The IRS
recently launched a limited audit effort to gauge how well nonqualified
deferred compensation plans are complying with the tax Code. My understanding
is that the number of companies to be contacted will be less than 100. The IRS
will use this effort to refine its audit techniques in three areas of nonqualified
deferred compensation:
- Initial election to defer compensation
- Subsequent election to defer compensation
- Eventual payment of said compensation
Before
proceeding further, let’s define the “nonqualified” part of this term. Someone
is deferring compensation. Perhaps someone (say, Tom Brady) is earning $15
million this year, but some or all of it will not be paid until some future
date. It happens all the time, and the IRS has limited “preapproved” ways to do
so. The classic way is stock options, for example.
Deviate in
any way from the IRS-preapproved road, however, and the plan is referred to as “nonqualified.”
I use nonqualifieds on a common basis, as they allow more flexibility
in their planning and implementation than qualifieds. There is no connation of good or bad to being
“nonqualified.”
The IRS is looking
at Section 409A, a particularly nasty Code section.
What was the
purpose of Section 409A? Let’s go back to 2000 and 2001. We are now talking
about Enron, an energy and commodities company headquartered in Houston and one
of the most scandalous business frauds of all time. Enron executives pushed
their way to the front of the line by accelerating the payout of their deferred
compensation before the company went under. You may recall that the average
employees were blocked-out of their 401(k)s, with the result that they saw
their retirement dwindle if not evaporate while company fat cats, like Kenneth
Lay and Jeffrey Skilling, walked away
with wheel barrels full of cash.
How did it
evaporate? There were two primary drivers:
(1) Enron made its 401(k) matching
contribution with company stock. Then it put in a lockdown, preventing
employees from selling that stock until age 50.
(2) Enron decided to transfer the
administration of its 401(k). Unfortunately, this occurred during the period
the stock collapsed, and employees were preventing from selling their stock
even if they could and wanted to.
The truth of
the matter is that many companies, not just Enron, use their own stock to fund
a 401(k). For example, Coca Cola employees keep more than 80% of their 401(k)
assets in Coca Cola stock. At Proctor & Gamble, the percentage is over 90%.
So what we
have is an issue of corporate 401(k) matching, as well as an issue of the
interregnum between plan administrators. That was not sufficient for Congress,
which loves nothing more than a good scandal (unless it is their own, of
course). In response, Congress passed Sarbanes-Oxley in 2002. It then passed
the American Jobs Creation Act – containing Section 409A – in 2004.
Congress was
after deferred compensation.
Section 409A
starts off easy enough: it applies to any “plan” that provides for the
“deferral of compensation” to “service providers.” A “plan” does not need to be
reduced to writing, and “”service providers” can included independent
contractors as well as employees. “Deferral” means any payment (to which a
service provider has a legally binding right) that may be received in a future
tax year.
STEP ONE: Carpet bomb. Look for
survivors later.
The IRS had
to start excluding something, otherwise this thing was going to dragnet
everything- think accrued sick leave or accrued vacation pay - into its wake.
Remember: any compensation not paid IMMEDIATELY could potentially detonate this
tax trap.
It didn’t
matter how much money you made, either. This thing was not limited to the big
wigs. Section 409A swept up the small and large alike.
How
ridiculous does this go? A number of years ago the IRS decided that schoolteachers
were violating Section 409A by deferring their salary over 12 months rather
than being paid over the 9 months comprising a school year. Let that sink in: the
IRS felt driven to protect Americans from the rapaciousness of schoolteachers
wanting to budget their salary over 12 months.
NOTE: The IRS received so much bad press that it was forced
to reverse its position. That was fine, but a more cogent question was whether the
law was so deeply flawed that its logical progression inevitably led to absurd
results.
Therefore,
the IRS gave us a few exceptions, including:
· “Short term deferrals”
o
This
means being paid by March 15 of the following year
· Qualified plans, which means pension
and profit-sharing plans, including your 401(k)
o
Obvious
· Certain welfare plans, such as vacation
and sick leave plans
o
Obvious
· Grants of incentive stock options (ISOs)
and employee stock purchase plans (ESPPs)
o
Have
their own rules
· Options to buy the stock of the
service recipient, but only if the exercise price is not less than the market
value of the stock on the date of grant
o
This
means that – if you work at P&G and can buy P&G stock through a plan, you
had better pay full retail price. If P&G gives you a discount – say you buy
for 90 cents on the dollar – the IRS sees this as a “feature for the deferral
of compensation.”
