Benefits trim

Benefits trim

by Beth Ewen  

A new section of the federal tax code, 409a, governs the deferred compensation plans that are popular among small businesses. Everything from bonus plans to phantom stock to severance agreements need scrutiny to comply by December 31. Wendy Citron, an employee benefits expert with Halleland Lewis Nilan & Johnson in Minneapolis, explains.

Upsize: I understand the new wrinkle in deferred compensation is 409a. What is it?

Wendy Citron: 409a is a new section to the tax code. It’s effective the first of this year, 2005, but employees have until Dec. 31 of this year to change their deferred compensation plans. There are some exceptions to the deadline.

Upsize: How significant is it?

Citron: It’s the first time there’s been any Internal Revenue Code regulation over deferred compensation.

Upsize: Summarize the difference.

Citron: In the past an executive could say, “I’ll turn my back on this amount of compensation. I’ll defer it.” They might wait until retirement when they’ll be in a lower tax bracket, or they might want it when their now-young children go to college. Before these rules, that executive won’t be taxed on that deferred amount.

409a is changing that so you’re taxed when you’re eligible to receive it. Then you would have taxation without receipt.

Upsize: Never a good thing.

Citron: That is not the situation executives want. There are exceptions and safe harbors, complicated rules. We’re waiting for the final guidelines.

Upsize: Do many small businesses have deferred compensation plans in place?

Citron: Usually with a small, family-owned business, they will have a business planner who will arrange something like this for the proprietors, so the business can be passed on yet there are retirement savings available.

Also, if people want to entice people to leave a more established firm to come to their startup, they’ll give stock options. This happened a lot in the late 1990s, early 2000s, when people were anticipating that big IPO or initial public offering. They’d give stock options, phantom stock, ISOs or incentive stock options.

A lot of executive compensation falls under the new rules. Stock appreciation rights are considered being under 409a.

Upsize: Is that why the IRS got interested, when deferred compensation became so popular?

Citron: I think that was part of it, the IPO binge attracted the attention. People got creative. Before, boards would put these deferred compensation plans into place, with a really minor restriction, or they had what’s known as a haircut provision. They said, “You could receive this at 65, but you could get it now with a 10 percent discount.”

Upsize: So no more haircuts are allowed under 409a.

Citron: No. If the employee has the choice to get the money now, they pay taxes now.

Upsize: Does this apply beyond stock options and phantom stock?

Citron: It’s really broad. For example, it could include provisions in severance plans. Bonus programs, too. We had done some work for brokers, for example. To the extent that employees have the ability to control when they get compensation, if they can get it now it will be taxed now. It can affect change of control agreements, too.

Upsize: So what should business owners do?

Citron: You have to go back to whatever year those agreements were put in place, and re-examine them.

Upsize: What are the key areas for employers to address?

Citron: No. 1, any kind of executive employment agreement. Look at the provisions around deferred compensation.

No. 2, stock appreciation rights, phantom stock or non-qualified stock agreements. Look at those carefully. Most non-qualified stock plans have safe harbors.

No. 3, severance plans is another big area. If you have a qualified plan, a 401k, say, and then you have an excess plan for higher paid employees, you need to look at that.

No. 4, bonus plans, especially if the plan is set up to preserve capital. Any time you have bonus plans starting after the first 2 1/2 months of the next year, the safe harbor, you have to look at it.

Upsize: A lot of small firms spread their bonuses throughout the year for cash flow. So they’d be subject to the changes?

Citron: You can frame performance bonus plans so they comply with 409a, but employees will have less flexibility about when they can take the money.

The other problem that smaller employers have is, these non-qualified deferred compensation plans are unfunded, quote unquote, by law. A lot of companies, they set up a rabbi trust to fund it.

Upsize: Why “rabbi”?

Citron: The first one was done for a synagogue. The funds are for that deferred compensation plan, but creditors would have first access to it in the event of a bankruptcy. Larger employers have a whole lot more money in those trusts than smaller employers. A lot are saying, “this is too much of a headache.” Some are saying, “let’s just pay employees more now and forget about deferred comp.”

Upsize: But isn’t deferred compensation a good tool to attract and retain people?

Citron: Small employers are trying to match whatever plan those key employees walked away from, when they were at a large company.

Upsize: Many of these factors, like the greater ability of a large corporation to fund a deferred compensation plan, have been in place a long time. Why are employers now saying, it’s too much.

Citron: It’s all the new requirements you need with 409. You need to re-do all your plans, re-sign contracts with your executives.

Upsize: What would you tell small employers to do now?

Citron: First, identify plans and arrangements in place, and communicate with employees that changes are afoot. Many companies are worried about re-negotiating with their key employees. They’re anticipating a contract battle. They’re sick that they have to go to their CFO, and say they have to change the agreement, that they’re re-opening negotiations. But they have to, and they’re protecting the employee from big tax burdens, so emphasize that point.

Second, start deciding if you want to keep current arrangements in place with a frozen plan (you can freeze the old plan, but it’s complicated) and then start a new plan, or start completely fresh.

Upsize: What’s the net effect?

Citron: It’s less choice, less options. It’s more standardized. Also the IRS wants to see where the money’s going, so the reporting of money becomes necessary and tracking it over time.

Upsize: It’s a big impact on the employee, to be taxed at a current rate rather than later?

Citron: That can mean more than a 20 percent cut in compensation. This is something very significant to individuals’ plans.

Upsize: Do you recommend small employers abandon deferred comp?

Citron: You can still do deferred compensation. It’s still a good tool to attract and retain. But try to keep it more simple. Things that are pushing the edge, you never want to be the test case.

Here’s an example. Many boards will have the ability to waive the vesting requirements in a deferred compensation plan. But if the key employee could influence the board on that waiver, the compensation may be considered to be under the employee’s control, and thus be taxed now. Those ‘waiver’ type of provisions may be in the current contracts, and it’s borderline. I’d advise not being near the border.

Upsize: You mentioned earlier that guidelines are still pending.

Citron: There will be guidance from the IRS by this fall, so stay tuned, and stay in touch with your attorney and accountant. You have to start working on this, especially if you need board approval, because you don’t want to be scrambling around at the end of the year.

[contact] Wendy Citron is an attorney with Halleland Lewis Nilan & Johnson: 612.573.2973; wc*****@*******nd.com; www.halleland.com