New Tax Restrictions on Deferred Compensation

A new tax law imposes much more restrictive rules on deferred compensation. But testament to how popular such compensation has become, attorneys do not expect companies to use it any less.

The legislation, passed as part of the American Jobs Creation Act of 2004, changes the way the Internal Revenue Service treats deferred compensation and taxes it, explains Susan Serota, a partner at Pillsbury Winthrop Shaw Pittman LLP. The biggest change is that employees must decide whether they want to defer receiving their bonus a year prior to earning it. They must also decide when they want to be paid. The new law kicks in this January.

The rule puts executives in a strange position. They must make those important decisions about their bonus before they even know how large or small it will be. The size of a bonus isn't usually known until the end of the year - and it's not actually paid until a few months later. So employees might be making that deferment decision in December 2004 on a bonus they're not going to receive until 2006, says Serota .

Performance-based bonuses are treated a little differently. In those instances, the decision on whether or not to defer may be made six months prior to the end of the period in which the bonus is earned. That is, if the firm makes calendar year performance-based bonuses - and most Wall Street firms do - employees can decide whether or not to defer their 2005 bonus as late as June 2005.

"There are many more restrictions on deferred compensation," Serota says.

Another restriction is that certain employees with bonuses that pay out when they leave the firm will find they have to wait six months before receiving their money. That rule applies only to public companies and their "key" employees, where "key" generally means the 50 highest paid people at the firm.

For instance, an employee might elect to defer payment of their bonus until January 1, 2009, but the company would likely put in an override that states the bonus will be paid out if the employee leaves. Under the new law, the employee would not receive that money until six months after they had left the firm.

Previously employees could elect to defer their bonus and then change their minds, with the result that they'd have to take a 10% cut on that bonus. Now, it's only under very special circumstances that the company can pay an employee their bonus earlier than they had elected to receive it.

According to Serota, the new rules were prompted by the Enron and Worldcom bankruptcies, which highlighted certain abuses by executives.

"Executives were able to receive their deferred compensation before the companies went bankrupt while the rest of the employees saw theirs tied up in much more restrictive tax-qualified plans," Serota says. "Congress decided to cure this by putting deferred compensation into a very restricted regime."

She adds, "Most firms will comply because most employees want to defer. They will come within the new regime."

This year is considered a transition year, with the IRS and Treasury Department expected to give companies more guidance on how to handle and interpret the new law, says Serota. "I don't think it will reduce deferred compensation, especially on Wall Street, where there is such a desire to defer. But the arrangements will be much more limited and less flexible"

Michael Segal, a partner with Paul, Weiss, Rifkind, Wharton & Garrison LLP, quoted a friend describing the government's actions: "They used a rocket to kill a rodent."

"In other words, they went overboard. The average guy will have to make an election on when to defer his bonus some 15 months before he knows what he's going to be getting, says Segal.

"In the past, Wall Street firms let people make that election much later in the year. You could have elected whether or not to defer your 2005 bonus in September, October, even November of 2005 - though it still had to be within the year the bonus was earned," Segal says. "Under the new law, that election would have to be made in 2004. People must decide how much to defer or put away and how much to take now before they have a clue on how much they're going to earn."

While employees who are paid performance-based bonuses can wait a little longer before deciding, the government is yet to clarify what they mean by "performance-based," Segal says.

If they mean bonuses in which the amount fluctuates according to performance, then most Wall Street employees are covered. If they mean bonuses that are calculated according to some specific formula, then Wall Street employees are not likely to be covered. "We're waiting for further guidance from Treasury on what is considered performance-based," says Segal.