January 18, 2007
On January 17, the Senate Finance Committee unanimously approved the Small Business and Work Opportunity Act of 2007 (the "Act"). The Act includes a number of tax breaks for small businesses in connection with the proposed increase in the minimum wage. The Act also includes two proposals that would significantly increase the tax costs of executive compensation. First, the Act would amend Section 409A of the Internal Revenue Code (the "Code") to "cap" annual amounts deferred under nonqualified deferred compensation plans. Second, it would revise Section 162(m) of the Code to apply to any payments made to former "covered employees" even though they are no longer employed as of the date of payment.
These provisions of the Act are described in a report provided to the Senate Finance Committee by the Joint Committee on Taxation. Actual legislative language is not yet available, and it is possible that the statutory provisions may not exactly mirror the Joint Committee’s description.
Annual Cap on Deferred Compensation
The American Jobs Creation Act of 2004 enacted Section 409A of the Code. Section 409A generally imposes a number of requirements that deferred compensation must satisfy in order to avoid early income tax inclusion, a 20% penalty tax, and an interest charge. The IRS issued proposed regulations in late 2005, and those regulations are expected to be finalized this year.
Section 409A does not currently place any limits on the amount of deferred compensation. However, the Act would impose a limitation on annual deferrals equal to the lesser of $1 million or the individual’s average annual compensation for services performed for the employer corporation over the previous five years. Earnings (whether actual or notional) attributable to the deferred amounts are treated as additional deferred compensation. Exceeding the $1 million limitation apparently would result in early inclusion of all amounts deferred by the individual for all taxable years, as well as trigger the 20% penalty tax and the interest charge. The change is proposed to be effective for amounts deferred in taxable years beginning after December 31, 2006. The Treasury Department would be directed to issue guidance allowing modification of outstanding deferral elections on or before December 31, 2007 to the extent necessary to avoid violating the new rule.
The definition of "deferred compensation" under Section 409A is extremely broad. For example, in addition to traditional deferred compensation arrangements including SERPs, the IRS has indicated that any severance paid pursuant to an arrangement that includes a "good reason"/constructive termination provision may be subject to Section 409A. Thus, the proposal could lead to the curtailment, or, in some cases, the elimination of these provisions for highly-compensated executives in favor of severance arrangements that do not technically involve deferred compensation, such as arrangements that only provide for payment of lump sum severance in the event of termination without "cause." In addition, under the "short-term deferral" rule, amounts paid by March 15 of the year following the year the compensation is no longer subject to a substantial risk of forfeiture are not subject to Section 409A. The proposed legislative change likely would lead to greater use of the short-term deferral rule (e.g., ensuring that all bonuses to top-level executives are paid no later than the March 15 following the year in which they are earned in order to avoid "deferred compensation" treatment of the bonuses).
If enacted, this change would require all employers again to revisit employment agreements, severance programs, deferred compensation plans, and other arrangements. It would raise a number of difficult issues, such as how to "allocate" deferrals between years. The most likely impact of the proposed change is that many employers would curtail deferred compensation programs and instead pay out amounts more quickly (thus generating more short-term tax revenue, one of the primary goals of the proposed change).
Section 162(m) "Covered Employees"
Section 162(m) of the Code generally limits the income tax deduction for compensation paid to any of a public company’s top-five officers (referred to as the "covered employees") to $1 million per year. "Performance-based compensation" (e.g., most stock options and many bonus arrangements) are exempt from this limitation. Under Section 162(m), an individual generally must be an employee on the last day of the company’s taxable year in order to be a covered employee. Thus, any compensation paid after termination of employment generally is not subject to Section 162(m) (e.g., any deferred compensation paid after termination).
The proposal would modify the definition of covered employee to provide generally that any individual who is a covered employee at any time after December 31, 2006 would always be a covered employee. For example, any severance paid to a CEO in the year of termination and any deferred compensation payable at any time after termination of employment generally would be subject to the limitation under Section 162(m) of the Code. There does not appear to be any "grandfathering" of amounts accrued prior to 2007 or payments under agreements to which the corporation is already contractually obligated . This provision could be especially problematic for employers that have automatically deferred to an executive’s termination of employment payments that otherwise would have exceeded the $1 million annual threshold in prior years.
The change to the definition of covered employee could result in many public corporations losing large tax deductions. As a practical matter, it may be difficult to make severance, deferred compensation, and various other types of payments qualify as "performance-based compensation" and thereby avoid the impact of the proposed change (although there is a fair amount of "play in the joints" in the definition of performance-based compensation).
There are a number of hurdles these proposals will have to clear, and, at this point, it is impossible to know whether they will become law. However, enactment is a real possibility. Employers may want to consider whether to weigh in with the Congress on the legislation and also begin thinking about how to deal with the proposals. We will provide an update once the direction of the legislation is more clear.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
Stephen W. Fackler (650-849-5385, firstname.lastname@example.org),
Charles F. Feldman (212-351-3908, email@example.com),
David West (213-229-7654, firstname.lastname@example.org),
David I. Schiller (214-698-3205, email@example.com),
Michael J. Collins (202-887-3551, firstname.lastname@example.org),
Sean Feller (213-229-7579, email@example.com),
Amber Busuttil Mullen (213-229-7023, firstname.lastname@example.org),
Jennifer Patel (202-887-3564, email@example.com),
Chad Mead (214-698-3134, firstname.lastname@example.org), or
Jonathan Rosenblatt (650-849-5317, email@example.com).
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