Proposed Legislation and Nonqualified Deferred Compensation Programs

FINANCE

Corporate Finance

Proposed Legislation and Nonqualified Deferred Compensation Programs

By Catherine L. Creech

Over the past two years, Congress has been considering legislation that would require significant changes in the design and operation of nonqualified deferred compensation arrangements. While the details are always subject to change until final passage, the tax-writing committees in the House of Representatives and the Senate appear to have coalesced around several key proposals. If the legislation is enacted—which seems likely at this writing—it will make fundamental changes to the constructive receipt and economic benefit doctrines that have existed for more than 60 years in designing nonqualified deferred compensation plans.

Political Landscape

There is precedent for Congress to use the IRC to address perceived problems in executive compensation. In 1988, Congress first enacted the golden parachute tax on executive pay. IRC section 280G denies the corporate income tax deduction for “excess” payments contingent upon a change in control of a public company, and IRC section 4999 imposes a 20% excise tax on such payments. In 1993, with IRC section 162(m), Congress enacted the “million-dollar deduction limit” on compensation paid to top executives of public companies. More broadly, the Sarbanes-Oxley Act of 2002 imposed fundamental corporate governance and reporting changes and, in response to reported abuses, section 402 of the act imposed potential criminal sanctions for corporate loans to top
executives.

The changes currently being proposed are born out of the same concerns that led to the Sarbanes-Oxley Act. They have been developed in the wake of a series of highly publicized corporate governance scandals, the reported proliferation of corporate tax shelters, and the perception in some quarters that uncontrolled executive compensation may be at the root of both. Arguments pointing to longstanding principles on constructive receipt and cash-basis accounting, which underlay the structure of most deferred compensation arrangements, have not been compelling in the current atmosphere, where both political parties have adopted a more populist stance on the topic.

The high-water mark for such views is illustrated in the Joint Committee on Taxation’s report on the Enron Corporation. The focus of the Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS 3-03, February 13, 2003) was on Enron’s tax returns and purported tax-shelter transactions, but the report also contains more than 200 pages discussing in detail Enron’s compensation practices. The facts described in the report suggest that while the overall compensation paid at Enron was perhaps startling in terms of dollar amounts, the structure of these arrangements, in particular the nonqualified deferred compensation arrangements for executives, was not particularly aggressive.

Nonetheless, the Joint Committee is highly critical of Enron’s practices in this area and suggests, among other items, that executives should be currently taxable on compensation if they had a choice as to the timing and form of their payouts, a choice as to the investment medium for determining their benefits, and if they were covered by a “rabbi trust.” (A typical rabbi trust pays future compensation to employees or independent contractors. The employer owns the trust pursuant to the grantor trust rules, and trust assets are subject to the claims of the employee’s creditors, enabling any trust income to be taxed to the employer.) Because some perceive Enron as synonymous with lax corporate governance and executive wrongdoing, the Joint Committee’s report may fuel the perception that nonqualified deferred compensation was being abused by corporate executives and that the rules governing these arrangements needed significant tightening.

Legislative Proposals

The current legislative proposals pick up a number of the aforementioned themes. The two leading proposals are H.R. 2896, The American Jobs Creation Act of 2003, sponsored by Rep. Bill Thomas (R-CA), chairman of the House Ways and Means Committee, and the National Employee Savings and Trust Equity Guarantee Act (Nesteg), sponsored by Senator Grassley (R-IA), chairman of the Senate Finance Committee.

Plans covered. The legislation would apply to any plan, agreement, or arrangement that provides for deferral of compensation, other than tax-qualified plans, annuities, and IRAs. All nonqualified arrangements for tax-exempt and governmental employers, which are governed by IRC section 457(f), would be subject to these rules. Only qualified section 457(b) arrangements for governmental employers are exempt. Thus, section 457(b) arrangements for tax-exempt employers would be subject to these rules, a rather odd result given the statutory limitations already in place.

Covered individuals. The proposals appear to apply to all employees covered by nonqualified deferred compensation arrangements. In contrast to prior legislative proposals, they are not limited to insiders or Rule 16 officers, except for some specific distribution rules discussed below. It is unclear whether these proposals are intended to apply to nonemployee remuneration, such as directors’ fees.

Deferral elections. Deferral elections would be required prior to the year in which the services are performed or as provided in regulations. A special 30-day grace period is provided for new participants in a deferred compensation plan. These provisions would require significant changes in practice, particularly with respect to annual bonuses that typically are scheduled to be paid in the following February or March and for which deferral elections often are not filed until sometime in the year that the service is performed.

Rabbi trusts. One significant change from prior legislative proposals is that the legislation would make no apparent changes related to domestic rabbi trusts. Employees would, however, be subject to current taxation on benefits to the extent that assets could be removed from creditors upon a “change in the employer’s financial health.” Foreign rabbi trusts, however, would be eliminated under the legislation, because assets held in such trusts would be currently taxable to U.S. persons who are beneficiaries. Assets in such an arrangement would be treated as property transferred under IRC section 83 to the extent that assets set aside for deferred compensation are “located outside of the United States.” As a result, employees who are beneficiaries of such arrangements would be taxed currently when they are no longer subject to a “substantial risk of forfeiture” (i.e., they are “vested” in their benefits). Employees performing services abroad have no statutory exception, but the Treasury would have authority to provide further exceptions by regulations.

