New Rules on Taxation of Deferred Compensation
By Scott Dondershine, CPA, Esq.
The purpose of this Client Alert is to advise friends, colleagues and clients of some of the substantial changes caused by newly-enacted Section 409A of the Internal Revenue Code of 1986. The Client Alert provides general guidance only and should not be relied upon for legal advice.
In general, the new section applies to amounts that are deferred or become vested pursuant to certain non-qualified deferred compensation plans on or after January 1, 2005. Compensation deferred prior to January 1, 2005 is still subject to the new rules unless by January 1, 2005 the employee had (1) a legally binding right to be paid the amount deferred and (2) the right to the amount is earned and vested.
The new rules apply to a variety of plans (even if just for one person) that provide for the deferral of compensation. Examples of common plans that are generally subject to the new rules include certain compensation arrangements providing for the payment of amounts more than 2 ½ months following the later of the company’s or the employee’s first fiscal year end in which the compensation is no longer forfeitable, e.g., bonus and severance payment plans. Certain restricted stock plans, stock appreciation right plans (“SARs”) and phantom stock plans are also covered under the new rules.
Finally, non-statutory stock option plans are covered under the new rules unless the exercise price of the option may never be less than 100% of the fair market value of the underlying stock on the date of grant. Incentive stock option plans and employee stock purchase plans are generally not subject to the new rules. Such plans are taxable instead under other Internal Revenue Code sections.
Under the laws in effect prior to Section 409A, service providers (employees, directors and consultants) generally were not taxed until receipt of the compensation being deferred, vesting of restricted stock (except if a special election to be taxed earlier was made) or exercise of non-statutory stock options. For instance, an employee generally would not be taxed until receipt of cash pursuant to a phantom stock plan or other plan that deferred the receipt of compensation. An employee receiving non-statutory stock options in a closely-held business would not be taxed on the value of the options (even if the exercise price was less than the value of the stock on the date of grant) until exercise. Upon exercise, an employee would be taxed on the difference between the fair market value of the stock at the time of exercise and the exercise price.
Under the new rules, plans not structured to avoid the adverse implications of Section 409A in the manner discussed below do not provide for the deferral of taxation. For plans subject to and failing the tests imposed by Section 409A, taxation occurs when a participant vests in the right to receive the deferred compensation which may occur well before the participant actually receives the income. For instance, a participant receiving non-statutory stock options generally would be taxed when he or she vests in the right to exercise the options and not when he or she exercises the options. Participants who have earned the right to receive deferred compensation would be taxed upon earning said compensation rather than upon receipt of the same.
In the event that an amount previously deferred and not recognized as income is taxable under the new rules, then the amount is currently taxable with interest on any amount that should have been previously taxed. An additional income tax of 20% of the compensation is also assessed, effectively acting as a penalty.
Fortunately, many plans can be structured or amended to avoid the provisions of the new section requiring current taxation. Pursuant to the new rules, amounts deferred under a plan subject to the new rules that are not subject to a “substantial risk of forfeiture” must be included in the employee’s income unless the plan meets certain requirements. A substantial risk of forfeiture is present if (1) entitlement to the amount deferred is conditioned on the performance of substantial future services or the occurrence of another condition related to a purpose of the compensation and (2) the possibility of forfeiture is substantial.
In order to avoid the immediate inclusion of deferred income, a plan must: (1) allow distributions no earlier than when a participant separates from service, becomes disabled or dies, at a time specified in the plan, or when there is a “change of control” event or unforeseen emergency; (2) not allow acceleration of the time or schedule of payment of benefits (with certain exceptions); and (3) must comply with certain rules limiting the elections available under the plan.
Many plans previously adopted will require revision in order to avoid current taxation of amounts previously thought to be deferred. The new law provides that existing plans must be operated in good faith compliance with the new rules during 2005 and must be amended prior to the end of 2005 in order to comply with the rules and to preserve any intended deferral. We strongly recommend that, if you or anybody you know has any plan providing for a deferral of income, including the plans discussed in this Client Alert, you contact your corporate counsel immediately in order to determine if revision is needed. The law firm of David, Brody & Dondershine, LLP can also provide assistance, if desired.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this client alert is not intended or written to be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this client alert.