Proposed Tax Bill Would Change the Face of Executive Compensation

Yesterday, Representative Kevin Brady (R-TX), Chair of the powerful House Ways and Means Committee, rolled out the Republican tax reform proposal. And, while no tax bill in my lifetime or likely anyone else's lifetime has made it through the legislative process unscathed, the draft bill fashioned as HR 1 certainly provides an indicator of where we may be headed.

Much seems completely as expected. We knew about the slimming to four tax brackets. We knew about the narrowing of deductions. We knew that some of the more heavily-taxed states would feel the pain of restructuring. What we didn't know and what frankly came as a surprise to me and to others that I know would completely change the face of executive compensation in the US. Honestly, on its surface, these proposed changes look to me as if they they had been constructed by Democrats. It wouldn't surprise me if these changes had been pre-negotiated, but that's entirely speculation on my part.

So, what's the big deal?

There are two extremely significant proposed changes according to my initial reading.

1. The draft would amend Code Section 162(m) (the $1 million pay cap) to eliminate the exemption for performance-based compensation. In addition, that section would be amended to cover the Chief Financial Officer in addition to the Chief Executive Officer. 
2. Code Section 409A would be repealed (you thought that was good news, didn't you?) and replaced with a new Code Section 409B. Essentially, 409B as drafted would apply the much more stringent taxation upon vesting rules that have previously applied generally only to 457(f) plans. 

162(m) Changes

Section 162(m) was added to the Internal Revenue Code by the 1993 tax bill. Widely praised at the time as a way to limit executive compensation, the exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined. Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay (some only very loosely incentive based) without limits while taking current deductions.

That would change. 

My suspicion is that companies would return to paying their top executives as they and their Boards see fit, but with the knowledge that particularly high compensation whether performance based or not would not be deductible. Additionally, so called mega-grants and mega-awards would likely become much rarer as the cost of providing them would no longer be offset by tax savings.

409B

The ability to defer compensation has long been a favorite of high earners. The requirement to defer compensation has also been considered a good governance technique by many large employers (for example, a number of large financial services institutions require that percentages of incentive compensation be paid in company stock and that receipt must be deferred),

Much of this would go away as very few people have the ability or desire to pay taxes on large sums of money before they actually receive that money.

What Might Happen If the Bill Passes

Nobody really knows what might happen. But since this is my blog, I get to guess. Here, readers need to understand that there is no hard evidence that what I say in this section will happen, but it seems as if it could.

The draft of HR 1 appears to keep tax-favored status for qualified retirement plans. That's important because qualified retirement plans are a form of deferred compensation with some special rules and requirements attached. What this means is that to the extent that an individual would like to defer compensation on a tax-favored basis, he would need to do it through a qualified plan.

However, qualified plans need to be nondiscriminatory; that is, they must (not an exhaustive list):

• Provide benefits that are nondiscriminatory (in favor of highly compensated employees)
• Provide other plan elements sometimes known as benefits, rights, and features that are nondiscriminatory
• Cover a group of employees that is nondiscriminatory

There are techniques by which this can be accomplished in a currently legal manner, but they are not simple. It would not surprise me to see more interest in these techniques.

As I said at the beginning, I don't expect this bill to pass as is. But, these particular provisions written by Republicans should not draw ire from Democrats. We'll see where it goes.

409A and the Reverse Haircut

No, you didn't read the title incorrectly. I used the term "reverse haircut." Don't go scouring google for it, though. I made it up, or at least I think I did.

What happened is that I was catching up on reading and in going through documents that I had received from a number of sources, my eyes fell on Chief Counsel Advice 201645012. I know -- it's not one of the biggies that caught your eyes. So, that's why I'm reporting it here.

Here are the salient facts from the Memorandum:

• On November 1, 2014, an employee entered into an agreement to defer $15,000 of the employee’s salary that would otherwise have been paid during 2015, with payment of the deferred amount to be made as a lump-sum payment on January 1, 2018, but only if the employee continues to provide substantial future services until December 31, 2017.
• Under the agreement the employee’s salary is reduced by $600 each biweekly pay period (so 26 x $600 or $15,600) and the employer credits matching amounts to the employee’s deferred compensation account of 25% of each salary reduction (so 26 x ($600 / 4) or $3,900) for a total amount deferred of $19,500.
• The matching amounts are credited each time a salary reduction amount is credited, which is the time the salary reduction amount would otherwise be paid as salary.

The issue here is whether the potential loss of the 25% matching contributions represented a substantial risk of forfeiture as compared to a risk of forfeiture. And, that is the reverse haircut approach. That is, the employee will receive those matching contributions only by providing future services.

People used to the qualified plan world may be a bit mind-boggled at this point. To them, this looks like a vesting condition, walks like a vesting condition, and quacks like a vesting condition, so it must be a vesting condition. And, the potential failure to vest must represent a substantial risk of forfeiture -- a term that doesn't exist in the qualified plan world.

Suppose, however, that the 25% was less, say 20%. Then what? Perhaps there would still be a substantial risk. Or, perhaps there would just be a risk. How about 15%? How about 10%? 

At what point would the potential diminution in compensation be so insufficient that its loss would not be material and therefore there would fail to exist a substantial risk of forfeiture? Or put differently, at what point would enough hair be returning to our hero's head that its loss would leave him wondering how he could go through the rest of his life so improperly coiffed?

What we know is that in this particular case, 25% was deemed by Treasury to be sufficient. In fact, the Chief Counsel Advice included the following language:

Yes, an amount that an employee could have elected to receive as salary may be treated as subject to a substantial risk of forfeiture under section 409A if the employer provides a matching contribution resulting in a 25% increase in the present value of the amount deferred.

How useful is that to you and me? Not very. CCA's cannot be relied upon for any precedential value. While Treasury is usually consistent in its administration of such issues, there exists no requirement that it be. We also don't know if, for example, 20% would have been sufficient. Or 15%. Or 10%. To any attorneys reading this, it must feel like a hypothetical in their law school contracts class.

We also don't know if the deferral period in question had anything to do with the decision of Chief Counsel.

What we do know is that roughly 6 months ago, based on all of the facts and circumstances of this particular situation, Chief Counsel deemed that the 25% reverse haircut was a material incentive and that such materiality did create a substantial risk of forfeiture.

 

409A Audit Could Be Coming to Your Company

All the way back in 2004, Congress passed and President George W. Bush signed into law the American Jobs Creation Act (Jobs Act). While it does not appear to have created many jobs, the Jobs Act added Section 409A to the Internal Revenue Code. The reasons were twofold -- first, to ensure that participants in nonqualified deferred compensation plans (NQDC) would never be advantaged over those in qualified plans; and second, to raise revenue for the federal government.

Thus far, the addition of 409A has done a pretty good job at the first of those goals by imposing a very strict set of rules on participants, usually executives, in NQDC arrangements. With regard to raising revenue, however, 409A has been fairly impotent to date.

Several years ago, the IRS rolled out an audit initiative of 409A plans. It had some teeth, but mostly with regard to larger plans (more participants) of larger companies. While there were exceptions, for the most part, if your company has less than about 5,000 employees or if your NQDC plans in total have less than about 100 covered participants, you've been mostly immune from this audit initiative.

