This is the second in a series of articles by which the Spencer Fane LLP Employee Benefits Practice Team will explain key changes made in the employee benefits area by the Tax Cuts and Jobs Act (Public Law 115-97), which was signed into law on December 22, 2017. In addition to establishing new rules for transportation fringe benefits (see our first article in this series), the Act makes a number of changes that may affect how employers structure their executive compensation programs. This article describes the Act’s impact on for-profit employers, and outlines options that those employers should consider for their compensation arrangements.
Deferred compensation arrangements that are not “tax-favored” retirement plans under Code Sections 401(a), 403(b), or (in the case of a governmental employer) 457(b) are generally referred to as “nonqualified” plans. So long as a nonqualified plan is “unfunded” (meaning the amounts deferred remain the property of the employer, and subject to the employer’s general creditors, until paid), the amounts deferred are generally not taxable until they are “paid or otherwise made available” to the employee.
A recent decision by a Michigan federal trial court serves as a warning to employers that their failure to shield participants in nonqualified deferred compensation plans from adverse tax consequences may subject the employers to unanticipated liability. Although this decision (in Davidson v. Henkel Corporation) involved FICA taxation, the court’s reasoning would seem to apply equally to the 20% penalty tax and interest assessments triggered by a violation of Code Section 409A.
Although the compensation that an employer pays to an employee is generally subject to FICA taxation at the time the compensation is paid, there are special rules for the FICA tax treatment of amounts payable under nonqualified deferred compensation plans (such as long-term incentive plans or supplemental retirement programs). These rules affect both the timing, and the amount, of the FICA tax that is payable with respect to such compensation (which tax is typically shared 50/50 by the employer and employee). In the recent case of Davidson v. Henkel, an employer that failed to heed those special rules found itself facing the prospect of bearing substantial additional tax liability – for both the employer’s and the employee’s share of the FICA tax. This case serves as a reminder that employers should pay special attention to when amounts deferred under a nonqualified plan are properly taken into account as “wages” for purposes of FICA taxes.
Recent IRS guidance makes clear that deferred compensation arrangements under which payments are conditioned on the execution of a release of claims could pose a problem under Section 409A of the Internal Revenue Code. Fortunately, the IRS has also announced a voluntary correction program under which this Section 409A violation may be corrected. Employers wishing to take advantage of this correction program must act quickly, however, because this aspect of the program expires at the end of 2012.
Governmental employers sponsoring Section 457 plans will be interested in this latest IRS guidance as to what does – and does not – constitute an employee’s “unforeseeable emergency,” thereby supporting an in-service withdrawal from such a plan.
Employers and their executives should note a year-end deadline for correcting certain failures to comply with the “documentation” requirements of Section 409A of the Internal Revenue Code. As explained in our March 2010 article, IRS Notice 2010-6 created a program for correcting such failures, but with many of its generous transitional rules expiring on December 31, 2010.
The American Jobs Creation Act of 2004 changed the landscape of compensation arrangements by adding Section 409A of the Internal Revenue Code, which imposes strict operational and documentation requirements on nonqualified deferred compensation arrangements. Section 409A applies to any plan, agreement, or arrangement that creates (in a given tax year) a legally binding right to compensation that is payable in a later year. Consequently, Section 409A applies to a wide variety of arrangements, including supplemental retirement programs, bonus plans, incentive compensation arrangements, employment agreements, severance agreements, and equity compensation
As noted repeatedly in the pages of this publication, the IRS has established a deadline of December 31, 2008, for coming into full documentary compliance with the requirements of Section 409A of the Internal Revenue Code. By this date, all plans and arrangements providing “deferred compensation” in return for the provision of services must be amended to comply with the various constraints imposed by Section 409A.
Employers are reminded that all plans, arrangements or agreements (other than tax-qualified retirement plans) that defer compensation must fully comply with the final regulations under Internal Revenue Code Section 409A by December 31, 2008!