Legislative Curtailment of Non-qualified Deferred Compensation Imminent?

Both the Senate and the House have recently passed bills that would increase the federal minimum wage. However, the Senate bill also contains provisions that would have a significant impact on executive compensation, which are not contained in the House bill.

Legislative History

On February 1, 2007, the Senate passed the Small Business and Work Opportunity Act of 2007 (the “Act”) which, if enacted, would make changes to sections 162(m) and 409A of the Internal Revenue Code of 1986, as amended (the “Code”), by limiting annual deferrals and modifying the definition of Covered Employee.

On February 12, 2007, the House Committee on Ways and Means issued H.R. 976, the Small Business Tax Relief Act of 2007 (“H.R. 976”). H.R. 976 is a revenue-neutral package, which, like the Act, raises the Federal minimum wage from $5.15 per hour to $7.25 per hour. However H.R. 976 does not contain the proposed changes to Sections 162(m) and 409A that are in the Act. H.R. 976 was passed in the House on February 16. The two bills will go to conference for reconciliation.

Proposed Changes to Section 162(m)

BackgroundGenerally, compensation paid to a Covered Employee of a publicly held company in excess of $1M is not deductible unless such compensation is performance- based compensation.

The Act proposes a change to the definition of Covered Employee. Currently, Covered Employee is defined as the company’s CEO at the close of the year, and the four other most highly compensated officers at year end as reported in the company’s proxy statement, if such officer is employed at the end of the fiscal year. The Act includes the following proposed changes effective in 2007:

  • any person who served as the company’s CEO at any time during the year would be a Covered Employee; and
  • any individual who was determined to be a Covered Employee on or after January 1, 2007 would continue to be considered a Covered Employee in future years, with respect to that company, even after termination or retirement.

Additionally, the definition of Covered Employee would extend to a Covered Employee’s beneficiaries.

If the Act is signed into law, a plan sponsor would need to track any compensation paid to a Covered Employee until compensation is no longer paid to that employee or former employee; this includes compensation paid pursuant to a deferred compensation program (qualified or non-qualified) after termination of employment.



  • Post-termination payments of deferrals would be considered compensation for purposes of Section 162(m).If a Covered Employee deferred amounts to be paid at a future date, distributed amounts are currently considered “compensation.” Amounts distributed in excess of $1M during the year will be non-deductible. In addition, the Section 409A rules severely curtail a Covered Employee’s ability to change the time and form of payout of deferrals.
  • Performance-Based Compensation that is deferred would need to be tracked to maintain its deductible status for purposes of Section 162(m).Currently, Section 162(m) excludes performance-based compensation as “compensation” for purposes of determining whether the $1M limit is exceeded. Presumably, performance-based compensation would maintain its status as such and should be excluded for purposes of determining the $1M limit. If a Covered Employee defers performance- based compensation, plan sponsors would need to track the amount determined to be “performance based” to be able to exclude such amounts, when paid, for purposes of determining whether the Section 162(m) limit is exceeded.
  • Earnings on deferrals would be included in “compensation” for purposes of Section 162(m).Earnings on deferrals are considered “compensation” under the current individual income tax laws. Earnings on performance-based compensation may also be considered “compensation” for purposes of determining whether the Section 162(m) limit is exceeded, although the underlying amounts are excluded from such calculation. Many employers provide participants with a hypothetical investment opportunity in funds similar to the company’s 401(k) plan. These earnings are unpredictable and may cause uncertainty when an employer and executive wish to maximize compensation deductibility.
  • Beneficiaries would be considered Covered Employees.If a Covered Employee dies, Section 162(m) would deem such individual’s beneficiaries to be Covered Employees. A great number of existing plans provide for lump sum payments to Covered Employees’ beneficiaries for certain compensation and benefits upon the Covered Employee’s death; such payments would be non-deductible to the company to the extent that such amounts exceed the $1M limit. Employers and beneficiaries alike tend to prefer a lump sum payment to reduce costs of ongoing administration of benefit payments. If a plan provided for payment in installments in order to preserve deductibility, an estate or trust would have to continue filing returns over that period of time, which may cause an undue burden to beneficiaries for the ongoing cost of administration of the estate or trust.
  • Payments under certain post-termination programs which are separately regulated and which policy considerations encourage employers to provide, are included in “compensation” for purposes of Section 162(m).Policy considerations encourage employers to offer certain programs to its broad-based employee population, such as qualified deferred compensation plans, for example, 401(k) or pension plans, and involuntary severance, vacation or disability programs. Distributions from such programs are currently considered “compensation” under tax rules and may be attributed to the Section 162(m) limit.

