Deferred compensation 101

Finacially Sound

by Mark S. Ritter

October 23, 2007

For the first time, businesses – large and small – will have  the first comprehensive set of guidelines concerning deferred compensation.

A deferred compensation plan is considered by man executives to be the Holy Grail of compensation arrangements. Under these plans an executive earns an amount of pay in one year, but does not receive the pay or incur income tax on it until a subsequent year.

These plans may be used for a variety of purposes, including retirement, severance/separation, life-event planning and general tax planning.

Of course, if income tax recognition is not successfully deferred, the plan does not achieve its purpose. (Who, after all, would want to pay income tax this year and receive the income next year?) Also, there are new tax rules that impose additional tax penalties over and above "regular" income tax where there is a compliance failure. This article is about avoiding such compliance problems and ensuring that your deferred compensation plans successfully defer income tax recognition until it was intended. The new deferred compensation rules (Section 409A) have resulted in a lot of commentary and discussion. So much so, in fact, that it can be difficult to sort through all of the technical material just to figure out exactly what you need to do to get into compliance.

As with any complex area of tax regulation, it's important not to lose sight of the overall picture as you work your way through the technical details. A seven-step process outlined below may help, but the important point is that you should take an organized, thorough approach to ensure compliance and take all required actions by the deadlines.

The rules apply to virtually every aspect of deferred compensation, including deferraland manner of payments. When it was first enacted,it was clear that a number of questionswould have to be answered before the rulescould be applied in many specific situations. Itwas equally clear that employers (now called"service recipients") would have to makemany changes to their existing arrangements and practices to conform to the new rules.

The Internal Revenue Service responded by issuing transitional rules and guidance while final regulations were being written to cover the specifics of the new rules. Since Jan.1, 2005, service providers (such as employees, independent contractors and board members) and service recipients have been in a transitional period where good-faith compliance and transitional rules have governed.

The transition period ends on Dec. 31. The final regulations become effective Jan. 1, 2008,and employers have to be in compliance by the end of the year.

Here are the steps Grant Thornton recommends that you follow in preparing for the deadline:

Step 1:

Make a thorough inventory of all deferred compensation arrangements at your company. This first step may be the most important because so many types of arrangements fall within the broad definition of deferred compensation. First, consider all service providers to your company – employees, independent contractors and board members. Second, identify any arrangements with those service providers that are considered deferred compensation. Deferred compensation is created if a service provider has a legally binding right during one tax year to compensation that is or may be payable in a later tax deferred compensation plans. The definition also includes such arrangements in employment agreements and letters, contractors' and directors' agreements and verbal agreements to defer payment of compensation until a future date.

Some arrangements may fall under a specific exemption, and some arrangements created before 2005 may be "grandfathered out" of coverage by the rules. However, all other arrangements are subject to the new rules. The exceptions from coverage are very technical, and it's a best practice to assume any such arrangements are covered pending a careful review to see if any of the exceptions apply.

Step 2:

For each arrangement identified, decide between removing the deferral of compensation and complying with the rules. It's worth considering whether the costs of compliance (and the risk of mistakes) are worth it in the first place, and you can elect to simply stop deferring compensation – for a while. The deadline for making this decision, and implementing it, is Dec. 31. Beginning next year, any arrangement that defers compensation is subject to the rules and penalties for noncompliance, even if you later eliminate the deferred-compensation feature.

Step 3:

Design each arrangement to comply with the rules. This may be the most technical step, and the rules concerning such areas as deferral elections, funding and distribution timing will need to be considered. In some cases, you may wish to consider the advantages of including some of the available exceptions to the basic rules weighed against the more complex plan administration.

Step 4:

Develop and implement policies and administrative procedures. Even with a properly designed arrangement, there is a risk that it will not be administered correctly. The final regulations contain many detailed develop clear and specific policies and procedures to assist those administering the plan, and you should appoint one individual with overall responsibility.

Step 5:

Prepare a written plan document  by Dec. 31. Although businesses were supposed to be in compliance by Jan. 1, 2005, written documentation was not required. It will be, starting next year. All deferred compensation arrangements must have written documentation by the end of 2007. The final regulations specify the required content for a written plan.

Step 6:

Obtain written service provider elections as to time and form of payment by Dec. 31. There are a number rules concerning service providers' payment elections that should be reflected in these elections. In addition, you should note that an election to postpone a payment otherwise payable in 2007, or to accelerate a payment into 2007 otherwise payable in a future year, is not permitted.

Step 7:

Evaluate your compliance situation for the period between Jan. 1, 2005, and Jan. 1, 2008. As mentioned previously, deferred compensation arrangements have been required to operate in good-faith compliance with rules since Jan. 1, 2005. An important last step is to review your operational compliance during the transition period to determine any necessary corrective actions that might be required.

Severe penalties are imposed on service providers if a deferred compensation arrangement fails to comply. The deferred compensation under the arrangement is taxed immediately using regular income tax rates, plus a 20 percent penalty tax and interest.

Therefore, achieving compliance through the type of careful process outlined above is very important.