Page 101 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 3. Current versus Deferred Compensation 87

personal service income maximum tax. This distinction between “personal service” and
“ordinary” income taxes came with the tax act of 1969.
Beginning in 1979, the same favorable tax treatment on salary reduction plans, but with
a different requirement, was returned. Qualified profit-sharing plans could again include a
provision that would allow the covered employee to elect either to take the employer’s con-
tribution in cash or have it contributed to the trust. Tax treatment will be based on the action
taken. Thus, if elected to be received as cash, it will be taxed when received; if deferred, the
normal rules for payment from a qualified trust apply.
Going back to our example, this would mean hiring the executive at $180,000 salary and
indicating that the $20,000 generated by the profit-sharing plan could be received as cash or
contributed to the trust. If deferred, the executive has $180,000 of reportable income, the com-
pany a $200,000 tax deduction. If received as cash, the employee has $200,000 of reportable
income, while the company still has a $200,000 deduction. This is called a CODA (cash or deferred
arrangement), Section 401(k) of the IRC, and needs to be carefully designed given the require-
ments of the 2004 American Jobs Creation Act. Such plans are discussed further in Chapter 6.

SECTION 409A OF THE INTERNAL REVENUE
ACT HIGHLIGHTS

Among other things, the 2004 American Jobs Creation Act added to the Internal Revenue
Code Section 409A, “Inclusion in Gross Income of Deferred Compensation Under
Nonqualified Deferred Compensation Plans.”
The deadline for amending plans to meet the requirements of this law has been extended
to December 31, 2007 by the Internal Revenue Service. Employer plans may be unilaterally
amended to comply with the Act and regulations, however, individual employment contracts
will need to be mutually agreed-upon, recognizing that it will be the executive who will suffer
the tax penalties if payments are not in compliance with the law. Written documents are
required of all plans.
The final regulations were issued April 17, 2007, and are effective January 1, 2008, with
notice 2007-79 transition rules applicable until that date.
Coverage

The act does not apply to tax-qualified deferred compensation plans or short-term deferrals
(those payments made within two and one-half months of close of calendar or fiscal year.
The act does apply to nonqualified plans (other than bona fide vacation leave, sick leave,
compensatory time, disability pay, Internal Revenue Code-described medical reimbursement
arrangement, or death plan.).
Plans covered include the following:

• Nonstatutory stock options and stock appreciation rights, if exercise price is less than
fair market value at time of grant and/or deferred receipt of cash or stock is
permitted
• Stock purchase plans not covered by Section 423 of the IRC
• Excess and supplemental pension plans (unless time and form of payment has fixed date)
• Restricted stock units (since it is only a promise to pay, whereas restricted stock plans
are excluded because stock is awarded)