Reports are now that the IRS has stepped up their audits. They are doing more of them and they are investigating more and more plans of companies that did seem immune in the early years of the program. In fact, I heard from an NQDC recordkeeper that a client of theirs with only 19 NQDC participants is currently under a 409A audit. I spoke with that recordkeeper, but between us, we couldn't determine what the pattern of companies that have recently come under 409A audit has been. That recordkeeper's anecdotal evidence, though, suggests that in other than very large companies, the primary target plans have been in order:

• Nonqualified defined benefit pension plans that do not have the same formula as a broad-based DB plan in which the covered executives also participate;
• Other nonqualified DB plans that simply make up for IRS limits (415 and 401(a)(17));
• Deferred compensation plans that look different from the company's 401(k) plans; and
• 401(k) mirror plans.

In other words, the target seems to be executive retirement plans.

What can you do?

To understand what the solutions might be, your first need to understand the problems. Generally, there are two ways that you can violate 409A -- either by failing to have or failing to have an appropriate written plan document, or by failing to follow both the plan document and the law and regulations.

In either case, the penalties are severe. But, those penalties are not imposed on the company. Instead, they are imposed on the executive, even if he had neither influence on nor knowledge of the defect from which that penalty will arise.

How bad is the penalty? It's this bad:

• An additional 20% income surtax on the amounts deferred and not compliant for all taxable years in which that was the case; plus
• Interest on previously unpaid taxes (due to failure to include the deferred amounts in income in the year in which they were deferred) at the Federal Underpayment Rate plus 1%.

And, that's in addition to ordinary income (and other) taxes that would be owed on those amounts. They add up quickly.

For most 409A defects, however, there are correction methods, structured somewhat analogously to those under the EPCRS program for qualified plans.

Many of you will seek help from counsel and from tax advisers. That may be a good solution for you. A problem that can occur in either case, though, is that it's very possible that neither has significant experience with determination of 409A benefits or with the administration of those benefits.If they do, that's great. But, if they don't, you probably need to look for additional expertise.

Is Your Executive Plan Top-Hat?

Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).

Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.

So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.

Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.

As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.

Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.

So, knowing that we currently don't know what a top-hat group actually is, why do we care?

Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.

Consider the following scenario.

Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).

If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.

Ouch!

What should an employer do?

I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.

If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.

Looking at a history of case law and DOL opinion on the topic, one might consider these elements:

• The percentage of the workforce in the top-hat group
• The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
• Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
• Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
• Whether individuals in the group need the protection of ERISA

Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.

Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.

Compensating Executives in a "Challenging" World

The rationale has always gone something like this: if you don't compensate your executives at least equal to their peers and if you don't reward their performance, you will never have a top tier executive group and your company will not succeed.

Is that statement true? Is part of it true?

We're getting much closer to finding out. The big news this proxy season is from shareholder proposals on executive compensation. That's right -- since Say-on-Pay votes are non-binding, shareholder groups are looking to force companies to put components of executive compensation to a binding shareholder vote.

Before getting into a few details, let's understand how most companies are reacting. It's not surprising, but as a group, large corporations do not think their shareholders understand executive compensation. They are seeking to keep these votes off of their proxies. As a precursor to doing so, they request what is known as a "no-action letter" from the Securities and Exchange Commission (SEC). In brief, when a government agency issues a no-action letter, it assures the requestor that it will not take action on a given issue. So, when a company seeks such a letter from the SEC, the company is asking the SEC to confirm that it will not take action, for example, for a failure to place a particular item in its definitive proxy.

One of the most ardent submitters of executive compensation proposals is the largest American labor union, the AFL-CIO. In a statement, the AFL-CIO said, "We opposed compensation plans that provide windfalls to executives that are unrelated to their performance."

On its surface, that seems very prudent. But, it may be a bit trickier in practice.

What makes compensation related to performance? How does one define performance? Is compensation as expressed in the Summary Compensation Table? Is it cash only? Does it include equity? Does it include the (proxy-includable) value of deferred compensation?

Here is how it would strike me.

• Base pay is not related to performance. But, generally, to the extent that such pay is deductible to the employer under Section 162(m) ($1 million pay cap), some observers will not consider it to be egregious. On the other hand, in today's world of pay ratios and calls for increases in rank and file wages, other observers will ask that it be capped at some multiple of either the median pay for the entire company or even that of the lowest-paid employees of the company.
• Bonuses are theoretically related to performance. To the extent that the criteria used to evaluate executive performance and by extension, executive bonuses, are appropriate, so should those bonuses be. To play devil's advocate, however, if an executive knows how her bonus will be calculated, she may take inappropriate risks (for the company) in order to maximize the expected value of her bonus. Similarly, she may find ways to accelerate certain items into the fiscal year in question while deferring others until the next year. 
• Long-term incentives are [nearly] always performance based. In today's world, it is expected that those incentive payouts will be based on the achievement of a set of goals related to metrics deemed appropriate for that executive. Often, there are circuit breakers (elements that if the executive fails to meet a pre-established minimum level of performance, he will not receive a payout or that part of a payout at all). But, long-term incentives are often paid in company equity. This means that compensation will, to a large extent, be tied to share price. As we know, however, share price is not always tied to corporate performance. On any given day, share price may be influenced by such as the state of peace or war in the Middle East, a speech given by the President of the United States, or the rise or fall of housing starts during the last month. 
• What about deferred compensation (here I am referring to traditional deferred compensation plans, either defined benefit or defined contribution)? It's rarely performance based. Theoretically, the company is paying an executive less today for a promise to give them some of that pay in the future. What sorts of plans should be challenged? If an executive voluntarily defers some of their compensation and it grows at a rate tied to some broadly investable index, is that okay? Suppose she has a DB SERP that looks just like the broad-based plan (qualified plan), but without limitations applicable to qualified plans. Institutional Shareholder Services (ISS) is generally fine with this, but major labor unions may not be. And, if that SERP looks very different from qualified plans, even if there is a good reason for it, this may be a situation where no institutional shareholders are satisfied.

What should Boards of Directors and their Compensation Committees do about all of this? ConocoPhillips shareholders are asking that the Compensation Committee develop a program to determine which portions of a bonus should be paid immediately, which portions should be deferred, and what adjustments should be made to those deferrals based on performance.

Perhaps this has some merit. If it does, however, it's a bit of a nightmare for people who need to figure out how to make such a plan 409A-compliant and for those who need to administer FICA tax payments.

On the other hand, if adjustments are to be made based on performance, can't the same executive who is able to manipulate performance metrics in the LTI scenario described above also find a way to manipulate them here? Where there are objective formulas, there are smart people who can figure out how to game the system. Where there are subjective evaluations, Boards will be accused of pandering to the executives of the companies.

More than ever, the Compensation Discussion and Analysis (CD&A) will be very key. Explaining why the mix of objective and subjective factors was chosen can go a long way to appeasing large shareholders. Explaining how levels of compensation were chosen is a must. And, for the first time, we may see companies rationalizing their levels of executive pay as compared to rank and file pay.

With all of these challenges to executive compensation, these are challenging times for Compensation Committees.

Are You Handling Your FICA Taxes on Deferred Compensation Properly?

FICA taxes on nonqualified deferred compensation (NQDC) were never a big deal. Chances were that if you had NQDC that your pay was well over the Social Security Wage Base. So, while there were situations where that was not the case, the IRS largely ignored the issue. There just weren't enough situations where it applied and there wasn't enough tax revenue in it to worry about enforcement.

Then came the uncapping of Medicare wages. That is, employees and employers were required to pay HI (Medicare) taxes on all wages, not just those up to the wage base. Suddenly, large amounts of NQDC were subject to this tax and it mattered.

For the last few years, there was a court case in Michigan related to payment of FICA taxes. I had largely forgotten about Davidson v. Henkel, but another blog reminded me of it (thanks Mike Melbinger). In the case, Henkel failed to pay FICA taxes on behalf of Plaintiff Davidson and others in the class leaving that class with a significant (to them) tax liability including penalties.

