Charyk’s principal specialties are taxation of partnerships, and employee benefit and executive compensation tax planning. He has been with Arent Fox since 1973 and served as managing partner since 2003. He has been an adjunct professor of law in the graduate division at Georgetown Law Center for more than 25 years, and is a graduate of Johns Hopkins and GW law school. Arent Fox has 300 lawyers in offices in Washington and New York.

Editor’s note: We are proud to have Arent Fox, one of Washington’s leading law firms, as a sponsor of General Counsel Weekly, and so we took the liberty of asking its managing partner what tax advice he thought in-house counsel should be aware of as the year closes. One set of issues he called our attention to are proposed IRS regulations concerning deferred executive compensation. We decided to put his comments in the form of six pieces of advice, following a couple questions.

Bisnow on Business: Just to be sure we’re on the same page, what is deferred compensation?

Anything scheduled to be paid in a year later than which it is earned. Of course there are some regulatory exceptions, such as something that is paid out within two-and-a-half months of the year in which it’s earned.

What prompts the changes?

We’ve had a whole new Section 409A of the Internal Revenue Code, promulgated under the American Jobs Creation Act of 2004, that came about as a reaction to Enron. Frankly, many experts believe it was legislative overkill, in that it seemed to assume that practically everything Enron did was bad, even though 85% of Enron’s compensation arrangements were conventional. But reform paints with a broad brush. The IRS gave guidance for the new section in late 2004 and this October, in the form of both proposed regulations, and they are bending over backwards to allow this guidance to be relied on pending final regulations.

Okay, let those tax warnings rip!

Warning One: No more haircuts!

A haircut is a term used to describe the ability of an executive to accelerate receipt of deferred compensation by allowing for a partial forfeiture of the deferred amount. For example, an executive otherwise entitled to receive $100,000 in 2010 could agree to receive just $90,000 in 2006. In the past this wasn’t a problem. Now, it is absolutely prohibited with respect to any amounts which vested after 2004.

Warning Two: Prepare your executives for delayed gratification on retirement!

If you have a public company executive who’s terminated, they can’t quit and claim deferred compensation immediately. They’ll have to wait six months. The rationale is that an executive seeing a problem could use inside information to decide to jump ship.

Warning Three: Don’t use discounted options!

Stock options and stock appreciation rights are vehicles that give executives the right to choose when to recognize income over a period such as ten years, so they control the trigger. What the new rules say is that for an option not to generate income until it’s exercised, it has to be granted at fair market value. It wasn’t that unusual for options to be granted at 95% or less of the initial value, or based on book value rather than appraised value. Now optionees will need to recognize any discounted value on the grant and on appreciation each year.

Warning Four: Be careful how existing elections are changed!

Existing deferred compensation plans often provide that you can make changes to existing elections as long as you do so before the compensation is payable. For example, if you had a lump sum payable on January 1, 2008, you could change before then to make it payable in 2010 or even by installments, as long as the change was made 90 days or some meaningful period in advance. Now we have what’s called a one year, five year rule. You have to change the election at least 12 months beforehand, and the change must further defer the timing at least five years from the original date of payment. So in that example, you’d have to make the change before January 1, 2007, and defer the election to at least January 1, 2013.

Warning Five: Keep separate records for pre-2005 benefits governed by old law!

Any benefit that had become vested and to which an executive had an unmitigated right before December 31, 2004, can still be operated in accordance with its original terms. So you can still have haircuts or change elections, provided you don’t materially modify the program. Many companies are therefore setting up one plan to cover old money and another for new money, or at least keeping separate accounts. Where it will get tricky is if you wait too long, it might get difficult to attribute whether earnings are related to old money or new. For example, the delayed gratification issue doesn’t apply to old stuff as long as you can show it’s old stuff. Suppose you had $100,000 in 2004 and added $20,000 in 2005, and asked to switch $30,000 over to an index fund for investment purposes. If you don’t have separate records, it will become difficult. To keep flexibility on old money, you need to establish records now.

Warning Six: Act now to change 2006 deferrals!

There are some special transition rules that allow you to make changes without regard to the anti-acceleration rules or the one year, five year rule. So you can override some of the rules if you take action in 2005. If you want to push money into or out of 2006, you have to amend your election this year.