Deferred Compensation: A New Framework For The Future

Friday, July 1, 2005 - 01:00
William R. Charyk

Editor: Mr.Charyk, would you tell our readers something about your career?

Charyk: I started as a pre-med student at Johns Hopkins University and soon switched to a pre-law program. My law degree is from George Washington University. During law school I went through the summer associate program at Arent Fox, and I have been here ever since. After starting out in the real estate tax law area - which I found populated with a great many more senior and experienced attorneys - I made the transition into the ERISA/employee benefits tax area, which, at the time, was relatively new. In time, I became head of the firm's ERISA tax practice.

I have also been involved in firm management. I was the Department Manager of the General Business Department for a time and then became the firm's Managing Attorney for four years, following which I returned to practice. I am now in the third year of my second term as Managing Attorney.

Editor: Can you tell us about the culture of Arent Fox?

Charyk: In light of the fact that many of our most successful partners came to us as laterals, and not through the ranks, the culture of Arent Fox has changed over time. It has always been a culture that encourages entrepreneurial activity, however. We move people up the ladder and into positions of responsibility if they show us a talent for developing our client base, assembling effective teams, and so on. Arent Fox has always supported a culture that provides opportunities.

Editor: Much of your current work involves §409A of the Internal Revenue Code, which was enacted as part of the American Jobs Creation Act of 2004 and has had a substantial impact on nonqualified deferred compensation plans. What is the origin of this statute?

Charyk: Most ERISA attorneys believe that §409A is an overreaction to Enron and the other corporate scandals. It is as if everything that occurred with respect to Enron's compensation and employee benefits programs was scrutinized with great care, and a regime of very tight controls imposed in order to avoid any repetition of untoward behavior, whether actual or only potential. In the case of Enron, people were not given sufficient information concerning the company securities held in their accounts, nor an opportunity to change out of a particular investment, in a timely manner. However, on the non-qualified deferred compensation side, the Enron programs were in many cases not unusual, yet the association with Enron seems to have instilled a presumption of abuse. While Sarbanes-Oxley looks to senior management and, most particularly, to the members of the company's governing board to assume responsibility for ethical behavior within the enterprise, the IRS has taken a somewhat different approach to perceived abuses through some outright prohibitions.

In past years the IRS lost a number of cases in the deferred compensation area. In light of the corporate scandals, the IRS thought the timing was right to promote legislation that would significantly cut back on the flexibility heretofore permitted publicly-held companies concerning their deferred compensation programs. That is, the right legislation would permit the IRS to achieve what it had been denied in judicial proceedings. Most practitioners believe that the IRS has gone too far, and we await the promulgation of additional IRS guidance in July. At the moment, we are trying to advise clients with these deferred compensation programs on how to avoid unpleasant surprises.

By way of unpleasant surprises, let me point to two provisions of §409A in particular. One provides for immediate income taxation on what has been deferred, an additional excise tax equal to 20 percent of the amount improperly deferred, and an interest penalty on whatever tax turns out to have been due to the IRS from the date the compensation was earned. The second provision relates to key employees in a publicly-traded company. In most cases, such employees must wait for six months after termination to receive their money. This is an effort to avoid the situation where an executive - presumably someone who knows what is happening at the company - effectively jumps ship and takes his money with him before the ship goes down. These provisions are felt to be rather harsh.

Editor: What type of mistake will trigger the tax and interest penalties?

Charyk: Many deferred compensation plans include language intended to give the participant some flexibility on timing and method of payment. A person might have originally elected to defer the compensation until age 65, but then, as that moment approached, decided to push it out to, say, age 67. Prior to §409A, the participant could take such a step without the tax falling due at age 65 - as originally contemplated - and without incurring any additional tax liability. Section 409A provides that once an election is made, if the participant wishes to further defer recognition of income, the additional election must occur at least 12 months before the deferred compensation would otherwise be paid and the actual payment must be pushed out at least five years. If the plan continues to include language permitting the type of deferral election adjustments that were permitted in the past, that constitutes the type of mistake that triggers the tax and interest penalties.

