There are so many tax hikes being bandied about in Washington that it’s hard to keep track of them all. But one that deserves a bit more attention is a proposed tax hike on deferred compensation, which would likely fall more on middle managers than on so-called corporate fat cats. The provision adds up to a $1 billion tax hike, and it works by limiting contributions to deferred-compensation plans.
Under the congressional pay-as-you-go rules, Congress must offset its new spending with tax hikes or spending cuts. Apparently lacking the political will for spending cuts, Democratic leaders have busily been cobbling together tax hikes to finance their spending desires. The easiest tax-hike targets are “the rich,” which seems to be an expansive enough category to include large swaths of comfortable middle-class families.
Deferred compensation might sound like some kind of tricky tax dodge, but it’s actually a perfectly reasonable vehicle for retirement planning, as well as an important tool for early-stage companies to attract and retain talented workers.
Basically, deferred compensation means that an employee will delay receiving some portion of his or her salary or bonus. This allows cash-starved start-up companies to offer compensation based on expected future cash-flow. It also allows smaller and medium-sized companies to compete more effectively with large companies for top talent, retain workers through the use of restricted stock, and offer retirement savings in excess of the relatively low 401(k) limits.
These plans are far more common that you might think. Of the Fortune 1,000 companies, a full 90 percent have these plans.
Unlike “qualified” deferred-compensation plans — such as 401(k)s — these “non-qualified” plans are somewhat risky for employees since there is no guarantee that a company will be able to pay the promised amounts. Yet it is because of this risk that these plans give employees a stake in a company’s future success.
So how does the proposed tax-hike work?
The Democrats would impose an arbitrary cap, most likely $1 million, on contributions to these deferred-income plans, including any account earnings as well as new contributions. A million dollars may sound like a lot, but then again so did the original income limits for the alternative minimum tax. The deferred-comp cap, like the AMT, would not be indexed for inflation. This means that nearly everyone in such a plan would exceed the cap over time, with the draconian impact culminating in immediate taxes on the entire account, plus an additional 20 percent penalty.
Incredibly, Congress is considering this crippling change just months after the Internal Revenue Service published extremely complex final regulations for deferred compensation pursuant to the tax bill that passed in 2004. Many companies that have been racking up enormous legal bills to comply with these regulations would, if the tax hike passed, toss that work in the trash and terminate their plans entirely.
But the saddest irony here is that this tax hike won’t fall on the so-called fat cats. Recruiting and retaining top executives is now so competitive — perhaps because these positions carry greater personal civil and criminal liability than ever before — that companies regularly pay for the taxes and penalties incurred by top executives. Gretchen Morgenson of the New York Times, in discussing how a similar tax hike would hit primarily middle managers, referred to this practice as “so venerable that we might as well call it ‘ye olde tax gross-up.’” It’s the middle managers who would be walloped by the taxes and penalties — if their plans aren’t terminated in the first place.
Congress, in its unquenchable thirst for tax dollars, should resist the temptation to cap deferred compensation. Fiscal responsibility is about limiting the size and intrusiveness of government by reducing spending, not searching for every tax hike in the world and cobbling together ugly “pay-for” packages.