Attorneys Request Change to Guidance on Nonqualified Deferred Compensation Plans

Dear Sir or Madam:

We are writing on behalf of our clients to request guidance on an issue under section 409A of the Internal Revenue Code (the "Code") and the proposed regulations thereunder.¹ The issue discussed below is extremely important to our clients as they attempt to address the impact of section 409A and IRS guidance thereunder on their compensation and benefit plans. We understand that Treasury and IRS personnel are trying to finalize regulations under section 409A on an expedited basis. We appreciate your considering the requests discussed below.

The problem with the exception established by the proposed regulations is that it is too narrow. Certificates of divestiture are normally not issued in connection with nonqualified deferred compensation plan distributions, because these distributions result in ordinary income. Rather, these certificates are issued in connection with transactions resulting in capital gains. There are, however, many instances in which such a certificate is not issued but a government entity requires an employee to divest financial interests in order to comply with conflict of interest rules.

In order to facilitate compliance with these governmental conflicts of interest rules, we request that the exception to the anti-acceleration rule be expanded to permit an accelerated distribution to a nonqualified deferred compensation plan participant who is employed by a governmental entity if:

Federal Conflict of Interest Statute

Congress enacted a federal conflict of interest law to address situations where the decisions made by or advice given to the federal government by its employees could be tainted, even unintentionally, with influence from private financial interests.⁵ The law imposes criminal penalties on a government employee who participates in any official governmental matter in which that employee has a "financial interest."⁶ However, the penalties do not apply if the government employee (i) disqualifies or recuses himself from participating in the matter in which he has a financial interest or (ii) discloses certain "interests" and certain other requirements are met.

Federal Conflict of Interest Regulations

In addition to the federal conflict of interest law, the Office of Government Ethics has promulgated regulations that address instances in which a conflict of interest due to a financial interest in, for example, a private corporation arises.⁷ Under these rules, financial interests of a government employee will generally disqualify the employee from engaging in government-related activities when the employee knows that the matter will have a direct and predictable effect on his financial interests and where the employee believes that his impartiality may be questioned. Such disqualification or recusal, however, may not be necessary if the employee discloses the potential conflict and receives written authorization to participate in the matter.

Also under these rules, any agency may independently require an employee to divest certain financial interests prior to or during the employee's tenure.⁸ Specifically, an agency may prohibit or restrict the holding of certain financial interests if the agency determines that a reasonable person would question the impartiality and objectivity with which agency programs are administered. In addition, an agency may require the divestiture of a financial interest if the agency determines that a substantial conflict of interest exists such that the conflict (i) will require the employee's disqualification from matters so central or critical to the employee's official duties or (ii) will adversely affect the efficient accomplishment of the agency's mission because the employee would otherwise be disqualified under the conflict of interest laws. The following example from the regulations illustrates these rules:

We hope that this comment is helpful to you in providing additional guidance under Code section 409A. Please contact us at 202-857-0620 if we can answer any questions or provide any further information.

² Expanding the exception to the anti-acceleration rule will also expand the parallel exception to the six month delay for payments to key employees, as the latter exception refers to payments made under the circumstances described in the former.

³ The Conference Report to the American Jobs Creation Act of 2004 provides "It is intended that the Secretary will provide other, limited, exceptions to the prohibition on accelerated distributions, such as when the accelerated distribution is required for reasons beyond the control of the participant and the distribution is not elective. For example, it is anticipated that an exception could be provided if a distribution is needed in order to comply with Federal conflict of interest requirements or a court-approved settlement incident to divorce." H.R. Rep. No. 108-755, at 731 (2004) (Conf. Rep.).

⁴ Prop. Reg. § 1.409A-3(h)(2)(ii).

⁵ H.R. Rep. No. 87-748, at 4-6 (1961).

⁶18 U.S.C. § 208.

⁷ 5 C.F.R. §§ 2635.501, .502.

⁸ 5 C.F.R. § 2635.403.

⁹ 5 C.F.R. § 2635.403(b), Ex. 1.