A client came to us recently to discuss a serious cash flow issue. The company is in the construction business in California, which, like the rest of the country, is suffering due to the downturn in the real estate market. The client wanted to avoid layoffs, so he was contemplating asking officers to take a 40% pay cut and rank and file employees to reduce their pay by 10%. If enough employees agreed, he could retain most of his staff. As a “sweetener,” the client said he would promise all of the employees who agreed to the pay cut that their lost pay would be restored once the company’s cash flow returned to 2007 levels—in about five years according to the client’s projections.

The client was surprised to learn that this generous “make-up pay” arrangement would be viewed as a deferred compensation plan that is subject to specific requirements in both form and operation and that if the plan fails to comply with the rules, the employees could be subject to immediate taxation on the “deferred” amount plus a 20% penalty. In other words, if the client simply embarked on this program without getting expert advice, it could wind up hurting its employees more than benefiting them.

In our experience, our client’s consternation is not unusual. By now, it is widely recognized that in 2004, section 409A was added to the Internal Revenue Code. That section requires nonqualified deferred compensation plans to meet a number of requirements related to the election to defer, the circumstances under which payment can be made and the timing of such payments. The rules were explained and amplified in Treasury Regulations that went into effect in 2007 and required compliance by December 31, 2008.

It is also widely recognized that the new rules apply to the traditional executive salary deferral plans, supplemental retirement plans and the like. But the definition of a “plan” is broad and covers virtually any arrangement under which an employee receives compensation at a time later than the year in which he performs the related services. So, for example, a “plan” can include a stock option or stock appreciation rights plan (and similar arrangements for non-corporate entities), executive employment agreements that promise future benefits, severance arrangements and the like. (There are a number of exceptions that may apply, which adds to the complexity of the rules.)

Simply put, employers must be vigilant to avoid adopting an informal arrangement—like our client’s proposed make-up pay program—that will be considered a deferred compensation plan subject to the 409A rules. While it is not especially hard to comply with the rules and they are not especially onerous, failure to comply can be disastrous for the employees. And while the penalties fall on the employees, it takes very little imagination to see that the employees will look to the employer to make them whole.

So what could our client do? There were two solutions. The first was to adopt a formal written plan that complied with the 409A requirements. Since the company was not in a position to make a binding commitment as to when the make-up pay would be given to the employees, the client asked for an alternative. We suggested that after effecting the reduction in pay, management issue to all employees an informal statement that the Company would not forget the loyalty of those employees who chose to stay during the time of crisis but without any formal promise to make up their lost wages.

The important point to take away from this story is that employers need to be aware of the breadth of the 409A rules and need to discuss with their tax advisers the potential impact of these rules whenever they contemplate any arrangement that may constitute a promise to pay later for services rendered today.

Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.

Source: Report To Plan Sponsors