Lockheed Martin Addresses Dilemma Between Deferred Compensation Plan and Conflict-of-Interest Rules

We appreciate the energetic efforts of the Department of the Treasury and the Internal Revenue Service to promulgate guidance and regulations under Internal Revenue Code section 409A. Although the formal comment period for the proposed regulations has expired, I am writing on behalf of Lockheed Martin Corporation to bring to your attention an issue that should be addressed in the final regulations.

The conflict-of-interest exception to the prohibition against acceleration of distributions, provided for in Prop. Reg. § 1.409A-3(h)(2)(ii), does not permit the resolution of conflicts of interest as intended by Congress. The Proposed Regulations require the receipt of a certificate of divestiture from the Office of Government Ethics (the "OGE") under Code section 1043, but a certificate of divestiture is available only for limited purposes and in limited situations. Unless the final Code section 409A regulations are revised, taxpayers (and their former employers) will be required to violate Code section 409A in order to comply with government conflict-of-interest rules.

We recently became aware of this dilemma when the National Aeronautics and Space Agency ("NASA") contacted us concerning a former Lockheed Martin employee who has a post-2004 deferral in a Lockheed Martin nonqualified deferred compensation ("NQDC") plan. NASA provided the employee with NASA's written determination that the interest in the NQDC plan presented a conflict of interest with his official duties. Under the Proposed Regulations, however, we cannot distribute the former employee's post-2004 NQDC in compliance with section 409A unless a certificate of divestiture has been issued by OGE. NASA's attorneys have informed us that, in this situation, OGE regulations do not permit the issuance of a certificate of divestiture for the reasons described below. I anticipate that Lockheed Martin is not alone in having former employees join government agencies and commissions.

The legislative history of Code section 409A recognizes that there are situations where Treasury and the IRS should permit accelerated distributions of NQDC. Congress acknowledged that an early distribution of NQDC does not violate the purposes of Code section 409A where the distribution is necessary to prevent a violation of conflict-of-interest rules.¹ This exception is crucial to government agencies, employers, and their former employees, who are vitally interested in complying with applicable conflict-of-interest rules without triggering the early taxation and 20-percent penalties that would arise from a violation of Code section 409A.

The Proposed Regulations do not resolve the conflict-of-interest situation that Lockheed Martin faces, however, because they require issuance of a certificate of divestiture, as defined under Code section 1043, before an early distribution of NQDC may be made without violating Code section 409A. This approach is flawed in two respects.

First, it fails to account for conflict-of-interest rules imposed by governmental authorities other than the Executive Branch of the Federal Government (e.g., Congress, the Federal judiciary, state and local governments, or foreign governments). In those cases, a certificate of divestiture is not available because Code section 1043 applies by its terms only to officers and employees of the Executive Branch of the Federal Government.² The OGE has no jurisdiction outside the Executive Branch and, therefore, cannot issue a certificate of divestiture for other conflicts.

We recognize that the Committee Reports refer specifically to distributions required by "Federal conflict of interest requirements," but the reports refer to such requirements only as an example of distributions that are "required for reasons beyond the control of the participant and [when] the distribution is not elective."³ Treasury would certainly have regulatory discretion to apply that legislative intent to similar scenarios involving the other two branches of the Federal government and state, local, and foreign government conflict-of-interest rules. Applying this exception in the case of all government employees is consistent with the purposes of Section 409A.

Second, and of immediate concern to Lockheed Martin, is that the OGE regulations do not permit the issuance of a certificate of divestiture except where the income event flowing from a divestiture would be a capital gain.⁴ This limitation to capital transactions is attributable to the terms of Code section 1043, which have been interpreted to apply only to capital gain transactions. Early distributions from NQDC plans result in ordinary compensation income rather than capital gains.

For both of those reasons, tying the early distribution exception in the Proposed Regulations to the standards in Code section 1043 does not cover the conflict-of-interest situations that we believe Congress intended to except from the anti-acceleration rule in Code section 409A.

One possible resolution to the problem is a change in OGE regulations to permit the issuance of certificates of divestiture for ordinary income transactions, such as NQDC accelerations. That relief, however, would resolve the issue only in the case of Federal Executive Branch officers and employees.⁵ We do not believe that Congress intended to limit the exception to Executive Branch employees and ignore the issue for individuals who become employees of the other two branches of the Federal government. Moreover, it is not clear when any revisions to the OGE regulations would occur.

Furthermore, many state, local, and foreign governments impose similar conflict-of-interest rules that mandate divestiture in a broad range of circumstances. The regulations under Code section 409A should promote the integrity of government by permitting early distributions of NQDC in such cases. Treasury regulations should not apply Code section 409A in a way that forces employees subject to conflict-of-interest rules and their former employers to choose between violating section 409A and continuing a prohibited conflict of interest.

To resolve both problems, we recommend that the final regulations under Code section 409A permit early distributions of NQDC where divestiture of a former service provider's interest in a NQDC plan is necessary in order to comply with any governmentally imposed conflict-of-interest statute, regulation, rule, or order, as evidenced by either (i) a certificate of divestiture as defined in section 1043 (or a similar instrument issued by the legislative or judicial branch of the Federal government or by a state, local, or foreign government), or (ii) a written opinion of counsel for the service recipient or any governmental agency or entity that employs the service provider. We believe that such a rule would address conflict-of-interest issues in the manner that Congress intended.

Thank you for your consideration of our comments. If you have any questions, I would be happy to talk about these issues further. Please call me at (301) 214-9822, or I can be reached via email at David.A.Heywood@LMCO.com

² Under OGE regulations, a certificate of divestiture can be issued only to an "eligible person." Eligible person means, "Any officer or employee of the executive branch of the Federal Government," or a spouse, a minor or dependent child, or a trustee of such an individual. 5 CFR 2634.1003.

³ Conf. Rept. 108-755, p. 731.

⁴ 5 CFR 2634.1001(a) provides, "26 U.S.C. 1043 and the rules of this subpart allow an eligible person to defer paying capital gains tax on property sold to comply with conflict of interest requirements. To defer the gains, an eligible person must obtain a Certificate of Divestiture from the Director of the Office of Government Ethics before selling the property. . . ." Subsection (b) provides that "[t]he purpose of section 1043 and this subpart is to minimize the burden that would result from paying capital gains tax on the sale of assets to comply with conflict of interest requirements. Minimizing this burden aids in attracting and retaining highly qualified personnel in the executive branch and ensures the confidence of the public in the integrity of Government officials and decision-making processes."

⁵ It is also doubtful that NQDC is "property" within the meaning of Code section 1043(b)(2)(A).