Why do we care? Why am I taking the time to write about this?

Most NQDC plans are drafted by or reviewed by attorneys (as they should be). While this is not always the case, in the typical situations, the plans are somewhat boilerplate in nature. In my personal experience, counsel often does not ask the client all of the details about how the plan will actually be administered. Frankly, even when they do ask, the client may not know. After all, the client may not be administering the plan on its own.

The plan document is a legal document. When that document says that the company shall remit FICA tax, it must. When the document instructs how or when FICA taxes will be calculated, that is what must happen.

In many plans, this is really a non-issue. There may only be one way to calculate these amounts and taxes will be due annually. In defined benefit (DB) SERPs and Restoration Plans however, there are multiple ways of handling the FICA situation. Most prominently, the sponsor may calculate (and remit) FICA taxes when they are reasonably ascertainable (a technical term from the regulations, but for many, this means at the employee's date of termination from the company) or by early inclusion which essentially means that FICA is calculated and paid annually. Early inclusion is sometimes more beneficial than waiting until retirement, but it is also more administratively complex.

Some plan documents leave the option of payment entirely to the discretion of the sponsor or administrator. Others specify that there will or will not be early inclusion.

What does yours say? Do you know?

Suppose your plan specifies early inclusion and you've not been doing that, do you have a problem? You might.

In fact, in my experience, more companies than not are not particularly on top of the administration of their NQDC plans. They've never particularly focused on compliance with these FICA rules or, even worse, Code Section 409A.

Oftentimes, it will be a good investment to have someone assist you in making sure the processes in this regard are being handled properly.

Is IRS Stepping Up Nonqualified Audits?

Two weeks ago, the IRS released nonqualified deferred compensation audit techniques guide. While no one can be certain, this would seem to signal that the Service is showing more interest in auditing these plans, available almost exclusively to the highest paid of employees.

For years, many have thought that nonqualified (NQDC or NQ) plans to be a significant area of tax abuse and a potential source of tax revenue for the federal government. And, whether this is simply a much needed update or the beginning of a push, the language in the guide would seem to suggest where the IRS thinks there are problems.

Let's look at the paragraph headers in the guide as a means of determining where the focus is likely to be:

1. Examining Constructive Receipt and Economic Benefit Issues
2. Audit Techniques
3. Examining the Employer's Deduction
4. Employment Taxes
5. Important Note [related to 401(k) plans]
6. The American Jobs Creation Act of 2004 [the law that brought us Code Section 409A]

Constructive Receipt and Economic Benefit Issues

Here, the guide instructs auditors to look for assets set aside free from creditors for the benefit of employees. It also instructs these auditors to look to see how executives can use the benefits in these nonqualified plans. For example, if a SERP might be pledged as collateral, then the employee has enough control to have constructively received the benefit and is subject to current taxation, or was when the benefit was first constructively received. 

For employers with any knowledge of NQDC plans or those who use counsel who work at all in this area, getting this right falls under the heading of basic blocking and tackling. So, while the IRS might be able to find some defects here, it would not seem to be a source of significant revenue.

Audit Techniques

In this section, frankly, I think that the IRS is grasping at straws. It asks auditors to interview personnel most knowledgeable about the plans. Further, the auditors are encouraged to review Forms 10-K and to learn whether the company uses a consulting firm to assist with its NQDC plans. 

There seems to be little glue holding this section together. Instead, what I am seeing is that their may be a needle in a haystack and a fortunate auditor might find that needle. Other sections of the guide may prove more fruitful.

Examining the Employer's Deduction

Generally, the amount and timing of the employer's deduction must match the amount and timing of the executive's inclusion in income. Looking from the outside in, this would seem to be simple. But, corporate tax returns, especially for large corporations are quite complex. Similarly, a corporate executive is fairly likely to have a complex tax return. It's not unlikely that treatment of income from NQDC plans is nowhere near the top of the priority list for either the corporate tax department or for the executive's accountant. 

In fact, in my experience, some corporate tax departments do not have significant familiarity with this type of plan (some have exceptional knowledge). Similarly, and perhaps more glaring, many personal accountants, again in my experience, just don't know much about nonqualified plans. 

The Internal Revenue Code is a complex instrument. The instructions to government forms, especially if you include the various Publications that they reference, are quite confusing. If an accountant deals with particularly few NQDC plans, it would not be shocking to find that accountant confused by their tax treatment. Certainly, I would not expect them to confirm that the amount and timing of inclusion in income coincides with the corporate tax deduction.

Employment Taxes

This is the section that deals with FICA and FUTA taxes. Until the cap was removed from Medicare wages, this section would have been ignored. The reason is that although nonqualified deferred compensation is subject to these taxes when it is both vested and reasonably ascertainable (a technical term meaning that a knowledgeable person can figure out about how much it is worth), virtually all NQDC participants earned far more than the Social Security Wage Base each year. But, when the cap at the Wage Base was removed for Medicare taxes, new NQDC was necessarily subject to that tax. 

The regulations on this topic are, in a word, confusing. Specifically for what are known as non-account balance plans (generally defined benefit SERPs), the guidance on how to perform calculations was likely written by someone who did not know what they were prescribing and the guidance on the actuarial assumptions to be used in those calculations is virtually nonexistent.

However, in my experience with this topic, the IRS does have strong opinion on what the Treasury Regulations mean and intend. That said, when the regulations under Section 3121(v) were issued, I co-authored a research memo on the calculation of the amount of FICA wages from NQDC plans (the focus was on non-account balance plans). To say that the authors went back and forth many times before agreeing on the intended methodology is an understatement. To think that similar authors at other actuarial consulting firms would reach exactly the same conclusion is no plausible. Add to that the various accounting and tax firms who might have their own opinions and you would certainly have a lack of consistency. About 15 years ago, however, one IRS examiner that I spoke with off the record said that there was just one consistent method available under the regulations.

Said differently, while I don't know how much revenue is potentially available, the calculation of employment taxes with respect to NQDC plans, and specifically non-account balance plans would not all meet with the approval of that particular examiner.

Important Note [related to 401(k) plans]

The coordination of qualified 401(k) plans and NQDC plans that provide for deferrals in excess of those allowed in the qualified plan seems like it should be simple. It's not. In particular, it's not if the two plans (qualified and nonqualified) are administered by different providers (or if one is administered externally and the other internally). Generally, these plans allow participants to defer amounts where IRS limits would otherwise preclude such deferrals. In the simple situations where the 401(k) plan passes nondiscrimination testing, this is pretty easy. But, when the plan is forced to refund deferrals due to test failure or when deferrals are restricted in hopes of making the testing work, things can go horribly wrong. Do the two separate administrators communicate with each other? It's doubtful.

There is likely not a lot of revenue for the government to find here, but there are probably a large number of very small problems.

The American Jobs Creation Act of 2004 [the law that added Section 409A to the Internal Revenue Code]

I've written about 409A here many times. If you are interested, go the little search box at the top of the page and type 409A. I'd be surprised if you get fewer than 25 hits in this blog, but I've not counted. 

As is often said about relationships, it's complicated. 

The regulations are long and were written in a fashion similar to the regulations under Section 3121(v). Frankly, I don't think the people who worked on the project did a bad job writing the regulations. They're not perfect, but they wouldn't have been perfect if you or I had written them either, so we must be careful with our criticism.