What happens
if you are pulled into this thing?
· The plan better be in writing
· You better make a timely election to
defer
· Distributions to you may only be made
upon occurrence of six IRS-approved events
· You better not be able to accelerate your
deferred benefits
What is a
timely election? It is not what you may think. Timely in this context means
“before you earn it.” For example, if your 2014 bonus is payable in 2015, you
had better have your election in place in 2013.
What if you
want to make a change to an existing deferral?
· The payment must be deferred for at
least another five years
o
So
if you were to start in 2017, you can now start no earlier than 2022
· And you better make this change at
least 12 months before the payment was scheduled to be paid
What do you
have to do to get to your money?
· Death
· Disability
Good grief!
What else have you got?
· Separation from service
This means
you have to be fired.
· Change in control
This means
that there is a change in ownership or control of the company. I suppose you
could sell the company AND get yourself fired, just to be certain.
· Unforeseen emergency
Think
illness or accident or property loss. Even then, you have to show that expenses
could not otherwise be met by insurance or your liquidation of other assets.
Goes without saying that amount of distribution is limited to the amount needed
for the emergency, plus taxes.
· Date certain or fixed schedule
Finally,
here is the heart of the matter. The IRS wants you to select when the deferred
monies are to be paid and how (lump sum, series of payments) and then stick to
it. It wants you to decide this way ahead of time, and then severely penalize
you if later life events cause you to change in your mind.
What happens
if you botch it? Well, Section 409A will
kick-in.
· There is tax on the distribution
· There is interest (called a
“stinger”) equal to the regular underpayment rate plus 1%
· There is a 20% penalty
What if you take
a distribution early? Bam – you have tax, interest and penalty.
What if you
do not do anything wrong, but the company flubs the paperwork? Bam – you have
tax, interest and penalty.
Can you say lawsuit?
That 20%
penalty is not calculated as you would expect, either. A reasonable person
would anticipate the penalty to be 20% of the tax, or possibly 20% of the tax
plus the stinger. It is not, however. The penalty is 20% of the deferred balance,
whether received by you or not.
STEP TWO: Bayonet the survivors.
What if you
are in several plans simultaneously and one goes south? Does one plan
contaminate the other?
Of course it
does.
STEP THREE: Repeat steps one and two.
So what did
Congress really accomplish with Section 409A?
· Inability to distinguish
publicly-traded from privately-owned
I scratch my
head why Congress thinks that my auto mechanic down the street can get himself
in the same trouble as a Humana or a General Electric.
Publicly-traded
stock is almost like cash. These companies can buy other companies with it.
They can pay employees with it. They can fund retirement plans with it. They
can … well, they can play Enron with it.
A privately-owned
company however cannot. Privately-owned
companies are playing with their own money. Even the most reckless take a pause
when reaching into their own wallet. A publicly-traded executive is closer to a
Washington politician than any of the business owners I am likely to represent.
· Crippling tax bombs for the unadvised
Change your
deferral payment date 363 days – rather than 366 - before scheduled payout and
risk tax annihilation.
Does
Congress expect that every businessperson can keep a tax attorney on retainer?
· Yet another tax “industry”
There are
advisors out there specializing in Section 409A. There has to be. You could endanger
a large company by implementing a faulty plan.
However, this
is not quite the same contribution to the economy as Steve Jobs introducing the
iPhone, is it?
· Insinuation into routine business
transactions
We have a
client who recently hired a business development manager. Their intention is to
grow the company for 7 or so years, then sell out. It is their retirement
program of sorts, I guess. The deal with the development manager includes
deferred compensation, driven off year-over-year business growth and eventual
sale of the company. What should be a routine tax matter now requires a Section
409A specialist, to be sure the employment package doesn’t blow up.
You want an
alternative to 409A? How about this: all accelerations of executive deferred
compensation (remember: Enron was only about acceleration) have to go to a
shareholder vote. While we are at it, let’s lock down the executives for the
same period as the rank-and-file are locked out of their 401(k)s.
And if Enron
was caused by acceleration, why does 409A penalize additional deferrals?
What is the point?
So the IRS
is going to be looking at 50 – to 100 large companies to check on their 409A
compliance. I suspect these companies will be fine, as they have the people, resources
and advisors to navigate Section 409A. I would give you a different answer were
the IRS to train its attention on privately-owned companies, however.