ACLI Expresses Concern With Proposed Deferred Compensation Regs

Dear Eric:

On behalf of the American Council of Life Insurers ("ACLI"),¹ we are pleased to submit these comments on specific issues arising under Internal Revenue Code section 409A and the proposed regulations promulgated ("Proposed Regulations") thereunder. Our concerns relate to: (i) the rules regarding separation from service of commissioned agents and employees; (ii) the timing of deferral elections for commission compensation; and (iii) application of the written plan requirement. As these comments reflect a significant level of concern across a wide spectrum of the ACLI membership, we would appreciate the opportunity to meet with you to discuss our concerns with you at your earliest convenience.

We have previously submitted a request with other trade associations for the proposed regulations to be re-proposed in order to provide additional opportunities to comment on the new rules. We believe that approach is the most effective way to deal with the myriad comments that have been submitted, while also affording the Treasury Department and the Internal Revenue Service an appropriate amount of time to work through the concerns of the regulated community in a coherent and comprehensive fashion.

The purpose of this letter is raise with you three particular issues arising from the application of the proposed regulations to nonqualified deferred compensation ("NQDC") plans for commissioned agents. While the agent distribution system is the prevalent business model in the life insurance industry, we believe that the issues we raise cut across a broader range of financial services in addition to the life insurance industry. We respectfully submit that certain changes could be made to the Proposed Regulations that take into account the agent business model and accommodate the concerns raised by ACLI members, and that also maintain fidelity to the general conceptual themes that have been developed in the Proposed Regulations.

1. Separation From Service.

Code section 409A generally restricts payments from non- qualified deferred compensation (NQDC) plans to certain "permissible payments," which includes a payment on account of a "separation from service." The Proposed Regulations' interpretation of the "separation from service" standard would hamper phased retirement arrangements, which are widely used by commissioned agents. In addition, the Proposed Regulations would also not appear to accommodate other career transitions in which an individual moves from being an independent contractor to a statutory employee or common law employee position, or vice versa.

a. Phased Retirement. The Proposed Regulations accommodate an employee's separation from service for purposes of Code section 409A when he or she makes a gradual transition from full-time work to full-time retirement. With respect to employees, the rules indicate that a "separation from service" will not occur if the former employee provides services at an annual rate that is 50 percent or more of the services rendered, on average, during the final three full calendar years of employment and the annual remuneration for such services is 50 percent or more of the average annual remuneration earned during the immediately preceding three full calendar years of employment.

There is a separate rule for determining whether an independent contractor has experienced a "separation from service," which is derived from existing regulations under Code section 457. Under those rules, a "severance from employment" occurs for an independent contractor, in general, upon the expiration of the contract or contracts under which services are performed, provided the expiration of the contract is a good-faith and complete termination. There are additional rules, including a safe harbor, for determining when a contract expiration is a "good-faith and complete termination."

As applied to life insurance agents, the proposed rules would frustrate a common and valuable practice of making a gradual transition to retirement. Many agents continue to retain some contractual relationship with their former employers, and some continue to make occasional sales well after formally retiring. Having commissioned agents phase down their productivity, rather than completely terminate their relationship, is a valuable business model and provides a level of continuity and transition that our members and their clients need to preserve. The numerical tests under the Proposed Regulations for determining when a separation from service has occurred in a traditional employment scenario would not work well for commissioned agents, since semi-retired agents will typically have a work schedule or a remuneration rate that is unpredictable.

