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A new look for compensation: all CEOs with deferred pay must review their plans.

The American Jobs Creation Act of 2004 included Section 409A, which changed the rules governing non-qualified deferred compensation plans. The new rules, largely spurred by the Enron debacle, take effect on Dec. 31 for individuals who participate in them. If you participate in any of these plans, you need to make some decisions to avoid stiff taxes and penalties because individuals will now be legally liable, not just their employers. Employers also will now be required to include deferred income on either a Form W2 or Form 1099, even though no tax is currently due.


Many boards of directors have long deferred the taxation of a senior executive's income by using a deferred compensation plan. (See box, page 59.) Deferred funds are not deductible to the corporation until they are paid to the executive, and not taxable to the executive until actually received.

Currently, distributions are permitted in the case of death, disability, separation from service (at a specified time or schedule), a change in control, or an unforeseen circumstance. Certain employees of publicly traded companies can't receive distributions based on separation from service until six months later. These specified or "key" employees are defined as officers receiving $130,000 or more per year (adjusted for inflation), individuals who own 1 percent of the company's equity and earn $150,000 or more per year (also adjusted for inflation), and 5 percent owners.

"Haircut provisions" or any other acceleration device cause immediate taxation. A haircut provision is defined as a percentage loss the plan participant would suffer due to an early distribution from the plan. Deferred income must remain in the plan for at least five years.

Here's what's changing. If a plan violates the rules, income tax would be due immediately plus interest at the underpayment amount and 1 percent from the date of deferral. There would also be an additional tax equal to 20 percent of the taxable compensation. If an executive holds assets held in foreign trusts or uses a "financial trigger" to obtain access to the funds, that will cause immediate taxation. A serious problem that could cause a "financial trigger" is one in which creditors gain a lien against a plan. A case in point was Enron.

More forms of compensation also are covered under the new rules. According to Joseph Field, a senior partner at Withers Bergman in New York, "in the view of my firm, nonqualified compensation arrangements now subject to Section 409A rules include salary and bonus deferral plans, supplemental executive retirement plans, stock options giving the optionee the right to purchase stock at a price below fair market value at the date of the grant, most stock appreciation right plans and restricted stock unit plans."

An example of how far Section 409A extends is the issue of accumulated sick leave. Some employers will allow employees to carry forward unused sick leave to the following calendar year. Under Section 409A, this would be considered a deferral and subject to the new rules. Other popular compensation methods, such as collateral assignment equity "split dollar" arrangements, also could be deemed to fall under the new law.

Section 409A also will authorize the Internal Revenue Service to become a lot tougher in defining what qualifies as a "substantial risk of forfeiture." Under the new rules, the plan participant must have a very real and substantial risk of forfeiting the assets within the plan based on his or her performance of future services. Without such a risk, deposits would become immediately taxable to the participant. In the past, advisers assumed that if we "punish" the participant with a 10 percent penalty ("haircut") for early withdrawal, that would be defined as a substantial risk of forfeiture. This would give the plan participant a comfortable feeling that he/she could obtain access to 90 percent of the assets upon early withdrawal.

But this is no longer allowed under Section 409A. According to Jerome Hesch, a professor at the University of Miami School of Law and Of Counsel to Greenberg Traurig, "in determining whether compensation payable to an employee who owns a significant amount of the stock of his/her employer corporation or its parent is subject to a substantial risk of forfeiture, the notice requires that there be taken into account the employee's relationship to other stock-holders and the extent of their control and possible loss of control by the corporation."

The new provision also targets the employee's relationship with officers and directors. "If 4 percent of the voting power of the stock is owned by the president and the remaining stock is so diversely held by the public that the president, in effect, controls the corporation," says Hesch, "then the possibility of the corporation enforcing a restriction on the right to deferred compensation of the president is not substantial. Therefore, such rights are not subject to a substantial risk of forfeiture for the purpose of Section 409A."

