RSM Resources

Nonqualified deferred compensation plans remain a valuable tool for midsized companies to attract and retain key talent, despite some rule-tightening under the American Jobs Creation Act of 2004.

A nonqualified deferred compensation plan is an employer-sponsored benefit for retirement or other purposes. It allows an employee to defer receiving taxable wages or bonuses, including cash or stock,until a future time when the employee anticipates moving to a lower tax bracket— thereby paying lower taxes on the income.

Companies typically offer nonqualified deferred compensation to executives or highly compensated employees to offset IRS limit son qualified plans such as 401(k)s, supplement other retirement plans,encourage behavior aimed at long-term performance goals or provide voluntary deferred compensation. There are no limits on contributions.

Under the jobs creation act, establishing and maintaining a nonqualified plan remains relatively easy but is subject to three requirements. Deferred compensation:

• Must be arranged before the employee earns the income.
• Can be distributed to the employee only after an agreed-to future date.
• Cannot be protected or secured against creditors in the event of corporate bankruptcy or liquidation — although sponsors can set aside funds to meet future deferred compensation obligations.

What’s new
The American Jobs Creation Act restricted nonqualified plans in several significant ways:

• Eligible employees must make nonqualified plan deferral elections before the taxable year in which they earn the designated compensation. Some allowance is made for deferrals of long-term (12 months or longer) bonus awards. Participants must make such deferral elections not less than six months before the end of the bonus period. Also, the plan document or initial election form must set the deferral period and distribution method (installments or lump-sum).
• Upon making a distribution choice, the employee cannot choose to accelerate a distribution, and any decisions to defer distribution must provide for a deferral of at least five years.

Previously, an employee had to make a deferral election prior to receiving the income and could do so just days or weeks before receipt. This flexibility applied to the original payment and, in many cases, subsequent decisions to continue compensation deferment. Under the new rules, at a company on a calendar year, a plan participant who wants to defer a portion of 2006 compensation must make that decision by Dec. 31, 2005. A participant who chooses to defer this income also has to decide when to receive it. A participant who later wishes to change that date can make only an additional deferral election, and that election must be for a minimum of five years.

"Clearly, participants in a nonqualified plan now need to really think carefully about how long they want a deferral to take place, how much they want to defer, and where it should be invested," says Bruce Ellig, author of The Complete Guide to Executive Compensation andretired corporate vice president of employee resources at pharmaceutical giant Pfizer, Inc.

Noncompliance with the new rules for nonqualified deferred compensation plans carries significant risks. Over the past two years,the IRS has mounted an aggressive audit program focused on executive compensation in large and midsized companies. In a report published at the Society for Human Resource Management Web site, IRS audit executive Keith Jones says the agency has discovered companies where nonqualified plans do not comply with the law, including the new, more rigorous standards. The IRS has already started training on the new law and proposes to start auditing with 2005. For plan participants, noncompliance can lead to immediate taxation on all deferred compensation plus a 20 percent penalty on the total amount invested.

New rules for stock options
The American Jobs Creation Act has affected not only traditional deferred compensation plans but stock options and other equity-based programs. Under the act, stock options issued with an exercise price of less than fair market value can be taxed at vesting — not when exercising options at a defined future date. That tax includes regular income tax and the 20 percent penalty tax. Why the penalty? An option typically gives the employee unilateral control over when to "cash in," so it violates the new requirement that deferred income be for a specific,predetermined period.

This change generally does not apply to options vested by Dec. 31, 2004. Options granted or vested after that date must comply with the new law in three ways:

• The options must be issued at fair market value at grant date.
• The number of options must be known at grant date.
• The program must not otherwise provide for deferred compensation.

Recently proposed regulations would provide relief from the penalty tax. The government proposals would allow employers to exclude existing arrangements from new requirements by establishing a new exercise price equal to fair market value, or by cashing out options in 2005 without the 20 percent penalty — instead paying 2005 income tax on any income realized. However, determining fair market value traditionally has been challenging for privately held companies, because their shares are not publicly traded.

"If you’re a public company, all you need to do to establish fair market value is to pick up that day’s issue of The Wall Street Journal," Ellig says. "While a private company can do all the things a public company can do in regard to equity compensation, it’s harder to find a way to set a price."

The proposed regulations would provide private companies and lightly traded public companies with some assurance that the IRS would not subsequently overrule the estimated value for pricing the options.This guidance is much more realistic than the so-called "safe harbor" guidelines from incentive stock option regulations. That language requires a business to get two appraisals of the company’s fair market value, take the midpoint and divide it across the number of shares to sustain a reasonable estimate of fair value. In the recently published proposed regulations on Internal Revenue Code Section 409A, the government takes a less rigorous approach. A single appraisal, following the standards for employee stock ownership plans, would be "presumed reasonable."

Proposed regulations do authorize other approaches to estimating the value of a private company. The critical element is that the IRS finds these methods reasonable – meaning that the company has considered and consistently applied all relevant information. For example, the method used for pricing options should also apply when an employee is eligible to sell the stock. For lightly traded companies, the proposed regulations allow an average of traded value over an extended period of time up to 30 days before or after the grant date.

Compliance calendar
Under proposed regulations, companies have through 2006 to amend their nonqualified deferred compensation plans to comply with the American Jobs Creation Act. This does not extend the timing for making elections to defer compensation. And not all relief opportunities have been extended. An employer that wishes to terminate an existing arrangement, rather than bring it into compliance, must act during 2005. In addition, an employee’s privilege to revoke an existing election is limited to 2005. Continuing arrangements must comply with the new law by the end of 2006 or face penalties.

Tips for compliance
If your company offers nonqualified deferred compensation — or plans to —experts suggest the following steps to ensure you comply with the latest laws and regulations.

Systematically review your executive compensation tools. The recent changes in the American Jobs Creation Act are just part of a series of regulatory reforms affecting compensation and benefits programs. Consider retaining a qualified, third-party expert to review your total compensation approach to ensure it is both competitive and in compliance.

Read the fine print in employment agreements. Nonqualified deferred compensation may be in the form of an individual contract or an employer plan. Contracts are customized to suit an individual’s needs by, for example, providing for fixed installment payments over a period of years or payments only after retirement. As a veteran observer of negotiations on compensation agreements, Ellig says businesses need to pay close attention to how specific elements of nonqualified plans and employment contracts are drafted, because many executives hire outside attorneys to help cut the best deal possible.

Link deferred compensation to performance. Executives and key employees, by virtue of their positions, can significantly influence overall company performance. For that reason, Ellig favors structuring nonqualified deferred compensation with key performance targets. A performance share plan, for example, establishes a targeted number of shares available within a specified time frame. If both the company and the individual achieve most or all of the preset performance goals,the payout in shares is higher than the target. On the other hand, if performance falls short, the payout can drop to zero.

Balance compensation with common sense. Headline-grabbing executive paydays have sparked angst among lawmakers and the general public. While public companies have greater disclosure and reporting responsibilities stemming from the Sarbanes-Oxley Act of 2002, private and not-for-profit companies need to monitor their executive pay packages to ensure they stay in line with market norms and company performance.

By taking these steps, you can help your company build or maintain a high-quality nonqualified deferred compensation plan that meets the interests of key employees as well as follows recent legal and regulatory changes.