Timing of payments. The proposed legislation would require payouts on a fixed schedule or upon attainment of a specified age. Accelerated payments would be barred except on “separation from service” (it is unclear whether this is intended to be a broader concept than termination of employment), death, disability (as defined in the Social Security Act), or upon a change in control or an unforeseeable financial emergency. In addition to the rule against accelerations, the provisions would allow only one “second election” to delay a payout or change the form of the payout provided that the “second election” is made at least 12 months prior to the scheduled payout date, and provide for an additional deferral of at least five years. There is no requirement that the second election be made prior to a termination of employment. It appears that the second election rule would adversely affect the typical situation in which a participant changes from a lump sum to installment payments prior to retirement. Presumably, a change to installments would satisfy the rule only if the election delayed the commencement of any installment payment for five years. In addition, any “key employee” of a publicly held company would be required to wait six months for any payment. For these purposes, IRC section 416(i) defines a key employee as a top-50 officer with compensation in excess of $130,000, a 5% owner, or a 1% owner with compensation in excess of $150,000. This definition likely encompasses a broader group than a Rule 16 insider for purposes of the Securities and Exchange Act.

Because no acceleration of payments would be allowed, the legislation would eliminate “haircut” withdrawal rights, which typically allow a participant in a nonqualified deferred compensation plan to voluntarily take a withdrawal at any time, subject to the payment of a financial penalty. In contrast to H.R. 2896, Nesteg prohibits payouts to insiders within the meaning of Rule 16 of the Securities and Exchange Act for one year following the change in control, and such payments would be treated as “excess parachute payments” under IRC section 280G and be subject to the 20% excise tax under IRC section 4999.

Investment elections. Under Nesteg, but not H.R. 2896, investment elections under a nonqualified deferred compensation plan would be limited to those that are “the same” as the employer’s qualified plan, which raises numerous practical and administrative questions. Nesteg also includes a prohibition against investments in hedge funds, brokerage windows, and fixed rates of return above what is commercially available.

Deferral of stock option gains. Nesteg, but not H.R. 2896, would impose current taxation on the present value of any right to receive deferred compensation benefits if a taxpayer exchanges an option or “any other compensation based on employer securities” for a right to receive future payments. There are numerous technical questions about the scope and application of these rules, because options typically are not “exchanged” for deferred compensation. There are also questions as to whether this exchange rule might be triggered if a deferred compensation plan includes phantom stock or stock units and an employee elects to change investment elections (if permitted under other provisions of the legislation).

Taxation. If a plan violates the aforementioned funding or payout rules, the employee would be immediately taxed on the amount deferred. If a change in a plan violates the payout rules, then the affected employee also would be subject to interest at the underpayment rate as if the deferred compensation had been included in the employee’s income on the earliest date that the employee was vested in the benefit. Moreover, the provisions of Nesteg impose an additional penalty of 10% on deferrals that violate the new rules. It appears that violating the payout rules could result in current taxation and interest payments only for affected employees and not taint all employees under the plan, but this is subject to interpretation.

Repeal of guidance moratorium. Nesteg, but not H.R. 2896, would repeal the moratorium on IRS and Treasury guidance on deferred compensation, which would potentially open the door to more regulatory changes. The moratorium dates back to 1978, the introduction of proposed Treasury Regulations section 1.61-16, which would currently tax any amount that an employee voluntarily deferred from salary or bonuses (other than qualified plans). Under that proposed regulation, the assignment of income doctrine would apply when the employee made the election to defer. The Treasury Department has stated that it would not finalize the regulation if given authority in the future. In section 132 of the Revenue Act of 1978, Congress directed the Treasury Department and the IRS to tax deferred compensation arrangements under the principles in place on February 1, 1978 (just prior to the issuance of the proposed regulation). Section 132 has not precluded the IRS from continuing to develop its own ruling positions (e.g., Revenue Procedure 92-64, on rabbi trusts, and Revenue Procedure 92-65, on the timing of deferral elections).

Nesteg would lift the moratorium altogether but preclude the Treasury Department from finalizing the 1961 proposed regulation. In contrast, H.R. 2896 would not technically eliminate the moratorium, but it would give the Treasury Department authority to prescribe regulations necessary to carry out the proposal, including specific authority to write rules: valuing the amount deferred under a nonelective, defined benefit–type arrangement; defining change in control; exempting arrangements from the offshore trust rules if they do not result in an “improper deferral”; and disregarding any substantial risk of forfeiture where necessary to carry out the purposes of the legislation. This last item is curious because the Treasury Department already has authority to regulate what constitutes a substantial risk of forfeiture under IRC section 83 and query what this additional authority is intended to provide.

Implementation

The legislation, as drafted, would apply to deferrals after December 31, 2003. H.R. 2896 clarifies that deferrals and earnings thereon made prior to January 1, 2004, are grandfathered under this legislation. The Treasury Department is directed to provide guidance allowing individuals to cancel outstanding deferral elections for amounts earned during 2004 if such amounts would be subject to current taxation. Deferrals for 2004 payments also are grandfathered to the extent that they were deferred under a binding election made before October 24, 2003. Presumably, these dates were inserted on the assumption that legislation would be enacted in 2003, and are subject to change.

Catherine L. Creech, JD, is a partner of the law firm of Davis & Harman LLP, in Washington, D.C.