Proposed Legislation to Tax Immediately Deferred Compensation for Senior Executives
July 2002
Last week, Bill Thomas, chairman of the U.S House of Representatives Committee on Ways and Means, introduced the American Competitiveness and Corporate Accountability Act of 2002. As reported by the press, this bill is primarily a vehicle to address concerns raised by corporate inversions and tax shelters. However, the bill includes a provision that, if enacted, would adversely change longstanding tax rules relied upon by corporations when providing non-qualified deferred compensation benefits to senior executives.
Key Provisions
Section 403 of the bill would create a new Section 409A of the Internal Revenue Code to accelerate the taxation of amounts deferred under certain compensation arrangements maintained for senior officers. If enacted, the bill will require benefits provided to a "disqualified individual" under a "funded deferred compensation plan" to be taxable immediately upon vesting. Any non-qualified plan that provides for deferred compensation is a "funded deferred compensation plan" unless the employee’s rights under the plan are no greater than the rights of a general creditor; any amounts set aside directly or indirectly for paying the deferred compensation remain "solely" the property of the employer without being restricted to the provision of benefits under the plan; and the deferred amounts are subject to claims of the employer’s general creditors at all times, not merely after bankruptcy or insolvency. Executives considered to be "disqualified individuals" would be Section 16(a) insiders or employees who would be insiders under the federal securities laws as if the corporation issued publicly traded securities.
Impact on Deferred Compensation Practices for Senior Executives
If adopted in its proposed form, the bill would impact existing deferred compensation practices for senior executives in at least three significant ways.
Accelerated Payment of Benefits
A plan will be considered a "funded deferred compensation plan" if it allows for accelerated payment of benefits due to "any event" other than "separation from service, death or at a specified time (or pursuant to a fixed schedule)." If enacted, this provision will treat any arrangement that permits in-service withdrawals or provides for an immediate lump sum payment upon a change in control as a "funded deferred compensation plan" even if no amounts are set aside for the payment of benefits under the plan.
Use of Rabbi Trusts
The bill would impede significantly, but not eliminate, the use of rabbi trusts to set aside assets for the deferred compensation arrangement. A rabbi trust could no longer restrict a general creditor’s right to trust assets before insolvency or bankruptcy. Any company using the IRS model rabbi trust would be treated as having a "funded deferred compensation plan" under the bill.
Offshore Trusts
A plan will be considered a "funded deferred compensation plan" if assets are set aside in a trust making it more difficult for U.S. general creditors to reach the trust assets. As a result, use of offshore trusts will likely result in a "funded deferred compensation plan" under the bill.
Effective Date
Section 403 of the bill applies to amounts deferred after July 10, 2002. If the bill is enacted in its current form, it appears that vested compensation deferred after July 10, 2002, under existing "funded deferred compensation plans" will be subject to immediate tax.
Future Legislative Action
We anticipate additional legislative proposals to restrict how corporations may provide benefits to their senior executives. One such set of proposals is contained in the "National Employee Savings and Trust Equity Guaranty Act," which was recently revised by the U.S. Senate Committee on Finance. This bill would repeal Section 132 of the Revenue Act of 1978, which limits the U.S. Treasury Department to the legal authorities in effect on February 1, 1978, when determining the tax consequences of non-qualified deferred compensation plans. If enacted, the bill authorizes the Treasury to issue new guidance regarding fundamental tax principles regarding these plans. Targeted areas for reconsideration include whether certain restrictions qualify as a "substantial limitation" under the constructive receipt rules, whether arrangements are "funded" for tax purposes notwithstanding the form selected by the parties and whether assets set aside to provide non-qualified deferred compensation are truly reachable by the employer’s creditors. We will monitor the progress of these and others bills and provide details as they become available.
