IRS Gets Tough On Deferred Compensation

The much-anticipated and much-delayed rules from the IRS on the income tax treatment of deferred compensation are now available. At almost 400 pages, the rules are not exactly light reading for the average taxpayer. Taxpayers have until the end of 2007 to make any necessary changes to their deferred compensation plans.

The Internal Revenue Code has special tax rules for “nonqualified” deferred compensation plans. These are not to be confused with “qualified” employer retirement plans, like a 401(k) plan, or with bona fide vacation leave, sick leave, compensatory time, or disability pay or death benefit plans. The new regulations expand the already broad definition of what constitutes deferred compensation. Essentially, a plan provides for deferred compensation if an employee has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that is, or may be, payable under the plan in a later year.

The impetus for the new rules was a growing concern that some individuals were deferring money over which they still had control, and which they could receive basically whenever they wanted it. The memories are still fresh of top Enron executives cashing out their deferred compensation early and leaving the company financially floundering. In a nutshell, the new rules accomplish the following:

* limit the flexibility for the timing of elections to defer compensation;

* restrict distributions during employment to fixed dates, certain changes in control, or extreme hardship;

* prohibit acceleration of distributions of deferred compensation;

* prevent key employees of public companies from receiving deferred compensation due to severance from service until six months after severance; and

* require that deferrals of distribution dates or changes in the form of payment be made at least one year in advance of the scheduled distribution date.

If the rules are not followed, the tax consequences are significant. The participant is immediately taxed on the value of the deferred compensation once it is no longer subject to a substantial risk of forfeiture. On top of that, there is a 20% excise tax on the amount that is included as income. For good measure, there is also an interest penalty. To avoid such a scenario, employers and employees with deferred compensation plans should promptly come up to speed on the new rules and get appropriate professional help with making sense of, and responding appropriately to, the new IRS rules for deferred compensation.