But, certain parts of the regulations that have lots of calculational elements where the calculations almost necessarily must be performed by actuaries were written by attorneys. I know some of those attorneys. They're smart people. And, they spent lots of time understanding the statute and developing regulations to enforce that statute. They could have done far worse.

The people that I know, however, who worked on the project are not actuaries. While they have some familiarity with actuarial calculations, they don't actually do them and I think they would tell you if you asked candidly that they have only a minimal understanding of them. Yet, for certain types of plans (mostly non-account balance plans), there is much in the way of actuarial calculations that determines potential tax liabilities. 

Frankly, we don't know what was intended. We tend to reference the FICA regulations, but even there as I noted above, the regulations are not prescriptive.

Section 409A is a mess. I don't think anyone intends to violate it, but there are lots of people who don't get it right. Finding the violations is difficult, but if examiners do find violations, with those violations will come some fairly meaningful tax revenue.

*           *          *          *          *           *             *              *             *            *            *           *          *

So, that's my take on where the IRS is headed and what value it has to them. Time will tell if I got it right for a change or not.

Executives Need Retirement Education, Too

It's been a long time since I blogged. I needed a break. I needed some fresh ideas. I didn't feel like writing on anything technical. I didn't feel like offering my opinions. I just needed to stop writing for a little while.

This morning, however, I saw an article in the News Dash put out by Plan Sponsor. It stressed that plan sponsors feel that perhaps the biggest issue in nonqualified plans is participant education. Citing from the article, one in five said that education was a top challenge while 18% cited participation and appreciation. I think that they are essentially the same thing, so that makes 40% (rounded) and that's enough for me to conclude that this is a major issue.

Why is this? Executives generally make a lot of money (whatever a lot is). They are generally used to dealing with financial matters. They already have their qualified plans. What makes these plans so different?

There's a lot. Taxation is different. They usually don't have a real pool of assets that they can play with. They don't get the same level of disclosures. They don't understand Code Section 409A. And, they generally don't know if what they are getting is good compared to what their peers at other companies are getting or not.

What's the answer?

I suggest rewards education for executives. In my experience, it is rare that this can be done internally. Internal people are often considered to have a bias or an agenda. It comes better from the outside.

Who or what should that outsider be? It should be an independent person, one who has no horse in the race, so to speak. It should be a person who can speak to all facets of executive rewards -- cash compensation, deferred compensation, equity compensation, retirement compensation, change-in-control agreements, and the like. Unfortunately, there are not too many of them around.

Oh, wait, I can do all that!

A Service to Go with a Sad Story

I am going to pitch a service here that all employers should consider. If you are spending money to provide additional benefits for your executives, that money should go to them and not to the government.

Sometimes a good idea comes out of a sad story. And, I'm happy to report that in this case, it's sad because a company wasted money providing a generous benefit for its executives and then didn't tell the executives the pitfalls, but it's not sad in the context of someone going bankrupt or suffering a tragedy.

I got a call yesterday afternoon from someone who found me on the internet, probably through this blog. His wife is a participant in a SERP. Her employment with the company ended in July (I don't know how or why, I just know that it ended).

In early 2007, the wife received a communication from her employer. It told her that her SERP was being split into two pieces -- a 409A-grandfathered piece and a non-grandfathered piece. This was a not uncommon strategy. In addition, the non-grandfathered piece had a default payment of a lump sum of the present value of the accrued benefit payable six months after termination. A participant could elect a different form and or timing of payment (within limits defined in the plan). All of this is very normal in the world of SERPs post-409A.

Apparently, that is all the communication told her. It didn't explain the complexities of 409A. From what I could gather, her employer didn't want to give too much information because they were worried about potential litigation. So, they probably figured that giving no guidance at all meant that they gave no incorrect guidance.

When I answered the phone, the unhappy husband told me that he and his wife assumed that she could change her option when she terminated. So, she accepted the default and went on her merry way. Now, she will be receiving a lump sum that they don't really need right now and paying about half of it to various governments in the form of taxes.

Here's the idea. An employer could choose to go all the way or just do part of this.

Get an outsider like me who understands executive rewards and the 409A and other tax implications to help communicate to your executive group. In what I would term a perfect world (assuming that the employer chooses to not do the communication themselves), here is what would be entailed:

• Provide the outside consultant with the plan provisions and data for all the parts of the rewards package that you would like covered (SERP, deferred compensation plan, equity compensation, cash compensation, severance, change in control, etc.)
• Invite your executive group to a meeting. In that meeting, the outside consultant presents to the group generically on those elements of the rewards package. In that meeting, each executive, will get a summary/informal statement of their rewards package showing values and costs. The executives will place greater value on their rewards packages when they know how much they are worth and how much you are spending on them.
• With signed waivers (consulting, not legal, tax or accounting advice), allow executives to have individual meetings with the outside consultant after the group meeting. Let them ask questions about what they can change and when, what are their options, and what are their restrictions?
• These meetings can cover as much or as little of the executive rewards package as you would like, but the idea is to use the money that you are spending on executives for executives, not for the government.

Consider it. Let me help.

409A Bares Its Teeth ... And Bites

Anyone who reads this blog knows what I think of Code Section 409A. Like many other sections added to the Internal Revenue Code in a politically charged environment, it was an overreaction to a financial meltdown. This one was added to the American Jobs Creation Act of 2004 in response to Enron, WorldCom and other failures of that era.

The gist of the section makes sense. Essentially, Congress  (I hope I'm not attributing more logic to them than they deserve) wanted to ensure that participants in nonqualified deferred compensation plans (NQDC) couldn't get treatment preferable to that of the rank and file in qualified retirement plans. For example, there are generally restrictions on when an individual can receive on an unpenalized basis a distribution from a qualified plan. Section 409A seeks to ensure that the deal is no better in the NQDC world.

The tax penalties for failure to comply with 409A are severe. I've discussed them many times. Essentially, a failure is subject to 20% additional income tax (a marginal tax rate of 39.6% becomes 59.6% on that money) plus interest on underpaid taxes at the federal underpayment rate plus 1%. That's pretty severe.

Despite the IRS having announced that they had started an executive compensation audit program, more than a few companies have been cavalier in their efforts to comply with 409A.

They should perhaps reconsider.

I say this in response to a Federal Court ruling in Sutardja v US. Often, I provide my readers with a link to these cases so that they can experience all the excitement in reading the decision that I have, but this time I am refraining. There just wasn't enough excitement. However, here is a synopsis.

• Dr. Sutardja is the CEO of Marvell Technology Group Limited
• On 12/10/2003 (note that 409A became law in late 2004), the Board of Marvell approved a grant of not more than 2 million stock options to Dr. Sutardja. The closing stock price that day was $36.19.
• On 12/16/2003, the Compensation Committee of the Board approved a grant of 1.5 million shares  to Dr. Sutardja at an exercise price of $36.50, the stock price on that day.
• Said grant was ratified on 1/16/04 when the stock price was $43.64 (Alert: alarm bells go off ... discounted stock option alert).
• In January 2006, Dr. Sutardja exercised some of his options. He paid an additional amount to make up for the perhaps incorrect grant price.
• The IRS hit Dr. Sutardja and his wife with a tax bill for a 409A penalty for more than $5 million.
• After the Court went through a whole lot of technical mumbo jumbo, it ruled in favor of the IRS.

So, what's the point?

Marvell could have handled this more cleanly. 409A wasn't a glimmer in anyone's eyes when they authorized or granted the options. While they didn't use an approved method, Dr. Sutardja and Marvell tried to use what they viewed as good faith to fix the issue. Dr. Sutardja and his wife lost.

