By Norman Eule and Jack Garson
Garson Claxson, LLC

Last year President Bush signed into law a major new tax bill, which could impose significant, unexpected taxes on employees’ bonuses and other compensation if companies’ employment agreements and plans do not satisfy certain new legal requirements. The new law, known as the American Jobs Creation Act of 2004, contains a largely overlooked new tax on certain forms of deferred compensation. Under prior law, executive compensation that was deferred to a future date was generally not taxable to the executive until the compensation was actually received. Now, as a result of this new Jobs Creations Act, deferred compensation will be subject to immediate income taxation, and an additional 20% excise tax—resulting in a federal income tax rate of 55% at current rates—together with an interest charge equal to the IRS’ underpayment penalty rate plus 1%, if employers fail to comply with the Act’s requirements.

The new rules apply both to individual employment contracts and deferred compensation arrangements, as well as a variety of other compensation arrangements. These rules apply to payments by both corporate and non-corporate employers to independent contractors, such as consultants or directors, as well as payments to employees. Some exceptions are provided for certain types of common benefits plans, such as bona fide vacation leave, compensatory time, sick leave, death benefits or disability pay plans.

Under these new rules, deferred compensation will also be currently taxable if a sponsoring employer moves assets to fund the arrangement off shore, or the arrangement calls for assets to be set aside to fund the payments upon an adverse change in the sponsoring employer’s financial condition.

To avoid current income taxation and penalties under the new rules, a deferred compensation arrangement must:

• satisfy prescribed timing requirements for making and amending deferral elections by an employee or independent contractor;
  
• allow payment of deferred amounts only upon the occurrence of any of six(6) specified triggering events: separation from service, disability, death, a specific date or fixed schedule established at the time of deferral, a change in ownership or effective control of a corporate employer, and the occurrence of an unforeseeable emergency; and
  
• generally not permit accelerated payment of deferred amounts.

Significantly, the IRS recently announced that it will broadly apply these new rules to contracts and arrangements that are not typically thought of as involving deferral of compensation. For example, it is anticipated that these new taxes will apply to stock appreciation rights, annual bonuses and stock options. Thus, for example, an executive who receives stock options that are already “in the money” with a current value of $1 million might now find herself subject to immediate taxation on the value of the options, together with interest and a 20% add-on excise tax, if her company’s stock option plan failed to satisfy the Act’s new deferred compensation requirements. Assuming the executive was in the maximum tax bracket, her federal tax liability for the year in which the options were issued could well exceed $500,000, even though she had not yet exercised the options or otherwise realized any economic benefits! In essence, absent careful review and drafting, the new law compels the current income taxation of compensation that will not be received until some time in the future.

The new rules will have a far reaching effect on almost all employment contracts and other plans and agreements that provide for deferred compensation. Employers should carefully consider these new rules before adopting any new compensation arrangements.

In addition, compensation deferred after December 31, 2004 , under existing employment contracts and other compensation or equity-type arrangements will be subject to these rules. Moreover, even compensation deferred before January 1, 2005 , will be affected by these rules if the plan or arrangement under which the compensation was deferred was “materially modified” after October 3, 2004 . An amount will be considered to have been deferred prior to January 1, 2005 , only if it was “earned and vested” by December 31, 2004 .

Businesses and their legal counsel should, therefore, immediately review and, if need be, amend existing employment agreements and compensation programs to comply with these new rules. Failure to do so will expose affected employees and independent contractors to significant and unanticipated tax liabilities and, thereby, likely result in unwelcome and disruptive workplace morale problems. However, with timely planning and proper legal review employers should be able to minimize the tax impact of these rules while preserving the nature and value of their compensation and benefit programs

About the Authors:

Norman Eule and Jack Garson are attorneys at the Bethesda, Maryland law firm of Garson Claxton LLC. Norman and Jack work extensively with executive employment agreements and can be reached at neule@garsonlaw.com and jgarson@garsonlaw.com, respectively.

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