliance.
• Deciding whether to freeze or terminate existing plans with respect to old deferrals.
• Amending plans to comply with the new law for future deferrals.
• Communicating plan changes to all employees affected by the change.

The new legal landscape for executive compensation created by the American Jobs Creation Act of 2004 does not necessarily mean the end of creative incentive compensation plans for key employees. In the short term, it will mean a degree of uncertainty as professional advisors interpret the new law and the guidance issued by the IRS.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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