The government hasn’t required much in the way of compliance when it comes to nonqualified deferred compensation, such as special executive retirement perks and bonuses.
That changed in April, when Congress enacted a slew of IRS-enforced regulations known as 409A. Beginning Jan. 1, 2008, you'll have to comply with the broad new regs, or the beneficiaries—your executives—could face stiff tax penalties. Blame Enron’s collapse for Congress’s renewed interest in the issue.
(The IRS originally set a deadline of Dec. 31, 2007 for bringing deferred-compensation documents into compliance. But this month, the IRS pushed that document compliance deadline back one year to Dec. 31, 2008. Employers do still need to begin complying with the new regulations on Jan. 1, 2008.)
Working definition: If you promise a payment now that won’t be paid out until a future year, that’s nonqualified deferred compensation.
Follow these three steps to comply with the new 409A regulations:
1. Take an inventory of your organization’s nonqualified deferred compensation arrangements. Look beyond formal plans and review informal ones too, as well as those applying to only one or two individuals.
The new rules cover some arrangements that you might not have considered deferred compensation, says Eddie Adkins, compensation and benefits technical practice leader for Chicago-based accounting firm Grant Thornton.
Example: An organization gives its top execs $5,000 to spend on financial planning and allows them to carry it over to the following year if they don’t spend it all this year. The new IRS rules count that as nonqualified deferred compensation.
Note that pay for vacation time and sick leave that rolls over from year to year is exempt from the rules.
Advice: Educate all senior managers about the new rules. HR might not be aware of every financial promise the CEO has made to an employee, yet those arrangements must comply with 409A.
2. For each arrangement, decide to either remove the deferral of compensation or keep it and comply with the new rules.
3. Redesign your existing nonqualified deferred comp arrangements so they comply with 409A. You'll want to complete your redesign before the end of 2007 so they will be in compliance on Jan. 1, 2008. Each year, you (or your employee) must elect whether to defer compensation for the following year by Dec. 31. The rules allow you to postpone that decision until June 30, but doing so will dump a pile of extra paperwork on your desk.
Likewise, you need to set a distribution schedule for existing deferred payments. There’s an out that lets you change the distribution plan later, but the delay has to be at least five years later than the original date, and the change has to come at least a year before the original distribution date.
Advice: Make decisions by Dec. 31, 2007 and stick to them. “Just because there’s an exception out there doesn’t mean you have to use it,” says Adkins. “The more you use the exceptions, the more complicated your plans get and the more likely you’re going to do something that’s wrong.”
A twist: When an organization does not comply with 409A regulations, it’s the employee who pays—big time. Consequences include a 20% penalty tax and immediate taxation of the compensation. Expect employees to sue you if you commit compliance errors.
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