On Jan. 17, 2007, the Senate Finance Committee unanimously approved the Small Business and Work Opportunity Act of 2007 (the "Act"), which is the Senate’s amended version of the bill passed by the House Jan. 10, 2007, the Fair Minimum Wage Act. In addition to a minimum-wage increase and several small-business tax breaks, the Act contains two proposals that would significantly impact nonqualified deferred compensation. These proposals provide for: (1) an annual limit on the amount of compensation that an employee can defer, and (2) the expansion of the definition of a "covered employee" under Section 162(m) of the Internal Revenue Code (the "Code").

Limitation on Deferrals

Description. In its current form, the Act would limit the annual aggregate amount of compensation that an employee can defer to the lesser of: (1) $1 million or (2) the employee's average annualized compensation over the past five years. This limit would be effective for plan years beginning on or after Jan. 1, 2007, but it is unclear whether amounts vested prior to that date are subject to the limitation.

Computation of Deferred Compensation. All compensation deferred by an employee in a calendar year would be aggregated for the purpose of computing this limitation. The Act, however, defines “deferred compensation” as it is defined under Code Section 409A. Consequently, certain payments, such as "short-term deferrals," would not be included for purposes of computing this annual limitation.

Penalties. If an employee attempts to defer compensation in excess of this limitation, the Act would impose on the employee the penalties set forth in Code Section 409A. These penalties include: (1) the accelerated inclusion of all deferred compensation under the plan, and similar nonqualified plans, into the offending employee's income; (2) payment of a 20 percent excise tax on the included compensation (in addition to applicable ordinary income taxes); and (3) payment of interest at a rate equal to the tax underpayment rate, plus 1 percentage point on the unpaid taxes applicable to the deferred amount, determined as if the amount had been taxable in the year it was earned.

Although the penalties resulting from a violation of this limitation are imposed upon the employee, if this proposal becomes law, we expect to see most companies implementing mechanisms that track the amount of compensation deferred by their employees annually in order to avoid these negative tax consequences. Expansion of "Covered Employee" Definition

Description. Section 162(m) of the Code denies publicly held companies a deduction for any compensation paid to a "covered employee" in excess of $1 million. Under current law, a "covered employee" is any individual who is the CEO of a company or one of the four highest-paid executives of a company as of the end of a taxable year. The Act would expand the definition of a "covered employee" to include any individual who is the CEO of a company or one of the four highest-paid executives of a company at any time during a taxable year, and any preceding taxable year, starting after Dec. 31, 2006.

Many nonqualified benefit plans currently provide that if the compensation paid (wages and benefit plan distributions) to any "covered employee" during a taxable year would exceed $1 million, benefit plan distributions will be carried over to the year following the covered employee's termination of employment. Under current law, this allows a company to take a deduction for any amount paid to the individual, because the individual is no longer a covered employee after his or her termination of employment. If the new definition of covered employee becomes law, however, any employee who was a covered employee of a company would remain a covered employee even after his or her termination of employment, and the company would remain subject to the $1 million deduction limitation. Although this proposal would be effective for plan years beginning after Dec. 31, 2006, there is no indication that amounts deferred prior to Jan. 1, 2007, would be excluded.

Prospects of Senate Bill Passage

The House and the Senate are currently in joint discussions trying to resolve the differences between the two bills, and it is unclear at this time whether the Senate provisions will survive the discussions. President Bush has indicated that he will veto any bill increasing minimum wage, unless the bill also contains tax cuts. If you have any questions or need further information, please contact one of the members of the Reed Smith Employee Benefits Team listed below, or the Reed Smith attorney with whom you routinely work.