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Be Careful With Deferred Comp

Tracy Byrnes

The backlash from the collapse of Enron appears to be never-ending. Between Sarbanes-Oxley headaches and audit committee members who practically have to put their lives on the line, can the rules get any tighter?

Yes, they can.

Now deferred compensation rules have been tightened because, no surprise, the execs at Enron took advantage of them too.

"Deferred compensation was an unregulated environment and things had gone too far," says Tom Long, a tax analyst at RIA, a Thomson business providing tax information and software to tax professionals.

So back in October 2004, the American Jobs Creation Act introduced stringent rules to prevent abuses. If you are eligible for deferred compensation, you'd better heed the warnings or you could actually end up with less money than when you started.

Deferred compensation is an arrangement with your employer in which a portion of your income is paid at a date after which it is actually earned. The primary benefit is the deferral of tax. You don't pay tax on the deferred compensation until you get the money, even though you have technically earned it.

There are two types of deferred compensation -- qualified and nonqualified. Qualified can be a pension or retirement plan. Nonqualified is mainly used for upper management. Examples of nonqualified deferred compensation include perks like stock appreciation rights agreements and nonqualified stock options for the CEO that wants to extend his salary beyond his working years.

Nonqualified deferred compensation plans must have restrictions or "substantial risks of forfeiture" in place to qualify. (Qualified plans do not need these restrictions.) For instance, one company's "substantial risk of forfeiture" might be that you need to stay with the company for five years to qualify for your bonus, says Mark Luscombe, a principal federal tax analyst with CCH, a provider of tax and business law information. Another risk could be that you must meet certain performance goals to get the money.

The idea is that the money is not a sure thing. You have to meet certain criteria and/or stick around at the company long enough to qualify for it.

But many nonqualified plans started to add clauses that indirectly removed the risk; for instance, by stipulating that if the company got into financial trouble, the employee could take the money earlier. But that defeats the notion of having risk!

And that's what happened at Enron. The company was at risk (to put it mildly), so the execs took their money and ran. Sure, they were hit with a 10% early withdrawal penalty but "big deal," says Bill Fleming, director of personal financial services at PricewaterhouseCoopers in Hartford, Conn. It was still better than forfeiting their money altogether.

This incident opened the eyes of the IRS to other existing abuses, and the agency decided to crack down.

As a result, new rules were created and now apply to deferred compensation plans that began after Dec. 31, 2004. If you violate these rules, you could pay dearly, says Luscombe.

Here's why. If your plan is deemed to be faulty, you will immediately owe taxes on your deferred compensation -- it's as if you received the payment today. In addition, you'll owe a 20% early withdrawal penalty because now you're getting your money before the plan says you should.

Even worse, you'll owe interest on the money because your tax bill is considered late. That's right, late. By deeming the plan inadequate, the IRS is saying that the money really shouldn't have been considered deferred compensation when it was originally awarded to you. In that case, you'll then owe interest back to the date the compensation was awarded.

As an extreme example, assume that in 2005 your company offers you deferred compensation of $1 million that you'll receive in 2010 if you meet your performance goal. And let's assume that it throws in a "financial trouble" provision that says if the company is in dire straits, you can take your money early. Now let's say the IRS doesn't catch on to this improper clause in the plan until, say, 2008. At that point, it could say the whole deferred compensation plan has violated the new rules. You will then immediately owe taxes on the $1 million. Because the money is no longer considered deferred compensation, the IRS will assume that you should have received it back in 2005 and paid its corresponding tax bill. But that means your taxes are now three years late. You will then owe interest on that $1 million from 2008 back to 2005.

So be warned. Starting in 2005, make sure your deferred compensation plan complies with new rules. Ask your human resources department for the plan's guidelines and carefully read the fine print. And be very cautious if you're part of an existing plan. While these plans are grandfathered and are not subject to the new rules, any change made to the plan after Oct. 3, 2004, makes the plan vulnerable. The whole plan could be spoiled if the new rules aren't followed. And that could mean immediate taxes and lots of retroactive interest.