Executive compensation plans, and long-term incentive plans in particular, create a binding promise to pay employees compensation under specified conditions. As such, there are certain tax and legal rules and requirements a company must consider. Generally, employers should look to ERISA, Internal Revenue Code Section 409A, as well as state and federal labor rules to define the plan’s compliance responsibilities. Many phantom stock plans are subject to either ERISA and/or Section 409A. Companies should seek guidance from qualified advisors and tax prep experts if they wish to avoid these regulations.
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. Qualified plans, such as 401(k) programs, are subject to all of the rules and restrictions of ERISA. Nonqualified plans, including most phantom stock plans, are not. Thus, most phantom stock plans are exempt from the portions of ERISA pertaining to participation, vesting, funding and fiduciary responsibilities.
IRC Section 409A
Internal Revenue Code Section 409A was designed to address perceived abuses by executives who used their authority to accelerate distributions in deferred compensation plans while knowing that the companies they represented were approaching financial ruin. Their goal was to accelerate their plan distributions before the company went bankrupt, thus guaranteeing they could get all of the compensation the companies were planning to pay them at a later date. However, the actions of those executives unfairly benefited them over the interests of other employees and even the company’s shareholders. Therefore, in 2004 Congress passed Section 409A to regulate the timing of compensation payable on a deferred basis and to restrict executives from obtaining distributions on an accelerated or discretionary basis.