Time to End the Silicon Valley ‘Talent Tax’

Published August 1, 2006

President George W. Bush wants to make the American workforce globally competitive, but new government rules may soon push the best and brightest of Silicon Valley out of the country. Unless the U.S. wants to add talented professionals as a new national export, Congress should revoke the tax disaster known as Section 409A.

As a provision of the Internal Revenue Code, Section 409A takes aim at “nonqualified deferred compensation plans,” an important tool that helps businesses recruit highly qualified workers. These plans allow executive-level employees to temporarily defer income such as bonuses and stock options, granting tax savings and retirement options that extend beyond the limited benefits of traditional pensions and 401(k) plans.

Nonqualified deferred compensation is often a form of performance-based pay, as a good share of deferred compensation is usually held in company equity. And since plan assets can be seized by creditors in cases of corporate bankruptcy, such deferred compensation is also a way to ensure financial problems within a company do not spin out of control.

With few government rules to encumber their effectiveness, nonqualified deferred compensation plans have been a valuable asset to employers and employees for more than 50 years. But after the collapse of Enron and other corporate titans early in the decade, public anger over “golden parachutes” and perceived tax abuse spurred federal lawmakers to tighten the government’s grip over nonqualified plans. The result was passage of Section 409A in the American Jobs Creation Act of 2004, a short-sighted “talent tax” on top-performing professionals.

Vague Parameters, High Penalties

Principally, Section 409A forces nonqualified deferred compensation plans to adhere to tough new rules under the threat of severe tax consequences, eliminating the flexibility and control that deferred compensation plans traditionally gave employees. 409A imposes strict government guidelines as to how and when employees can defer nonqualified compensation, restricts the funding of nonqualified deferred compensation plans, and reduces the freedom of plan participants to defer or accelerate their compensation.

Most egregiously, the tax provision gives employers vague parameters for setting the exercise price for employee stock options, which has become an unnecessary headache for many in the business community and a cash cow for tax advisors.

For those plans found noncompliant with 409A guidelines, participant compensation is made immediately taxable, and plan holders will have to pay an additional 20 percent tax penalty. As many executives put large sums of money into these plans, continuing to use them under new government conditions can be a costly gamble.

High-Tech Hornets’ Nest

In California, the hornet’s nest of Section 409A makes recruiting especially difficult for high-tech entrepreneurs, who often lack the financial reserves necessary to compensate every top performer with a million-dollar salary.

Silicon Valley was built by young visionaries working out of garages, creating new inventions that would one day revolutionize the world and bring large future compensation. Now, the valley competes with thousands of foreign firms who all desire a chunk of its success and are willing to pay handsomely to take away its most valuable assets. Silicon Valley’s failure to retain its talented workforce will be the nation’s loss: The U.S. has become increasingly dependent on high-tech industries as manufacturing and farming jobs are eliminated and outsourced to developing nations.

Section 409A will hurt the nation’s global competitiveness more than it will help. It threatens to leave America dangerously undermanned to face the economic challenges ahead. Countries such as India, Ireland, and Singapore have advanced their government policies to foster billions of dollars in investment and may soon be successful in luring more of America’s labor force overseas.

The Treasury Department has yet to finalize the governing rules of Section 409A, which has left many businesses scrambling to pay for costly legal aid to avoid non-compliance with the half-baked law. But Congress shouldn’t wait another day to recognize its failure and fix the mistakes of Section 409A. When Silicon Valley entrepreneurs can continue to employ the best and brightest of the nation, every American will benefit.

Vince Vasquez ([email protected]) is a policy fellow in technology studies at the Pacific Research Institute.