Lawyer Article

This article was published in the January 30, 2007 edition of Southeast Tech Wire.

On January 17, 2007 the Senate Finance Committee passed the Small Business and Work Opportunity Tax Act of 2007 ("Act"), which has been incorporated into the underlying version of H.R. 2, the Fair Minimum Wage Act of 2007, that is currently being debated in the Senate. In general, if the proposed changes to Sections 162(m) and 409A of the Internal Revenue Code of 1986 are ultimately enacted into law:

• Public companies will no longer be able to deduct as an annual expense more than $1 million of compensation paid to certain highly-paid executives or their beneficiaries, even after the executive is no longer employed by the company. No exception is made for existing contracts.
  
   
• Individuals cannot defer more than the average of their prior five years’ annual compensation (or $1 million, if less). All earnings on deferred compensation count toward this limit. Any deferrals in excess of this amount cause immediate taxation of all deferrals under all plans, a 20% excise tax and interest charges. This provision will apply to all private, not-for-profit and governmental employers.

While the House minimum wage bill does not currently contain similar language, it appears that these provisions will likely be included in the Senate’s final version of the minimum wage legislation and that this legislation will continue to move rapidly through Congress. It is therefore imperative that employers and other interested parties act now if they wish to have these provisions changed or removed from the final version of the legislation.

Womble Carlyle's Government Affairs Practice in Washington, D.C., and our Employee Benefits attorneys are available to assist you in addressing any questions that you may have regarding this matter and to assist clients in contacting Congress regarding changes that they would like to see made in these proposals. A more detailed description of the proposed amendments is provided below.

Code 162(m)
Code Section 162(m) limits to $1 million the deduction that a public company may take for compensation paid to any single "covered employee." Covered employees are defined as the CEO and the five other highest-paid officers as of the end of the taxable year. Currently, when one of these officers ceases to be a covered employee (such as after retirement), the deduction limitation no longer applies to compensation paid to the executive. The proposed amendment provides that if an employee has ever been a covered employee, the employee will always remain a covered employee. In addition, beneficiaries of covered employees are considered under the proposed legislation to be covered employees (so that the Code Section 162(m) limitation applies to compensation paid to the beneficiary of the covered employee as well). This means that, even in retirement, anyone ever considered a covered employee would remain subject to Code Section 162(m), and payment of any compensation to them (including severance, nonqualified deferred compensation, or any other payments) in excess of the $1 million limit will not be deductible by the employer. If adopted, the provisions will be applicable for taxable years beginning on January 1, 2007. There does not, however, appear to be a "binding contract" exception for currently-existing compensation plans and arrangements. In other words, even though a contract was entered into prior to December 31, 2006, if the employee is a covered employee and payments are made after December 31, 2006, then the limitation would apply. If the amendment is enacted, this limitation will have a significant impact on current contracts. It would require payments under many of those contracts to be treated by a company as non-deductible.

Code Section 409A
Code Section 409A, which was passed as part of the American Jobs Creation Act of 2004, generally applies to nonqualified deferred compensation that is deferred after December 31, 2004. Because of the broad definition of “nonqualified deferred compensation” in the statute and proposed regulations under Code Section 409A, almost any type of non-current compensation – including discounted stock options, discounted stock appreciation rights, restricted stock units, 401(k) wrap plans, defined benefit SERPs, long-term incentive plans, and severance payments – may be subject to the statute.

The bill amends Code Section 409A to impose an annual cap on the amount of compensation that can be deferred. This cap is equal to the lesser of (i) the prior five year’s annual compensation average or (ii) $1 million. If any deferrals exceed this amount, all deferred compensation for all plans for the individual for all years would immediately be taxed (even if not immediately payable) and would also be subject to a 20% excise tax and interest charges.

As the legislation is presently drafted, it appears that the present exemptions from Code Section 409A generally would continue to apply with respect to the deferred compensation annual cap. That is, fair market value options and SARs, restricted stock, short term deferrals, and any other arrangements that are exempt from Code Section 409A would not be subject to the deferral limit.

These new rules would apply to deferrals after December 31, 2006 and earnings on those amounts. The language from the proposed bill indicates that earnings on prior amounts (deferred before December 31, 2006) would not be subject to these requirements. This could create administrative difficulties for employers with "grandfathered" assets (deferrals earned and vested prior to December 31, 2004) if a second "grandfather" for earnings is imposed.

If this legislation becomes law, its impact on nonqualified deferred compensation could be even more far-reaching than the original version of Code Section 409A. Because of the cap on the amount of deferrals – and its inclusion of earnings in that determination – it could effectively end the use of supplemental executive retirement plans, 401(k) wrap plans, and other types of nonqualified deferred compensation that traditionally have been used to help executives accrue compensation for retirement. In addition, the proposed legislation has the potential to eliminate the use of certain types of equity programs because of the uncertainty of their value, which could lead to potential violations of the deferral cap. For example, restricted stock units and phantom stock are often used to provide employees with an award that is based on the underlying value of the stock. Were the legislation to be enacted, the increase in the value of stock on which a restricted stock unit or phantom stock award is based could create an inadvertent violation, resulting in immediate taxation of all of the employee’s nonqualified deferred compensation awards, in addition to a 20% excise tax on those amounts and potential interest charges. 

The following Womble Carlyle Government Affairs and Employee Benefits attorneys are available to assist you in addressing any questions that you may have regarding this matter. Please contact the attorney with whom you usually work or any one of the following attorneys if you have any questions.

• Patrick M. Allen (Winston-Salem) 336-721-3574
• James Broughton (Washington, D.C.) 202-857-4468
• Janice C. Baldwin (Winston-Salem) 336-721-3654
• James E. Daniel (Charlotte) 704-331-4931
• Diane J. Fuchs (Washington, D.C.) 202-857-4457
• Michael D. Gunter (Winston-Salem) 336-721-3607
• Jane Jeffries Jones (Charlotte) 704-331-4953
• Mark N. Poovey (Washington, D.C.) 202-857-4591
• Bryan L. Tyson (Charlotte) 704-331-4973
• William R. Whitehurst (Winston-Salem) 336-721-3653