Guest Article

(From the May 19, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks in the article have been added by BenefitsLink.)

Senate-Passed Tax Bill Includes Executive Compensation Provisions

The Senate on May 15 narrowly approved a comprehensive tax cut bill that apparently includes significant proposed changes to existing rules relating to executive deferred compensation. The estimated 10-year cost of S. 1054, the "Jobs and Growth Tax Relief Reconciliation Act"-- which would temporarily exempt investors' dividend income from federal tax and accelerate some EGTRRA rate cuts, among other things-- is $350 billion.

House and Senate leaders now face the difficult task of reconciling S. 1054 with a related tax cut bill (H.R. 2) the House approved on May 9. There are significant differences between S. 1054 and H.R. 2, including the fact H.R. 2 would subject dividend income to capital gains tax rates instead of exempting such income from tax. H.R. 2 also does not have the executive compensation reform provisions included in S. 1054, or any other revenue offset provisions. The estimated 10-year cost of H.R. 2 is $550 billion.

The following summary of S. 1054's executive compensation and employee benefits provisions is based on the Senate Finance Committee-approved version of the bill. The text of the Senate-passed bill is not yet available, although we are not aware of any amendments relating to the executive compensation provisions.

Summary of Executive Compensation Provisions in S. 1054

The Senate bill would create a new IRC section 409A that would subject a publicly traded or closely held company's officers, directors, and 10 percent owners to tax on their interest in a nonqualified "funded deferred compensation plan" as soon as their rights to the deferred compensation are no longer subject to a substantial risk of forfeiture. This proposal is a slightly modified version of the executive deferred compensation proposal introduced by House Ways and Means Committee Chairman Bill Thomas (R-CA) last year.

The proposal in the Senate bill would treat any nonqualified deferred compensation plan (or arrangement) as "funded" (and thus immediately taxable to the individual) unless--

For purposes of the requirement that the beneficiaries and the employer's general creditors have the same rights to the deferred compensation amounts, the bill specifies that the deferred compensation must be payable only in certain circumstances (e.g., separation from service, death, disability, or at a specified time (or pursuant to a fixed schedule)) and that the plan may not include any payment acceleration clauses. As a result, executive deferred compensation arrangements that allow beneficiaries to receive payments due to hardship or a change of control would be treated as "funded" under this proposal.

With respect to the requirement that amounts set aside remain solely the employer's property until made available to the employee, the bill further explains that--

This new IRC section 409A would create particular problems for executive deferred compensation arrangements that use "grantor" or "Rabbi" trusts as a funding mechanism. Under current IRS rules, employers can set aside executives' deferred compensation in Rabbi trusts without causing them to immediately recognize income even if the trust's assets do not become available to the employer's general creditors until the company is insolvent or files for bankruptcy. Also, some employers set up offshore Rabbi trusts so the assets technically will be available to their general creditors, but somewhat difficult to reach. If this proposal were enacted, these arrangements would no longer serve their purpose-- that is, to fund a company's deferred compensation obligations without immediate adverse income tax consequences for executives.

As noted, the new IRC section 409A would apply only to nonqualified deferred compensation arrangements maintained for officers, directors, and 10 percent owners of publicly traded or closely held companies. Another provision in the Senate bill would extend the effective ban on offshore Rabbi trusts to all nonqualified deferred compensation arrangements. In general, this provision would amend IRC section 83(c) to provide assets set aside (in a trust or otherwise) outside the U.S. to pay nonqualified deferred compensation would not be treated as being subject to the claims of the employer's creditors for purposes of determining if there has been a transfer of property in connection with the performance of services under IRC section 83(a).

Other Executive Compensation Reforms

The Senate bill also includes two other proposals relating to executive compensation. The first generally would amend IRC section 83 to require employees to recognize taxable income in any year they exchange employer stock options (or any other compensation based on employer securities) for a right to receive future payments. The amount to be included would be the present value of the right to future payments, or some other amount specified by Treasury Regulations.

Finally, the bill would specify minimum income tax withholding requirements for employers that use a flat percentage rate for determining withholding amounts from supplemental wage payments-- including bonuses and commissions. The minimum rate would be 28 percent, but that would increase to the maximum tax rate in effect for the taxable year to the extent total supplemental wage payments to the employee for that year exceeded $1 million. (The maximum tax rate in effect this year is 38.6 percent.)

Employee Benefits Provisions

The Senate bill would amend IRC section 420(b) and ERISA to extend through 2013 the ability of employers to transfer excess pension assets to a separate account used to fund retiree medical benefits. This authority is currently set to expire after December 31, 2005.

S. 1054 does not propose temporary or permanent funding relief for defined benefit plans. Senator Judd Gregg (R-NH), Chairman of the Senate Committee on Health, Education, Labor, and Pensions (HELP), filed and later withdrew an amendment that would replace the 30-year Treasury rate for pension funding and lump sum calculation purposes with a composite corporate bond rate.

The House-passed version of H.R. 2 does not address these or any other employee benefits-related issues. But it is possible the 30-year Treasury issue will reemerge in the ongoing debate over this tax bill, or as part of some other legislative vehicle.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.