Tip of the Month for December 2005

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TIP: Stay Current on Deferred Compensation Tax Rules;
IRS Clarifies Changes But Pitfalls Remain
Despite clarifications issued in September 2005, the Internal Revenue Service (IRS) has yet to resolve all the issues resulting from recent reform of tax regulations governing deferred compensation plans. If you have a deferred compensation plan in place, be aware that - despite further IRS pronouncements - many "gray areas" and potential pitfalls remain. Be sure to consult your tax attorney to discuss how best to avoid potentially hefty tax penalties.

Deferred compensation plans utilize a variety of methods - stock options, "mirror" 401(k) plans, and other programs - to allow highly compensated individuals to defer taxation on their pay by agreeing to push back the payment until a later date (usually retirement). In 2004, the IRS implemented a broad plan to reform deferred compensation in response to a series of highly publicized corporate scandals that brought to light some abuses of the system. In September 2005, the IRS announced its long-awaited clarification on how executives, and their companies, are expected to follow the new rules. The good news is that the September regulations did resolve many questions, the bad news is that some "gray areas" remain, especially regarding "mirror" 401 (k) plans and non-monetary privileges and support services.

"Mirror" 401(k) plans are designed to allow highly compensated individuals to put additional money into spillover 401(k) plans when they have reached the contribution limits ($15,000 in 2006) of a typical 401(k). It was feared that the sweeping reforms in 2004 might outlaw these spillover plans completely. The new IRS stipulation that the dollar amount to be deferred must be determined a year in advance further muddied the issue because this proviso runs counter to the usual 401(k) regulation that allows a contributor to change the amounts deferred at any time. Clarification on this issue has still left some major questions unanswered. Contact your tax professional for updated information on "mirror" 401(k) plans and for timely updates on the new rules regarding non-monetary compensation.

Questions also remain regarding non-monetary fringe benefits. Some executives receive continued access to services like secretarial assistance and rent-free office space after they leave a company. In some instances, former executives may also be allowed to continue to use company automobiles or to fly on corporate jets. Under the new regulations, these "perks" may now be considered deferred compensation because they are a form of non-monetary severance pay. If they are to be considered as deferred compensation, executives may have to wait six months before they can use them.

Breaches of the new rules may result in heavy tax penalties. Make sure you get professional help from an experienced tax consultant to develop or modify your plan.


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