Blame it on Enron
New tax laws on deferred compensation have employers scrambling to review and adapt old plans. Many executives will find the deals less appealing.
In 2000 about three dozen Enron Corp. executives moved $32 million out of deferred compensation accounts and into limited partnerships they had created for their families. When the merchant energy company went bankrupt two years later, the assets were safely out of creditors’ grasp. Most of the executives’ 21,000 fellow workers weren’t so lucky: They lost about two thirds of their 401(k) savings, mostly because of a $1 billion plunge in the value of the plan’s company stock holdings.
The Enron bosses’ maneuver was legal, but the image of well-paid managers protecting their interests while rank-and-file workers were losing the bulk of their retirement money was disturbing enough to prompt a congressional inquiry into deferred compensation benefits. The situation also persuaded the Internal Revenue Service and Congress to change many of the rules governing deferred compensation packages, in particular the regulations governing an executive’s ability to choose when to receive such compensation.
The new law, section 409A of the Internal Revenue Code, was included in the American Jobs Creation Act of 2004, which took effect on December 31. The Treasury Department had wanted to tighten these regulations for years, says David Sugar, a senior consultant in the executive compensation practice of consulting firm Hewitt Associates. “But without the outrage over Enron, Congress wouldn’t have gone out on a limb to take away something that executives enjoy so much,” Sugar notes.
Once the dust has cleared, the new regulations will likely make things simpler for employers. But the loss of flexibility means that deferred compensation will become considerably less appealing to executives, because there will be much greater uncertainty about the plans’ worth over time. One consolation for the high and mighty: Preexisting deferred compensation grants are grandfathered under the new statute.
Even if these changes don’t reach far down the corporate ladder, they will have a broad impact. Hewitt Associates reports that 70 percent of companies in a 2004 survey of 500 large employers offer some type of deferred compensation and that the average base salary of participants was $136,000. What’s more, the revisions will affect everything from stock disbursal programs to severance payouts.
Congress wrote the original laws covering these so-called nonqualified deferred compensation plans in 1978, to formalize a body of regulations based on prior case law. Since then the IRS has wanted to refine the rules governing these plans. Unable to do so on its own, the agency for years waged court battles against executives, trying to stop them from making last-minute decisions to claim their deferrals and thus -- as the IRS sees it -- exercise too much control over the taxes they pay. But the agency lost case after case in court.
“The only resolution for the IRS was to change the law,” notes Hewitt’s Sugar.
Under the terms of ERISA, in nonqualified plans an employee elects to defer a portion of his or her cash compensation, typically until retirement or departure from the company. For tax purposes, the payment is not considered income. Unlike contributions to a qualified plan -- a 401(k), for example -- the expense incurred in contributing to a nonqualified plan cannot be deducted by the employer.
The benefit to both the employee and employer is deferral: The company grants the bonus at the time of service but doesn’t have to pay it until some point in the future. The employee doesn’t pay taxes on the compensation grant until he or she receives it. The employer typically credits interest to the account, tax free, between the time the grant is awarded and when it is received.
The new law requires employees to declare well in advance when they will draw down their deferred compensation. If they don’t, they risk losing the grant’s tax-advantaged status -- and could even trigger the loss of deferral for all employees in the plan.
Says Heidi Töppel, a senior consultant at benefits adviser Watson Wyatt Worldwide, “The theme in all these changes is to remove the flexibility permitted under case law -- the ability of employees to stop deferrals, accelerate payments and decide when and how they want to receive their benefits and pay tax on the income.”
Observes Douglas Heffernan, a partner at Faegre & Benson, a Minneapolis law firm, “A lot of plans that are usually not recognized as deferral arrangements have been caught up in this.” He points to plans based on employer equity that are traditionally used as incentives rather than long-term deferrals, like discounted stock options and restricted stock with deferred payouts -- anything that makes a payment for current services at a future date.
Conventional market-value stock option plans and employee stock option plans are specifically exempted from the new law, but other plans where participants can react to share price movement could be vulnerable.
Stock appreciation rights might have been a case in point, but a year-end ruling by the Treasury Department and the IRS gave a reprieve to some, though not all, SAR arrangements. Stock appreciation rights work like options; the employee takes the gain between grant and exercise, but instead of making the employee buy the shares on the market, the company simply writes a check. “Not many companies have been using stock appreciation rights,” notes Hewitt’s Sugar, “but with the prospect of stock option expensing coming up, SARs had become a renewed topic of conversation.”
All discounted stock option plans are made obsolete by the new law, observes Mel Todd, president and CEO of the Todd Organization of Greensboro, North Carolina, a consulting firm specializing in executive compensation. “For several years some of the big accounting firms have been marketing discounted stock option plans, where the employee is granted a strike price well below the market,” he says. Because a payment date is not declared in advance, the executive would have unlimited flexibility over the option exercise, causing these plans to run afoul of the new legislation.
Even severance packages have been snared by the new law. “Companies historically have offered severance in a lump sum or over time,” says Watson Wyatt’s Töppel. “That choice is being taken away because the IRS wants to limit the employee’s control over the taxable event.” The severance can be in either form, but now the employer makes the choice, rather than the employee, and must apply the policy consistently.
And, notes Brigen Winters, majority tax counsel for the House Committee on Ways and Means from 1999 to 2002 and now a principal at Groom Law Group in Washington, “the old definition of deferred comp is so broad that it will apply to some nonelective arrangements, like supplemental employee retirement plans.” Because supplemental plans are not available to all employees, they do not qualify for deduction by the employer under ERISA. Until now all payouts under such plans have been linked to an employee’s retirement decision, which for a qualified plan can be made at the last minute. Going forward, supplemental plan decisions will have to be made well in advance, when the employee joins the plan.
Human resources managers are now reviewing all their plans, but their reviews are necessarily incomplete, as interpretations of the new law were not scheduled for publication until late December.
Benefits executives are grappling with the Financial Accounting Standards Board’s changes to option accounting at the same time, notes Watson Wyatt’s Töppel. “There haven’t been so many external changes bombarding the regulations on executive compensation for a long time,” she says.
Although most existing grandfathered grants will be frozen as of year-end 2004, any new arrangements will be closely studied by benefits managers before they are finalized. Says Faegre & Benson’s Heffernan, “Executives will be more conservative about how much of their pay they want to lock up.”