Rather than apply a numerical test, we believe that other objective tests could be used to more easily permit phased retirement arrangements to exist in industries that utilize an independent agent business model. For instance, a new contractual relationship with the service recipient that would allow phased retirement if an agent attained a certain age or length of service could be used. Under this rule, there would be a clear point at which the agent would be deemed to have separated from service, and could therefore begin to receive payments of deferred compensation.

b. Other Career Transitions. Similarly, there are other types of career transitions that would be hampered by the proposed separation from service rules. In particular, insurance professionals sometimes make career transitions from an independent agent to a statutory or common law employee of the insurance company, or vice versa. Because the benefit programs offered to individuals as independent contractors are materially different from the benefit programs offered to statutory or common law employees, the change in the employment status and the corresponding change in benefit eligibility should be deemed a separation from service. For instance, the termination of an independent contractor agent's agreement generally triggers termination benefits based on the services that were rendered as an independent contractor. As drafted, the Proposed Regulations would not clearly consider such a transition to be a "separation from service," thereby inhibiting the consummation of previously negotiated agreements. Because these benefits are based on or related to services as an independent contractor, and are not based on or related to services as an employee, they should be permitted to commence; a separation from service should be deemed to have occurred.

Rather than inhibit the types of career transitions that benefit both the service provider and the service recipient, we believe it would be useful to link the definition of "separation from service" to eligibility or non-eligibility for benefits under qualified or other bona fide retirement plans of the sponsoring employer, due to a change in employment status (i.e. change from an employee or independent contractor, or change from an independent contractor to an employee). When the service provider moves from an independent contractor position to a statutory or common law employee position, participation in the independent contractor's benefit plans end and the individual becomes newly eligible to participate in the employer's qualified plans. Such changes should be deemed a separation from service, for purposes of section 409A. Conversely, if a service provider moves from a statutory or common law employee position to an independent contractor position, the individual loses eligibility for participation in the employer's qualified plans and may become newly eligible for independent contractor benefits. That transition should also be deemed a separation from service.

2. Deferral Elections and Commission Compensation.

Under section 409A(a)(4)(B), participants may elect to defer compensation for services performed during a taxable year only if such election is made before the end of the preceding taxable year, or at such other times as provided in regulations. The Proposed Regulations contain a clarification of the application of this general rule to the receipt of commissions by a service provider. For purposes of making a deferral election of commission compensation, section 1.409A-2(a)(10) of the Proposed Regulations indicates that the service provider earning the commission will be treated as performing services related to that commission "only in the year in which the customer remits payment to the service recipient." In addition, the Proposed Regulations define commission compensation as compensation earned by a service provider based on the direct sale of products or services to an unrelated customer, which consists of either a portion of the purchase price of the product or service or an amount based on volume of sales, and which is "contingent upon the service recipient receiving payment from an unrelated customer for the product or services."

There are different types of commission compensation arrangements prevalent in the life insurance industry that would not meet that regulatory definition. For instance, some commissions are paid to insurance agents based on assets under management, which are not directly linked to either a direct sale of a product or service, do not consist of a portion of the purchase price, and are not based on volume of sales. Other types of commission compensation, such as contract renewal commissions that are paid to service providers even if the customer owes no premiums under the contract, also do not fit within the proposed rule. In addition, commission compensation paid to "general agents" for management services do not appear to fit within the proposed definition of commission compensation. We respectfully suggest that the Proposed Regulations be expanded and clarified to apply to such situations.

3. Written Plan Requirement.

Section 409A requires compliance in both form and operation. The Proposed Regulations indicate that a plan is established on the date the material terms of the plan are set forth in writing. The plan must indicate the amount (or formula for determining the amount) and the time when it will be paid. With regard to the time at which payments will be paid, the guidance should permit substantial compliance particularly for plans in existence prior to the date on which guidance is issued. Some "plans" are actually individual contracts with thousands of service providers. To require amendments simply to include specific terms (e.g., "separation from service") is unduly burdensome. So long as the terms of the agreement are in substantial compliance in form, and are in compliance in operation, pre-existing plans should not have to be amended.

Again, we would like to meet with you to discuss these issues with you in more detail, and will contact you in the near future to arrange a mutually convenient time. In the meantime, if you have any questions regarding the issues discussed in this letter or you would like any additional information in advance of our meeting, please do not hesitate to contact us.