The real point is that Congress intended that 409A be a revenue raiser for the United States. The IRS is trying to live up to that intent. Now, there are procedures in place to fix 409A problems. Most companies don't have the expertise to do that internally. Depending on the NQDC plan in question, review of the plan including its administration may appropriately be done by some combination of attorneys, tax experts, compensation experts and retirement plan experts. Often, it should include people from more than one of these categories. 

If you engage such people to conduct a review, one of three things can happen and two may be better than the alternative:

• They will find no problems because there are no problems.
• They will find problems and you can use approved correction procedures before the IRS finds the problems.
• They will not find any problems, but the IRS will (this is the one bad one, but I think it's unlikely if your experts are really experts).

Consider conducting such a review.

MAP-21 and SERP Funding, Now May be the Time

If you work with US defined benefit (DB) pensions and you haven't been living under a rock, then you are probably familiar with MAP-21, the law passed this summer whose more formal name is Moving Ahead for Progress in the 21st Century. It was positioned as a highway bill, but you are too smart for all that and know all about positioning. Where building highways costs money, lowering corporate deductions for pension plans raises money (or gets scored that way by the Congressional Budget Office). So, MAP-21 included pension funding relief.

In a nutshell, MAP-21 allows plan sponsors to use significantly above-market discount rates in the determination of funding requirements for their qualified pension plans. The trade-off comes in increases in PBGC premiums. But, while the first of these items is optional, the second is required.

So, where am I going with this? If you read the title of this post, you may be wondering.

Flashback to late 2004. Congress passed and a different president signed into law another act supposedly designed to create jobs. This one had a much more in-your-face title, the American Jobs Creation Act of 2004. With that innocuous name, however, came a new section of the Internal Revenue Code, Section 409A that among other things removed distribution and funding flexibility for DB SERPs. Since that time, many executives have wondered how to get their benefits, or at least portions of them, out from under the dark veil of 409A.

For some companies, MAP-21 may have provided an answer.

WARNING: before considering an option such as what I am about to describe, plan sponsors should very carefully consider the underlying risks.

The time may be right to consider a QSERP. Briefly, a QSERP is a means to transfer certain nonqualified benefits to a qualified plan. You can read about them in more detail here.

So, why might now be the right time. MAP-21 has given companies the ability to use higher discount rates in funding their pension plans. This means that any restrictions that might have arisen due to low funded statuses have likely disappeared. So, companies have the opportunity to fund this obligation in a qualified plan without having to fund it all at once.

Risk managers might tell you not to do this and there are good reasons. Paramount among them is that temporary use of above-market discount rates does not change the "true" funded status of a plan.

Other risk managers might tell you that you should do this and you should do it now. Why? Let's consider a simple example. Suppose you have agreed to pay your CEO an additional $100,000 per year (for life starting at age 65) from the SERP. This is over and above what he will get from the qualified DB plan. The present value of that obligation is the same whether that benefit is in the qualified plan or in the SERP. But, in the qualified plan, you get these advantages and many others:

• The benefit will not be subject to 409A
• You could efficiently fund the benefit immediately and generally get an immediate tax deduction for that funding
• That tax deduction may be taken at a higher corporate tax rate than it will be in the future
• When the CEO retires, his benefit can be paid out of a large pool of assets rather than creating a cash flow crunch

This is a complex process and there is much to consider. But, for the right company, now is the time. You'll only know if you are the right company after careful analysis. Ask an expert.

Distribution Dilemma in Times of Tax Uncertainty

Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).

409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):

• Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
• To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
• Failure to comply results in significant penalties.

Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.

That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.

Oops, wrong guess.

There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.

What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?

I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:

• 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
• 9 of the 15 didn't know what the rules were around changes.
• 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
• Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
• Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.

Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.

Beware the Compensation Audit

OK, HR people, if your company got audited, how would it do? I'm not talking about the audits of broad-based employee benefit plans that the IRS and DOL have been conducting for years. I've heard attorneys give advice with regard to those benefit plans that they may not be compliant, but you'll never get caught on audit. I'm talking about compensation audits, targeting primarily executives. I'm talking about 409A and 162(m) audits. Would you feel confident if you got that dreaded letter than an auditor would be arriving soon? Many companies have felt confident. Many of them have not been so happy when the auditor left.

Before discussing those audits and what you might do to prepare (long before you get that audit notice), I digress. What is your role in the company? Do you have a boss? Murphy's Law says that the first person in the company with a 409A problem will be either your boss or your boss's boss. In my experience, the 409A version of Murphy's Law strikes far more often than logic or probability dictate that it should. And, if it does, you are going to get blamed ... and that's not good.

Let's suppose you do get a request for information from the IRS for a 409A audit. They give such requests a nice name. They call them Information Document Requests. I have one sitting in front of me. Thankfully, from my standpoint, it was provided to me by a company that I did not assist with their 409A compliance process. I say thankfully because at the end of their audit, they were not happy with what the IRS found. In any event, here is what the IRS requested (paraphrasing somewhat to take out IRS-speak where possible) from them:

• Every plan and arrangement providing for a legally binding right to compensation in one year, but payment in some future year that is not subject to 409A. The company is then asked to explain why it is not subject to 409A. If the answer that they will give is the exclusion for short-term deferrals, then the company is to provide the relevant terms of that plan and and relevant terms for substantial risk of forfeiture.
• Terms and conditions, including deadlines for initial deferral elections.
• Terms and conditions for any subsequent deferral elections, including documentation of the initial deferral election, documentation to show that the subsequent election was made at least 12 months before the initial payment date and documentation to show that the subsequent election reflects at least a five-year pushback. 
• Detail related to any accelerations in payment that have been made.
• A list of specified employees and the times at which such employees have been specified employees.
• Payments made to specified employees and documentation demonstrating compliance with the six-month delay rule.
• Any funding of deferred compensation as a result of an event relating to a decline in the company's finances.
• Violations of 409A and whether they were fixed in one of the IRS 409A corrections programs.

For some companies, that's a lot of stuff (that's a technical term for saying that it may take you a long time to comply with the Information Document Request). But, that's only the first part of the misery. Let's look at where the IRS has been generating revenue (that is also a technical term, this time for finding compliance errors).

• Time and form of payments
• Short-term deferral rule
• Identifying specified employees

With regard to time and form of payments, the biggest culprit has probably been in severance plans. Recall that broad-based severance plans may be exempt from 409A, but to the extent that the payment is more than two times the pay cap under Code Section 401(a)(17), they are not. So, we are talking about executive severance payments here and there have been a lot of them the last few years. 

How have companies gone wrong? Many executives have had employment agreements that provide for significant severance payments in the event of termination without cause. And, in a lot of those cases, they allowed the executive freedom to take that payout in a lump sum or installments as he saw fit. 

Oops! That's a 409A violation. And, if he was a specified employee and he took the payment within 6 months of separation from service, Oops again.

Companies (and their advisers) have taken significant advantage of the short-term deferral rule. Oversimplifying somewhat, here's how it works. Suppose compensation is earned in one year (and vests in that year) and is paid out (without employee choice) by March 15 of the following year, then it usually qualifies as a short-term deferral. Think of a typical annual bonus plan.

Now, let's change the situation. An employee earns compensation (and it vests) in one year. He separates from service the next year before March 15 and the amount gets paid out (because of the separation from service). It is NOT a short-term deferral because the payment could have been after March 15 if the separation from service had occurred later. Essentially, you can't dodge the short-term deferral rule in this fashion.