Overall, participants in these plans have until Dec. 31 to cancel a deferral of income to future years or to terminate their participation in the plan. "Not taking action this year will likely cause a plan participant to continue deferrals throughout 2006 since deferrals generally can't be terminated in midyear," says Blaine Laverick, an expert at the Principal Financial Group in Raleigh, N.C.

Certain popular executive benefit arrangements, funded with life insurance and in wide use today, may unintentionally create a deferred compensation promise that now needs to be properly documented. Failure to properly document this could cause the deferred compensation to be in violation of Section 409A. The result is that plan balances may be exposed to tax, penalties and underpayment interest.

There are several other tough new disclosure rules, explains attorney Field. "The new provisions feature a new penalty for failure to disclose reportable transactions and a new penalty for understatements arising from listed and reportable transactions," he says. There are also new disclosure requirements imposed on tax shelter advisers, new rules applicable to leasing transactions, and additional IRS powers to investigate and penalize taxpayers, promoters and advisers involved in tax shelters.

There are solutions to at least some of these new issues. Consider plan sponsors who either wish to terminate the plan or freeze the existing plan. If a plan distributes $1 million, $400,000 would be reserved for tax and $600,000 would be available to the plan participant for investment. We can have a bank lend the $400,000 to the participant at a reasonable rate of interest, so that the full $1 million can be invested. We can employ the income generated by the $400,000, which otherwise would not have been there, to pay the annual interest. We can employ the annual growth on the $400,000, which otherwise would not have been there, as well as excess income, to pay down principal.

In so doing, the best case scenario is that we have offset the effect of the tax. The worst case scenario is that we have reduced and deferred the effect of the tax. The investment account would be wrapped with a non-commissionable, institutionally priced, private placement life insurance contract. This contract, if properly drafted, would provide asset protection as well as indemnification from any income tax on the growth, cash distributions or the ultimate passing of the asset to the next generation.

Another opportunity is a Section 162 Double Bonus Plan. Employers may deduct the annual deposit, a distinct advantage over traditional deferred compensation plans. The employee invests the bonus into a cash-building life insurance contract, which will serve as a retirement vehicle providing tax-free distributions. To indemnify the employee from the tax caused by the bonus, the employer will provide a second bonus.

Under Section 162, we may also design a Leveraged Bonus Plan. With this strategy, the employer will provide a bonus, but will only have to provide an additional bonus to cover interest. This represents a savings over the Double Bonus Plan. Here, too, the entire deposit would be tax deductible for the employer. Michael Rothstein, regional vice president of Peachtree LBP Finance Company in Norcross, Ga., says there are a number of advantages to this plan. "All company bonuses are tax deductible," he says. "There are no ongoing accounting, recordkeeping or administrative issues. Executives receive a supplemental benefit that is not subject to the general creditors of the employer. The executive, or his/her trust, owns the cash values from day one."

Moreover, there is an opportunity to earn tax-deferred growth on the life insurance policy cash values. "The plan can be structured with a nonrecourse loan delivered with no personal guarantee," adds Rothstein. "The employer does not have to accrue a liability as is the case with traditional deferred compensation."

Clearly, the issues are extremely complex. Section 409A demands a precise review by both taxpayers and their advisers. The price for not engaging in such a review soon could be severe tax penalties.

Mark Silberfarb is CEO of the Global Financial Institute in Irvine, Calif., and New York.

RELATED ARTICLE: Qualified vs. Nonqualified

Qualified Pension Plan

* Tax-deductible deposit

* Tax-deferred growth

* Taxable distributions

Nonqualified Plan

* Nontax-deductible deposit

* Earnings taxable to the employing corporation

* Income tax payable when funds are actually distributed; deduction for companies at that time

Source: Global Financial Institute
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Title Annotation:NET WORTH; chief executive officers
Author:Silberfarb, Mark P.
Publication:Chief Executive (U.S.)
Geographic Code:1USA
Date:Dec 1, 2005
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