More on Potential Limits to Deferred Compensation

Gretchen Morgenson's "Fair Game" column in the January 28 edition of the New York Times highlights the potential problems for executives who participate in deferred compensation programs if the Small Business and Work Opportunity Act passes in its current form. The proposal would apply both to initial deferrals and to earnings on those deferrals and will affect even executives who earn substantially less than the $1 million maximum cap. As the article states, "'[t]he vast majority of people affected by this will be in the $100,000 range.' And it is unlikely that their companies will cover taxes generated by exceeding the limit."

• Example: If your salary is $100,000, and you have $1 million in your deferred compensation account, your savings would have to earn only slightly more than 10% to push you over limit. If that happened, your entire account would be subject to taxes and the penalty.

• Example: A start-up company pays a small salary but has a generous equity-based deferred compensation program. If the value of the deferred equity in one year fails the annualized compensation test, the entire account becomes taxable and subject to penalty.

From a policy standpoint, it is unfair to impose a tax on money that you have not yet received and have no control over. But the Senate Finance Committee would argue that employers can easily solve that problem by paying higher (taxable) salaries if they want to maintain a certain level of compensation for key employees. Or, they can limit deferral amounts to essentially 100 percent of salary, which is far more than the average worker can defer in 401(k) plans.

There is no specific reason to limit deferrals to 100 percent of yearly compensation, other than it is a convenient measure and one the probably tests well politically. Perhaps the final proposal will be modified to raise the limit, but in the wake of the various executive pay controversies and scandals (e.g., option backdating, enormous severance packages), Congress is unlikely to feel substantial pressure to drop the proposal entirely from the bill.