Identification of specified employees is not easy for large companies. At a minimum, they are the key employee group as determined under Code Section 416(i). Here is the problem. During the year, you may not know who those 50 highest-paid officers are for a year. This is why the 409A regulations defined specified employees as compared to just key employees. Specified employees can be a group of up to 200 that includes the key employees, but may also include certain other employees. It's that group that must not be paid out within 6 months of separation from service. And, all 409A plans and arrangements of an employer must use the same definition of specified employees.

Many companies have applied the 6 month delay rule to all 409A plans of the company for all employees. In that case, it doesn't matter who the specified employees are. Other companies have chosen not to do this. Therefore, they need to know who their specified employees are. IRS experience says that many companies don't know who their specified employees are. This is another good revenue source for them.

So, how should companies prepare for the possibility that they may get audited? Have an independent third party review. Don't have it done by the people who did your initial compliance work. They'll never think they made any mistakes. If the initial work was done by an attorney, consider having the third party review done by a consultant. You'll get a different and hopefully useful perspective. If the initial work was done by a consultant, consider an attorney to do the third party review.

Or, in either case, if I didn't do the initial compliance work, I'll give you a different perspective than the person who did it originally.

A New Look at an Old Friend

About 10 years ago, they were all the rage for companies that had defined benefit (DB) plans. Lots of DB plans were still in surplus, or at least thought they were, and lots of companies still had ongoing DB plans. Something happened in the interim (OK, a few somethings happened), but that's not the point here. Roughly 10 years ago, lots of companies were looking for an ideal way to fund their DB Supplemental Executive Retirement Plans (SERPs), In my opinion, the most effective way to fund these nonqualified (NQ) benefits was through a qualified plan (QP). This strategy has gone by many names, but the most prevalent in the industry has been the QSERP.

On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.

What does this do for the executive? Here are some of the benefits.

• It generally secures the benefit. Of course, if the plan sponsor goes bankrupt, such security is subject to PBGC limits on guaranteeable benefits.
• It takes the benefit out from under the purview of Code Section 409A.
• While the benefit is still in the plan, it does not fall prey to the doctrine of constructive receipt under Code Section 83.
• If the benefit is payable in a lump sum, it can be rolled over into an IRA further deferring taxation.
• The executive can wait until just before his benefit commencement date to make an election as to the timing and form of benefit distribution.
• The benefit is exempt from FICA taxes.
• The benefit is protected in the event of a change-in-control.

And, for the plan sponsor, here are some of the benefits.

• To the extent that the benefit is funded immediately, the sponsor gets an immediate tax deduction.
• Since the plan is qualified under Code Section 401(a), the trust will be exempt from taxes under Code Section 501(a), meaning that the plan assets grow tax-free.
• Payment of the benefit comes from a trust that holds all of the plan assets, not from the corporate coffers, or a far smaller rabbi trust.
• Qualified plans have better optics than do SERPs.

How about for the shareholder? How does a QSERP affect them?

• In every case that I can think of, implementation of a QSERP has been either income-neutral or income-positive.
• The company is less likely to have sudden cash flow requirements.
• From a risk standpoint, it is far easier to use risk management techniques in a qualified plan than in a SERP.

So, why can companies put in these QSERPs? Generally, from a technical standpoint, it goes to two things in the Internal Revenue Code: 1) the nondiscrimination rules of Code Section 401(a)(4) are highly objective; and 2) the combined limits under Code Section 415(e) were repealed.

Yes, that's highly technical stuff. But, suffice to say that it works. For years, I had the extreme pleasure <cough, cough> of teaching nondiscrimination testing to generally younger and aspiring actuaries. One of the things about the testing that I drilled into their heads was this: if you don't pass, you're not trying hard enough. 

Sometimes benefits actually are discriminatory, and there is nothing that any of us can do to change that. But, I have seen some benefit formulas over time that are extremely discriminatory to the naked eye. So, what do we do? We take the employee data and put it in a big pot. We add in the benefit provisions. We stir a bit with the nondiscrimination rules (remember, they are objective; either you pass or you fail.) and out comes a nondiscriminatory plan.

We're late in 2011 now. The funding rules have changed. There are fewer large defined benefit plans, and of those that remain, many are in one state of freeze or another. 10 years ago, there was no 409A. There was no Dodd-Frank, 

There is still lots of merit to this approach. Consider it. Talk to us.

Causing A SERP to Violate 409A By (lack of) Default

Code Section 409A has been one of the biggest disasters ever written into the Internal Revenue Code. It was supposed to raise lots of money for the government, but to my knowledge, it has not. It was supposed to make nonqualified deferred compensation no less favorable than its qualified brother, and it certainly has done that. But, some of the pitfalls that have come up are way beyond the scope of what Congress could possibly have considered. Let's consider a not uncommon situation.

XYZ Company decides to start a new (traditional) deferred compensation plan for certain executives. Eligible executives will be able to make deferral elections (amount, timing of payment, form of payment) during year X-1 with respect to compensation earned during year X. Earnings will be credited on those amounts based on the earnings of a funds selected by an executive from the group of funds also available under the qualified 401(k) plan. Deferrals will be matched by XYZ dollar for dollar on the first 10% of compensation deferred to the nonqualified plan (NQDC). As these executives previously participated in a nonqualified cash balance plan (that plan was frozen when the qualified plan was frozen), vesting is 100% after 10 years of service, with service counting back to date of hire.

Believe it or not, all, or at least most of these executives will be in violation of Code Section 409A the moment that they make their elections. Why? How can that be? Without reading down, do you know?

Here is the catch. Vesting service starts before the effective date of the plan. This is not the first plan of this type (account balance plans) in which the executives participate. For those who are immediately vested (10 years of vesting service), making an election in Year X-1 is making an election for services already performed. Yes, the mere fact that vesting service starts before the effective date of the plan causes the problem.

How do you fix this? The good news is that it is actually fairly simple. Make the initial deferral election a default. In other words, specify it in the plan with no choices. Given that no choices are available, the rules will be interpreted so that the executives have not made an election after the date on which some services have been performed.

Do you think this is ridiculous? So do I. Do you think that Congress intended it this way? Neither do I.

This, dear readers, is the level of stupidity to which 409A has sunken.

Executive Compensation and the Tax Code -- the Knot that Won't Untie

Do you remember when a company could pay an executive what it wanted to? Do you remember when the market decided how much a company would pay its executives? It wasn't that long ago. There weren't a lot of rules.

So, what happened? Things got out of hand. You can place the blame where you like. You can put it with executive compensation consultants, and surely, there is a group of them (not all of them) that deserve a lot of the blame, as everyone in the industry knew that a key to getting a new engagement was promising a company's management that you could get them more. You can blame it on Compensation Committees, as they didn't seem to care how much their company's executives got so long as a consultant could support it. You could even choose to blame it on me, although that would be misguided.

And, then what happened? Congress found a new whipping boy so to speak. The first key change was when they decided that deferred compensation should be subject to FICA tax. In a vacuum, this is probably the correct thing to do within the context of public policy. Your wages should be subject to a payroll tax (taking the broad leap of faith here that a payroll tax is appropriate) in the year that you earn them to some reasonable degree of certainty. What was the problem with that? I don't think that Congress actually knew what they intended. Did they really mean to FICA tax company-provided nonqualified plans? I bet they didn't know. In 1983, it probably didn't matter. The Social Security Wage Base applied equally to the OASDI (old age, survivor, and disability) portion of FICA and to the HI (Medicare) portion. It wasn't until much later that they pay cap on HI taxes was removed.

