The Senate Finance Committee approved a proposal as part of the Small Business and Work Opportunity Act of 2007 on January 17, 2007, which contains a limit on the maximum annual amount of nonqualified deferred compensation for individuals. The proposal has not yet been passed by the House of Representatives or by the Senate as a whole.

Annual Limit. Under the proposal, for any taxable year beginning on or after January 1, 2007, an individual may defer no more than the lesser of (1) $1 million and (2) his or her average gross income from the employer for the preceding five taxable years.1 Earnings on nonqualified deferred compensation subject to the proposal would be included as additional deferred compensation. The determination of whether compensation constitutes nonqualified deferred compensation subject to this proposal is expected to follow the rules contained in Section 409A of the Internal Revenue Code of 1986, as amended ("Section 409A").

Pre-2007 Deferrals. The proposal generally does not apply to amounts deferred for taxable years beginning prior to January 1, 2007 or to earnings on such amounts, including earnings in 2007 and thereafter. However, it is not clear whether the proposal will cover any such amounts that are "redeferred."

Penalties for Noncompliance. If enacted, noncompliance with the proposed rules would result in the same additional 20% tax that taxpayers face for noncompliance with Section 409A, as well as interest at the underpayment rate plus 1%, on all deferred amounts that are subject to Section 409A.

Transition Relief. The Treasury Department has been directed to provide transition relief in 2007 to allow taxpayers to reduce existing deferral elections to bring their deferred amounts under the new limits, without causing them to be noncompliant with Section 409A.

Investment Manager Impact Unclear. The impact of the proposal on investment management firms who utilize the cash method of tax accounting (and other nonnatural persons) is unclear. To date, the Senate Finance Committee has not released the proposed legislative language, and the only official description is a summary prepared by the Joint Committee on Taxation (the "Summary"). The Summary does not indicate whether an "individual" includes an entity or an owner of the entity. In addition, the Summary does not define "employer," other than to state that private and public corporations are included.

For example, if the proposal were to apply to a deferral election made by an investment management firm with an offshore fund that it manages, the proposal (beyond limiting the amount of principals' deferrals) could have a severe impact on the manager's ability to match the elective and nonelective deferrals of its employees. Absent special rules, the manager may be limited to a $1 million deferral from a particular fund even if it owes its employees significantly more deferred compensation in the aggregate.