From the Editor
Take the Money and
u
As companies scramble to bring their deferred compensation programs and elections into compliance with the 2004 American Jobs
Creation Act (2004 Jobs Act), one overriding question is frequently
being overlooked: does executive deferral still makes financial sense?
Until recently, the numbers clearly favored deferral . The new restrictions and draconian penalties imposed by Internal Revenue Code
(IRC) Section 409A, however, may well tip the scales for many executives against this longtime tax planning vehicle .
Until now, deferring as much income as possible made economic
sense for most executives . The leverage afforded by deferring pre-tax
compensation generated more income for executives than taking the
compensation immediately and investing the after-tax dollars on their
own. The benefits compounded if the executive dropped to a lower tax
bracket upon distribution of the deferred income, usually upon retirement . Deferral also provided chronic spendthrifts with a means of automatically saving for retirement while allowing trigger-happy investors to
trade without short-term capital gains taxes eroding their returns .
The Internal Revenue Service (IRS) also has historically been accom modating to deferred compensation-in large part because the
Revenue Act of 1978 Section 132 constrained the issuance of new regulatory guidance. The agency also initiated little audit activity and has
had a remarkably poor record in litigating contested deferral arrangements . As a result, over the years creative compensation and tax advisors have devised new deferral programs that permit multiple investment options, flexibility in changing distribution elections, rabbi trusts,
hardship withdrawals, and haircut provisions . By steadily enhancing
the benefits and reducing financial risks, nonqualified deferred compensation plans eventually came to offer nearly the same advantages
as 401k plans .
The economics of deferral began to change with passage of the
2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) . JGTRRA reduced tax rates on earned income to a maximum of 35 percent
and slashed taxes on most dividends and long tern capital gains to 15
percent . These lower rates reduced-but did not entirely eliminatethe financial leverage of deferral . As an example, an executive in the
maximum tax bracket elected to defer $100,000 for 12 years, during
which time his or her money doubled . At 35 percent, the executive
would be left with $130,000 after taxes . Had that executive instead
invested the $65,000 after-tax compensation and doubled his or her
investment in a long-tern capital gain, the executive would be left
with after-tax funds of $120,250-still $9,750, or 7 .5 percent, less than
under deferral . Had the executive been forced to take a 6 percent haircut to withdraw his or her money early, he or she would still end u p
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From the Edito r
slightly ahead . Add state income taxes to the mix, and deferral
remained highly attractive . Nevertheless, some executives who were
reluctant to part with control over their money-especially if they
were worried about their company's future-decided against deferring compensation
Then came the 2004 Jobs Act . Its original intent was to prevent executives from cashing out their deferred compensation accounts on the
eve of corporate insolvency while rank and filers' pensions and company stock accounts withered away . By the time the Congressional dust
cleared, it had morphed into a full-blown tax act projected to raise
more than $1 billion over 10 years . The addition of Section 409A to the
IRC significantly restricted the ability of executives to choose when and
how to take their deferral distributions . It also eliminated haircut provisions, along with most second elections for income deferred after
2004 . Those changes had the effect of putting deferrals at greater risk
in the event that an executive's or employer's fortunes took a turn for
the worse .
Unfortunately, what was generally lost in the debate was the simple fact that the deferred amounts frequently are compensation that
an executive already has earned, not a promise of a future bonus . A
distribution taken by an executive on the eve of a corporate financial
crisis is certainly bad optics . It does not, however, actually leave
shareholders, employees, or creditors any worse off financially than if
the company had paid the executive up front .
Perhaps more significant are the 2004 Jobs Act's new 20 percent tax
penalties and interest charges for IRC Section 409A violations . The
interest is based on the amount of tax underpayment from the time
of deferral (or vesting, if later) at the underpayment rate (currently 5
percent) plus an extra one percent . This not only eliminates the
advantage of deferral in "disqualified" arrangements but it could actually leave executives with less money than they originally deferred .
Although the 2004 Jobs Act does not say so explicitly, it also frees
the IRS from the regulatory shackles of the Revenue Act Section 132 .
The IRS is now empowered to issue new rules and aggressively attack
deferral arrangements that it considered inappropriate . The IRS's
recently completed "compliance initiative"-begun even before passage of IRC Section 409A-may be the first shot across the bow . In
addition, it will be easier and quicker for the IRS to uncover alleged
improprieties in plans because IRC Section 409A requires companies
to report all deferrals on Forms W-2 or 1099 .
The IRS might even sta rt winning some deferred compensation
cases-if such suits make it to court. Executives will be more eager
to settle because IRC Section 409A takes an ail-or-nothing approachthere are no exceptions, no excuses, and no Employee Plans
Compliance Resolution System (EPCRS) for executives . While the IRS
may be loath to hurt rank and file workers by attacking qualifie d
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From the Edito r
plans, the executives who defer will enjoy no such sympathy .
Moreover, it is possible that operational defects in one deferral
arrangement will infect others . For example, if a CEO bullies his or
her way into taking early distribution of his or her deferral, the IRS
may decide that the company's president, CFO, and COO also should
be taxed on their deferrals since they had similar power, even if they
did nothing wrong . The stakes have become so high that many executives will be pressured to settle IRC Section 409A audits rather than
risk a companywide tax meltdown .
Aside from IRC Section 409A, two other emerging factors must
enter into the deferral calculation .
1. With the federal government facing a large deficit plus a
costly long-term war on terror, a Pension Benefit Guaranty
Corporation funding crisis, and cash-strapped Medicare and
Social Security programs, tax rates may well be headed north .
Executives therefore could find themselves in a higher tax
bracket when they take payment of their deferral sometime
down the road .
2. A second is the overall governance sensitivity to the size of
deferral payments, particularly for executives at public compa nies . While payment of a $1 million executive bonus may not
draw much attention, a deferral of several years' bonus that
balloons over time into a $15 million distribution is far more
likely to be attacked as unreasonable .
In my calculus, the pros and cons of deferral can be summed up
by Table 1 .
Pros
Cons
Investment leverage
Potential for tax increase
Enforced savings
discipline/convience
No favorable dividend/capital
gain tax rates
Potential for distributions
at lower tax rates
Credit ris k
No tax cost of
investment turnover
Loss of contro l
Unfavorable public disclosure
Potential 409A penalties and interest
I believe that IRC Section 409A has tipped the scales definitely
against deferral for most, if not all, executives . The way things stan d
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From the Editor
now, there is simply more that can go wrong than right with deferral-the combined risk of tax increases, corporate insolvency, and
loss of control outweigh deferral's potential for greater income . I
would make an exception, however, for deferred compensation plans
that provide an employer match of deferred amounts . For most executives, a decent-sized match, offered by a reasonably solid company,
is probably worth the risk of deferring enough compensation to take
advantage of the full match.
Employers' perspectives on deferral may change, too, as executives
are compelled to assume these newly heightened risks . It may make
more sense for companies to automatically set aside the "would-be
match" in a deferral account, regardless of whether the executive elects
to defer. After all, there is a tax cost to the employer from delaying its
deduction for the deferred compensation and current corporate taxes
on plan investment earnings . A win-win scenario that some companies
should consider is : simply pay the would-be match currently as a
bonus to all executives and eliminate deferred compensation entirely .
My advice to executives and employers : take (or pay) the money
and run .
David E. Morse
Editor-in-Chief
Kirkpatrick & Lockhart LL P
New York, NY
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