Then came Code Section 162(m). Congress decided that no disqualified individual (that's a fancy term for the people they are targeting) should earn more than $1 million in a year. But, wait, suppose an executive performed really well. That might merit more pay. So, performance-based compensation was exempted from Section 162(m), so long as whoever crafted the plan got the design just right. Companies found ways to skirt this one pretty easily.

And, then came the nightmare before Christmas, Code Section 409A. I've written about it here many times before. The worst thing is that it was part of a jobs bill, the American Jobs Creation Act of 2004. If you don't work in this area or if you have been living under a rock, I'll give you the brief summary of how Section 409A creates jobs.

Ready?

It places additional 20% income taxes on nonqualified deferred compensation that doesn't meet some of the most convoluted rules that even the Treasury Department has ever come up with. And, what is worse, the more time that passes, the more problems that are uncovered with respect to plans subject to 409A ... all in the name of creating jobs.

Well, I have done a detailed statistical analysis (remember, I'm an actuary and I have training in this area), and I have determined with a particularly high confidence level exactly how many jobs were created (outside of government jobs to regulate and enforce this mess and attorneys to find ways around it) by Section 409A.

Zero. Zilch. Nada.

But, it has taken some perfectly innocent plan designs and made them seem like they were created by scoundrels the likes of which even Gordon Gekko has never seen. Imagine this: suppose that an employer provides its CEO with restricted stock units (RSUs). And, further, suppose that the restrictions lapse (the units vest) after 10 years, or after bona fide retirement on or after age 65. Lots of critics think that this is a desirable design of an executive compensation program. It ties executive compensation both to company stock performance and to the executive staying with the company.

Oops, the fact that the RSUs could vest upon retirement (seems innocent enough to me) makes the plan subject to Section 409A, and as often as not, nobody worked this out in advance, so the plan fails to comply with Section 409A and there are draconian tax penalties on the executive ... all because the company thought it was fair that he or she should have access to his or her earnings upon retirement from the company. The nerve of the CEO!

Excuse me, the nerve of Congress.

IRS Still Auditing Executive Compensation

Over a year ago, the IRS announced that it was stepping up its audit program with respect to executive compensation. Frankly, any activity at all would have been a step up. For the majority of the time since we have had an income tax (and therefore an Internal Revenue Code) in the US, audits of executive compensation have been virtually nonexistent. Why? The biggest reason is that there have not been a whole lot of rules. Number two on the list is that the IRS has not chosen to place its resources there.

For many who are fortunate enough to be the beneficiaries of executive [levels] of compensation, the good news is that most are still not getting audited. However, with the interplay of Code Sections 83 (constructive receipt and the economic benefit doctrine plus some other related stuff), 162(m) (the million dollar pay cap), 409A (taxing people to death when they mess up their deferred compensation programs), and 3121(v) (FICA tax on deferred compensation), the IRS has plenty of things to audit. Surprisingly, at least to this writer, we're finding that they are catching people on some fairly tricky applications of the law.

Notably, I've seen or heard of multiple people getting dinged on these infractions:

• Stock awards that vest at a retirement date, causing constructive receipt under Section 83
• Linked retirement plans where the offset from the qualified plan is not well enough specified, causing a 409A violation
• Failure to pay FICA tax on deferred compensation that employers didn't realize technically was deferred compensation
• Improperly constructed performance pay plans that run afoul of 162(m) by not qualifying as performance pay
• Severance pay plans that did not have a 6-month payment delay for specified employees because they looked like broad-based plans. The fact that the compensation considered exceeded the pay cap (401(a)(17)) caused the problem.
• A 409A plan having a plan document that specifies for one set of administrative procedures, but the plan being administered the way it always was before someone wrote a document without bothering to check to see how it was being administered.

There are more, plenty more. There are a few ways that you can handle this.

• Do nothing and play audit roulette.
• Have your documents reviewed by someone other than the person who wrote them (the person who wrote them will read what they intended even if nobody else reads it that way).
• Have your administrative processes reviewed by someone who is not your administrator, but has experience with the administration of nonqualified deferred compensation plans.
• If you find problems, take corrective action. The IRS has been nice enough to give us corrective methods that lessen or eliminate the additional tax burden, but only if you fix them before the IRS catches you.

Make a New Year's Resolution: Get Your 409A Documents Cleaned Up

About a month ago, I wrote about a court case in which an incompletely worded 409A (nonqualified deferred compensation) plan document caused the court to award an executive more money than his previous employer thought he was entitled to. You can read my original piece on Graphic Packaging v Humphrey here: http://johnhlowell.blogspot.com/2010/12/its-extremely-important-to-have.html .

I've read more of these sorts of documents than most of you would prefer. And, the good news for employers is that most executives don't read those documents as carefully as I do. The bad news is that most that I have read do not satisfy (in some situations) the concept of definitely determinable (stealing the term from the qualified plan world).

What does that mean? The words speak for themselves ... I think the lawyers would call that res ipse locutur, although literally that means the thing speaks for itself (I see now why I took Latin in school about 40 years ago).  For a benefit to be definitely determinable, a person should be able to read the plan document and know what the amount of that benefit will be.

Let's return to 409A documents. If you've made it this far, there is a good chance that you know that "specified employees" (generally the highest-paid executives (not more than 10% of the company) making at least $150,000 as indexed, but it's actually far more complicated than that) may have a 6-month delay before than can receive certain benefits under a 409A plan.

Let's consider a simple situation. Suppose Ebby Scrooge is the CEO of No Holiday Corporation. Ebby retired just the other day on December 31, 2010. He had earlier made a bona fide initial deferral election in his SERP to take his benefit in a lump sum at termination (or 6 months later if he was a specified employee). Ebby's lump sum on December 31 would have been $10 million, but he was a specified employee.

Poor Bobby Cratchit needs to process the payment to dear old Ebby. He has a quandary -- how big should Ebby's check be? Does the $10 million get interest at some rate from December 31 until mid-2011? The plan document doesn't say. Does it get calculated using 12/2010 interest rates or 6/2011 interest rates, or some other rates? The plan document doesn't say. Does the annuity factor get calculated using Ebby's age as of 12/2010 or as of some other date? The plan document doesn't say.

Get the picture? In Humphrey, the 11th Circuit Court of Appeals (based in Atlanta and covering Alabama, Florida and Georgia) found that where the plan document (written by or under the control of the employer) is not clear, uncertainty should be decided in favor of the participant. Oops!

What do your plan documents say? Do you know?

I am about to be perhaps a little bit critical of some attorneys who write these plan documents. I'm sorry, some of you are my friends (but of course, my friends couldn't be the ones who are doing less than perfect work). Very few attorneys have ever worked in plan administration. They don't consider whether the language that they write is easy to administer, difficult to administer, or anywhere else on the spectrum. For many, it's just not in their DNA. Surely, you will see in the document that where found in the document, the male is to be considered the female and the singular the plural, but that inconsequential stuff about how much to pay the executive -- nowhere!

What's my suggestion? Attorneys are best at the legal mumbo jumbo, but where a plan must be administered, a company may save itself a lot of money by paying a little bit (relatively speaking) to have some non-attorney such as this author review the document to see if it can be accurately administered. Looking back to Ebby Scrooge, if it's an issue of a 5% annual rate of interest, then the increase in payment amount for the 6-month period would be $250,000. Of course, in some cases, the employer may not have the right to unilaterally amend this document, but that's an issue for another article on another day.

In the meantime, I'd love to take a look.

