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Executive Compensation: Year End Tax Planning Alert

As the end of 2006 approaches, employers still have time for tax planning regarding 2006 bonuses that are scheduled to be paid in 2007.  The opportunity to defer 2006 bonuses scheduled for payment in 2007 has not yet elapsed. Conversely, if the intent is to pay 2006 bonuses in 2007, it is critical to take steps to ensure that those bonus payments comply with the requirements of Internal Revenue Code Section 409A, to avoid the imposition of additional taxes on those payments.

I. Possible Deferral of 2006 Bonuses. Under the recently-extended Section 409A transition rules, employees may still be given the option to defer 2006 bonuses currently scheduled for payment in 2007, provided that the deferral election is made by December 31, 2006.

II. Meeting Requirements for 2006 Bonuses Paid in 2007. If, on the other hand the intent is to pay the 2006 bonus in 2007, but the payment may be made later than March 15, 2007, employers should take steps to ensure that their bonus plan or arrangement has either complied with or is exempt from the requirements of Section 409A. Although the transition rules extend the period during which employers can amend their documents to bring them into compliance with Section 409A, good faith compliance is required in the interim for payments made during 2006 and 2007.

For purposes of Section 409A, compensation is treated as deferred and subject to the new rules if, under the terms of the plan or arrangement and the relevant circumstances, it is payable later than 2½ months after the close of the taxable year in which the employee, director or consultant is no longer subject to a substantial risk of forfeiture in regard to that compensation.

Consequently, for calendar year bonus plans and arrangements, if the arrangement provides for a bonus for 2006 to be paid in 2007, the bonus must generally be paid by March 15, 2007, in order for the payment to be exempt from application of Section 409A. However, where bonuses are based upon 2006 performance results, it may not be practicable for an employer to be in a position to meet the March 15 deadline. Not only must the performance results for 2006 be determined; they must also be evaluated and applied to the appropriate matrices, often involving multiple levels of committee actions.  Where the performance results are to be based upon audited figures, the situation is exacerbated.

One alternative is to draft a bonus plan, arrangement or agreement that complies with the requirements of Section 409A by treating the payments made after the 2½ month deadline as "deferred compensation" and specifying the payment date or fixed payment schedule consistent with the requirements of Section 409A. Another simple and straightforward solution would be to specify in writing that the employee's 2006 bonus will only be paid if he or she is in the employer's employ on January 1, 2007. Most bonus plans that utilize such an employment requirement, merely require that an employee be employed on the last day of the plan year for which the bonus is paid (e.g., on December 31, 2006) to be entitled to receive the bonus. However, a one day delay in the vesting date, to January 1, 2007, would make a world of difference under the 2½ month rule!  Because the legal entitlement to the vested bonus would not be obtained until January 1, 2007, the 2½ month deadline becomes March 15, 2008 - an extra year's breathing room for one extra day! The result is that the employer's management and compensation committees would now have more time to determine and assess the relevant data and calculate the payments without fear of the imposition of additional taxes on the recipients under Section 409A. Obviously, requiring the individual to be in service on the actual payment date itself (not all that unusual a requirement) would provide the same result under Section 409A.

The most critical aspect of Section 409A is that it penalizes the recipient of the compensation, regardless of the fact that it is the action or inaction of the payor that triggers the additional taxes. Consequently, employers should act now to comply with Section 409A or to come within the 2½ month exception. If there is a possibility that the 2006 bonus may be paid after March 15, 2007, the bonus documents should be reviewed for 409A compliance. In the alternative, a simple one-paragraph written agreement between the employer and the employee, director or consultant, whereby both parties agree to extend the vesting date to January 1, 2007, should suffice to extend the applicable 2½ month period by a full year. 

This client alert is a publication of Loeb & Loeb and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations.
Circular 230 Disclosure: To assure compliance with Treasury Department rules governing tax practice, we inform you that any advice (including in any attachment) (1) was not written and is not intended to be used, and cannot be used, for the purpose of avoiding any federal tax penalty that may be imposed on the taxpayer, and (2) may not be used in connection with promoting, marketing or recommending to another person any transaction or matter addressed herein.