Lawmakers Rethink Changes to Deferred Compensation

Both the preliminary versions of the House and Senate tax reform proposals would have made major changes to the treatment of deferred compensation for executives and highly-paid employees.

However, following the earliest stages of debate, both the House and the Senate seem to have backed away from major changes to deferred compensation arrangements, as well as from other retirement-industry focused proposals. 

As the law currently stands, compensation is generally includible in an employee’s income when paid to the employee. However, in the case of a nonqualified deferred compensation plan, unless the arrangement either is exempt from or meets the requirements of Treasury Regulation 409A, the amount of deferred compensation is first includible in income for the taxable year “when not subject to a substantial risk of forfeiture,” even if payment will not occur until a later year. In general, to meet the requirements of section 409A, the time when nonqualified deferred compensation will be paid, as well as the amount, must be specified at the time of deferral, with limits placed on further deferral after the time for payment. Various other requirements apply, including that payment can only occur on specific defined events.

This system would have be changed dramatically under the first drafts of tax reform proposals released on both houses of Congress. Under the preliminary Senate bill, for example, the rights of a service provider to compensation are treated as subject to a substantial risk of forfeiture “only if the rights are conditioned on the future performance of substantial services by any individual.” Under the proposal, a “condition related to a purpose of the compensation other than the future performance of substantial services (such as a condition based on achieving a specified performance goal or a condition intended in whole or in part to defer taxation) does not create a substantial risk of forfeiture, regardless of whether the possibility of forfeiture is substantial.” In addition, “a covenant not to compete does not create a substantial risk of forfeiture.”

The House Ways and Means Committee had included similar language in its initial tax bill, but since then the language was already amended out of the tax bill prior to its clearing the committee. And news has emerged that the Senate has “stricken” its proposals regarding deferred compensation. It also seems to be the case that the House and Senate are backing away from the limitation of catch-up contributions for high-wage employees, and from the proposal to implement a 10% penalty tax for early withdrawals made prior to age 59½ from governmental section 457(b) plans.

Of course, both the House and the Senate are still just getting started on tax reform. This tax reform effort will take some time to pan out, and preliminary details may change by the time actual legislation is voted on by the full House and Senate.