It's Extremely Important to Have Complete and Accurate 409A Documents -- So Says the 11th Circuit Court of Appeals

On November 16, the 11th Circuit Court of Appeals rendered its decision in Graphic Packaging Holding Corporation v Humphrey. You can read the decision here: http://scholar.google.com/scholar_case?case=7196368006507516478&hl=en&as_sdt=2&as_vis=1&oi=scholarr

Despite their growing numbers, most of us are not attorneys (I'm not) and don't revel in the reading of court decisions, so I'm going to try to save your eyes (and your brain) some serious pain. Rather than going through all of the court's legal reasoning, we'll look at this one from the proverbial 30,000 feet. In other words, we'll hit the high points and give you a VERY key lesson to be learned.

Mr. Humphrey was the President and CEO of Graphic Packaging (GPC) (or one of its predecessors) from 1997 through 2006 and served as its Vice Chairman in 2007. He retired from GPC on December 31, 2007 as a   specified employee (a term of art under Code Section 409A that usually requires that the employee experience a 6-month delay in payments from a nonqualified deferred compensation (NQDC) plan). Mr. Humphrey was a participant in such a plan, the"2004 Stock and Incentive Compensation Plan" under which he received a number of restricted stock units (RSUs).

Because the GPC stock declined in price over the period from December 31, 2007 until June 30, 2008, Mr. Humphrey's RSUs were worth less at the end of the 6-month period. When GPC paid him out his RSUs, they paid him the smaller amount.

Mr. Humphrey sued and the 11th Circuit Court of Appeals ruled in his favor.

Without going through all of the legal mumbo-jumbo, the court reasoned the following:

• Code Section 409A does not specify how the amount of  a payment should be calculated at the end of the 6-month waiting period for specified employees. It does not mention a valuation method or valuation date and does not mention the accrual of interest.
• The plan document did not specify how the amount of the payment should be calculated either.
• The company (or their counsel/advisers) wrote the plan document and the onus was on them to get it right.

So, the lesson is that an NQDC plan should answer these questions and answer them clearly and unambiguously. Do your plans do that? Many that I have seen do not.

Suppose they don't. Notice 2010-6 as amended by Notice 2010-80 (you can read about it here: http://johnhlowell.blogspot.com/2010/12/your-eyes-are-not-failing-you-we-have.html ) generally allows plan sponsors to amend their 409A plans by the end of 2010 without penalty (this is a generality and you should not assume that you have no penalty without a specific understanding of your facts and circumstances). A complication might occur if this was a material modification to the plan document, but as it will not uniformly improve the benefit for employees, my non-legal take on this is that it will not be a material modification. In either case, get your plan amended to say what it should say. Make sure that it is reflective of past practices and that future practices will follow the plan.

If I were in an employer's shoes, I would look to an expert for assistance with this, and not necessarily the attorney who drafted the plan. Attorneys are experts in legal issues, but often are not in plan administration and this particular issue has implications for administration. I would look to a consultant with knowledge of the law, knowledge of the administrative issues, and the ability to understand the issues.

As always, this author does not provide legal, tax or accounting advice.

Your Eyes Are Not Failing You -- We Have GOOD 409A News

The IRS and the Treasury Department have released Notice 2010-80: Modification to the Relief and Guidance on Corrections of Certain Failures of a Nonqualified Deferred Compensation Plan to Comply with § 409A(a) [of the Code]. You can read it for yourself here: http://www.irs.gov/pub/irs-drop/n-10-80.pdf

That's a lot of words, and you might have to be a cryptographer to figure out what it all means, but trust me, this is good news -- very good news. The regulators in Washington have read comments, and while other remarks -- both verbal and in writing -- have gotten no official observance from the regulators, this writer thinks that those remarks have been noticed as well.

So, what's the buzz, tell me what's a happening (apologies to Andrew Lloyd Webber for reusing his Jesus Christ Superstar lyrics in a slightly different context).

Here is a summary of the news:

• Documentary failures under linked nonqualified plans (NQ linked to other NQ and or NQ linked to qualified) are now eligible for relief under Notice 2010-6, so long as the linkage does not affect the timing or form of payments under the plans. For many companies, on a scale of 10, this relief qualifies as an 11. 
• Documentary failures for certain stock rights are now eligible for Notice 2010- relief.
• An additional method of correction is now available for certain separation payments that are subject to a release of claims, and this method is very workable.
• There is relief from the extremely onerous service provider (employee) reporting requirements for the Notice 2010-6 transition relief for "freebie" correction under Notice 2010-6.
• There is relief for service recipients (employers) with respect to the information that they need to provide to service providers (employees) for Notice 2008-113 corrections made during the same taxable year.

The fourth and fifth (last two bullets) may look like small potatoes, but I am aware of multiple Fortune 500 companies that chose to have 409A failures rather than go through the 2008-113 or 2010-6 correction processes because of the requirements to provide information. So, these small potatoes are actually bigger than the eye perceives.

On to the nitty-gritty ...

The Linked Plans Issue

In my experience, this was the worst provision of the 409A regulations. No practitioners that I work with saw this seemingly innocent failure coming. Let's consider two fairly simple and common types of failures.

Example 1. Company A provides Executive E with a qualified defined benefit plan under which E is entitled to an annual benefit not to exceed the 415 limit of 1% of 5-year final average pay (not in excess of the pay cap) per year of service. A also provides E with an 'excess' plan (nonqualified) under which E receives an annual benefit under the same formula, but without regard to the 415 limit and pay cap, and further offset by the qualified plan benefit. 

Pause for a slap on the wrist.

Now, suppose that E has elected a lump sum payment upon separation from service from the nonqualified plan, but that the amount of this lump sum could be affected by the timing and form of the qualified plan payment. This appears to violate the 409A regulations, and there was no fix available under Notice 2010-6. Notice 2010-80 allows for correction under Notice 2010-6.

Example 2. The facts are the same as in Example 1, except that E does not have a lump sum option in the excess plan, but E also participates in a top-hat plan (SERP) with a richer benefit formula (offset by all other defined benefits) that does have a lump sum option. E has made a bona fide initial deferral election in the excess plan to take a 50% Joint and Survivor Annuity (with his wife as beneficiary) and a lump sum on the last day of his tax year following or coincident with separation from service from the SERP. 

Here we appear to have two violations of the 409A regulations, so pause for 40 lashes.

Again, Notice 2010-6 would not have allowed for correction of this 'defect', but Notice 2010-80 amends Notice 2010-6 to allow for such documentary corrections.

Separation Payments Contingent on Employment-Related Actions

This is another biggie. Again, Notice 2010-6 is amended by allowing for additional methods of correction. Suppose the service provider (again, this is usually the employee) needs to complete certain action(s) such as executing and submitting a non-compete in order to receive his separation payments. Paying the benefit upon separation from service eliminates the teeth in the non-compete; that is, the service provider could take his payment and decide to not sign the non-compete. Delaying payment violates 409A. 

But now, the fix is in, and it's a good one. The document can be amended to allow for payment [in general terms] either 60 or 90 days following the separation (permissible payment event) so long as in the event that the 90-day period spans two taxable years, the payment will be made during the second of those taxable years.

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There's more -- of course there is -- much more in the Notice, but this should give you an overview of what I think readers may need to know. This stuff is pretty complex though, especially on the defined benefit side, and if you are dealing with it and don't have the in-house expertise (most companies don't), I suggest that you engage someone who is expert in both defined benefit plans and nonqualified plans to help. But, I repeat, this is good news. 

Don't wait. Act quickly. Get these things fixed.

The author is not an attorney or accountant and does not provide legal, accounting or tax advice.