New Deferred Compensation Rules for 2006

Posted by: Rod Kurtz on August 11, 2006

When IRS Code Section 409A was initially enacted in October of 2004, it provided some short-term relief for employers, who could put off (for a few months) the task of figuring out and adhering to the new guidelines regarding deferred compensation. However, by early 2005, the deadlines were sneaking up fast, and employers were desperately trying to make sense of the new rules.

Read the full story at AllBusiness.com.

When IRS Code Section 409A was initially enacted in October of 2004, it provided some short-term relief for employers, who could put off (for a few months) the task of figuring out and adhering to the new guidelines regarding deferred compensation. However, by early 2005, the deadlines were sneaking up fast and employers were desperately trying to make sense of the new rules.

Now, in 2006, some explanations are still necessary. The new rules involve much more than just deferred compensation plans. Also included are:

* Stock options
* Employment or severance agreements
* Supplemental executive retirement plans
* Change in control agreements
* Reimbursement agreements
* Bonus plans
* Arrangements with nonemployees for deferred payment

Employers will now have to provide full and formal documentary compliance of all such affected arrangements by the end of 2006. This also provides an opportunity for employers to amend or terminate all deferred payment plans by requiring the affected employees to essentially "cash out" before the end of 2006. In the meantime, any such deferred compensation agreement is to be operated in "good faith" compliance with the provisions of Section 409A.

There are several new rules included in Code Section 409A that came into effect as of January 1, 2005. For example, distribution of such deferred compensation must be made on a date designated at the deferral election. The only exceptions (or reason to change the date) are in the case of an employee who is no longer in service with the company, has become disabled, died, or had an unforeseen personal emergency. Other key rules state that deferral elections must take place prior to the year in which the compensation is earned, and assets which will be used as compensation must remain in the United States and not overseas.

Many gray areas still exist, which is part of the reason why the IRS is allowing business owners all of 2006 to make adjustments or terminate deferred compensation agreements altogether. For example, in public companies, key employees severance pay must be delayed for six months after they leave the company. The same holds true for Change of Control agreements. The question in this case is how one defines a "key employee." Bonus plans must now be paid in a timely fashion so they will not be considered deferred payment. ("Timely fashion" is not clearly defined at this time.)
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Valuation, used for stock options, is also under much tighter scrutiny. Stock options can no longer be issued with exercise prices that are lower than the fair market value on the date they are granted. Reasonable methods for determining valuation must be used prior to issuing a stock option. Such a reasonable valuation method must include all available information that relates to the value of the company's common stock, including the value of tangible and intangible assets, the present value of future cash flows, and the market value of common stock issued by similar companies.

The penalties are strict for not conforming to the new deferred compensation rules as governed by IRS Code 409A. If a compensation arrangement does not meet the requirements, and has not already been taxed to the employee, taxes will be included in the individual's gross income for the current year with a high rate of interest. In addition, a 20 percent tax will be added on. These penalties can amount to more than 50 percent of the money deducted before the employee ever sees the cash.

Therefore, it is advisable that business owners and employees designate some time prior to the December 31, 2006 deadline to review and consider renegotiating any agreements that include deferred compensation. Meetings with accountants and attorneys should be arranged with particular attention given to amending current deferred compensation agreements. In addition, valuation should be carefully based on reasonable valuation methods. In the future, employers may consider giving shares of stock rather than stock options. For more information on IRS Code Section 409A, go to the IRS Web site or contact your tax specialist.

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