Proposed Changes to Section 409A

BackgroundSection 409A imposes restrictions on deferral elections and distributions under a non-qualified deferred compensation plan or arrangement. The penalty for noncompliance is that the non-qualified deferred compensation is immediately includible in income in the year that underlying compensation is no longer subject to a substantial risk of forfeiture, and that the compensation is subject to a 20% penalty tax and applicable interest.

The Act proposes to limit the amount of non-qualified deferred compensation that a participant can defer without being subject to the Section 409A penalties. The proposal recommends that a participant’s annual deferral be limited to the lesser of:

  • $1M; or
  • The five-year average of an individual’s annual gross income immediately preceding the year in which the election to defer is made.

If a participant’s annual deferrals exceed the limit, all of the participant’s excess deferred compensation will be subject to the Section 409A penalties, i.e., being includible in current income and subject to the 20% tax and interest. This change would apply to deferrals made on or after January 1, 2007. Earnings attributable to non-qualified deferred compensation would be treated as additional deferred compensation and subject to the Act. Earnings on amounts deferred prior to January 1, 2007 would not be subject to the Act. The Act also indicates that aggregation rules will apply.

A company would need to determine the amounts “deferred” under each non-qualified deferred compensation plan, including:

  • Deferrals made, and employer contributions credited, under traditional non-qualified deferred compensation plans and arrangements and excess 401(k)s.
  • Earnings on deferrals and employer contributions made on or after January 1, 2007.
  • Accruals under SERPs.
  • Amounts payable under certain equity comp awards, e.g., restricted stock units that are not settled in the short-term deferral period (such as deferred stock units; discounted stock options or stock appreciation rights).
  • Amounts payable under certain executive severance arrangements.

Such amounts may need to be aggregated to determine if the threshold is met.




  • The five-year average causes an undue burden for certain participants.The five-year average takes into account taxable income earned by a participant in the five years preceding the “computation year,” which is generally the year to which the deferral limit is being applied. The five-year average limitation:
    • Disproportionately penalizes participants who participate in deferred compensation programs, but make well under $1M.
    • Disproportionately penalizes a participant whose taxable income was reduced due to participation in a deferred compensation plan in previous years.
    • May also unduly penalize non-employee directors if a significant portion of their compensation consists primarily of deferred compensation, such as restricted stock units.
    • Would also impact participants who do not have taxable income or who have little taxable income in the five years preceding a distribution, such as a participant who deferred compensation for more than five years after termination of employment or changed the form of his or her deferrals to which the Section 409A “12/5 Rule” is applied.¹ In such instances compensation may be zero during such five-year period, which would cause subsequent deferral distributions to be subject to the Section 409A penalty taxes.


  • Aggregation rules would require that all deferred amounts subject to Section 409A be considered when calculating whether the deferral limit is reached.A company may have to aggregate all deferrals under all non-qualified deferred compensation arrangements (see above) in determining whether the deferral limit is reached. Currently, there is no guidance on the methodology for calculating accruals under a non-account balance plan. Valuation depends to a large extent on the calculation of accruals and time lapsed from a specified date. Without guidance on valuation, determining the amount of deferrals that a participant can make under an account balance plan that is aggregated for purposes of determining the deferral limit would be unduly burdensome to the plan sponsor.
  • Earnings on deferred amounts are considered “deferrals” for purposes of determining whether the deferral limit is reached.Earnings on amounts deferred in a previous year will be counted against a subsequent year’s limit. Including earnings as amounts deferred makes participant planning for the amount to defer challenging, and increases the administrative burden of maintaining a deferred compensation plan. Further challenges arise if earnings are based on hypothetical investments, such as investments mirrored from a qualified 401(k) plan with an anomalous result of penalizing a participant who makes highly productive investment choices. Increase in the stock price would also be considered earnings for purposes of stock units or phantom stock plans.
  • Payments that are due, but not vested, under a contract or agreement entered into prior to January 1, 2007 would be included in the deferral limit.A plan sponsor may be legally required to pay an executive an amount that is subject to Section 409A that vests after January 1, 2007, such as severance payments due upon a future involuntary termination.


¹ The redeferral rules under Section 409A require that a participant who changes the time and/or form of deferrals must redefer to a time of distribution at least five years beyond the scheduled date of payment. If a participant was scheduled to receive his or her deferral account upon a termination of employment, but changed the form of receipt (for example, from a lump sum distribution to installments) the participant would not begin receiving his or her account distribution for five years after termination of employment.