A second way to trigger the penalties involves acceleration of payment. In the past, many programs permitted an acceleration of payment on forfeiture of 10 percent of the amount paid, an amount sufficient to prevent the IRS from attacking the transaction in light of its, the IRS', concept of constructive receipt of income. Under §409A, the statute is violated if a plan continues to include language permitting acceleration of payment.

Editor: In December of 2004 the IRS provided its first round of guidance concerning §409A. What has this added to the discussion?

Charyk: It was a good faith attempt to provide guidance on the most critical aspects of the statute. Most importantly, it established calendar year 2005 as a period in which to sort things out without penalty. In effect, for deferral elections that pertain to this year, flexibility is permitted so long as things are drafted properly by year end. But, if action is not taken prior to the end of the year to bring the arrangement into compliance with §409A it will be in violation, with the consequences I have mentioned. We hope to receive additional guidance in the early fall. For example, with respect to the five-year provision, if the participant had originally elected to defer compensation to age 65 and elected to then receive it in installments over the next ten years, it is not clear whether - in changing that election - the participant must push each payment out by five years or only the first payment. This is the kind of practical issue on which guidance would be most helpful.

Editor: What about employer securities, such as stock appreciation rights, restricted stock with deferral features, options, and so on? What impact has the new statute had on this?

Charyk: Many employers are unhappy with how §409A affects their existing arrangements. Take a stock appreciation right giving an employee the right to cash for the increase in value of a share of corporate stock from the date of issuance. In the past, the employee could choose when to cash in that right, at which point tax would be due. That no longer works because §409A subjects such a right to taxation when it is first vested even if it is not exercised at such time. IRS guidance suggests that this problem is avoided if the stock appreciation right is paid in stock, something quite unusual for these plans.

Editor: And getting out of unsatisfactory arrangements? There is a time issue here, and the curtain is coming down?

Charyk: The curtain comes down at the end of 2005. With respect to any arrangement subject to §409A, people have until the end of the year to determine whether to continue on - and bring the arrangement into compliance - or cash out. Employers must consider what arrangements they wish to continue to offer their employees and how to avoid the pitfalls that failing to take the correct steps will entail.

Editor: Would you share with us the advice that you are giving your clients on compliance?

Charyk: The basic notion is that if a plan participant had money vested prior to January of 2005, he or she is entitled to keep it under the old rules. That is, with respect to plans in place before the effective date of §409A, it is not necessary to take steps to make them compliant for pre-2005 vested funds provided the rules for dealing with the pre-2005 vested funds are frozen. With respect to vesting after December 31, 2004, of course, a new set of rules comes into play, and failure to be in compliance has some rather harsh consequences. One way to address the situation is to maintain the pre-2005 program as a separate arrangement and to establish an entirely new program going forward. Another is to retain a single plan document with one set of rules and accounts to represent what was earned prior to 2005 and another after the effective date. Since our clients have a variety of needs, and what works for one may not work for another, our advice varies considerably.

Editor: No one wishes to see the continuation of the manipulative practices that came to light during the corporate scandals, but there is a question as to whether §409A is too restrictive and places too many obstacles on incentive-based compensation practices that have proven to be, over the past 30 years, a major contributor to corporate success. Any thoughts on where we go from here?

Charyk: An effective lobby for highly paid - some would say overpaid - corporate executives does not exist. That probably explains why §409A was enacted without much coordinated opposition, and I do not anticipate that there will be any attempt to undo what has been done, even with respect to things that, at first blush, do not appear to make much sense.

I think this is an area in which it is important to maintain some perspective and avoid overreacting. I believe that the basic purpose behind deferred compensation will survive the imposition of the new rules, and that, after some initial grumbling, most companies with these programs will decide not to drop them going forward. The IRS and Treasury have issued guidance that represents a good faith effort to get us through 2005, and I am optimistic that we will have additional guidance, and of a positive sort, before the year ends. In time, the promulgation of rulings and final regulations will serve to address most of the open questions. In the meantime, however, there are situations that must be avoided, and I would advise companies to waste no time in having their plans reviewed for compliance with §409A by people with the appropriate expertise. This is clearly an area where a modest up-front investment might serve to avoid absolutely catastrophic losses down the road.

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