Attorney Seeks Clarity in Deferred Compensation Plan Rules

Sweetnam, Bill Jr

Attached is a letter seeking transitional guidance under newly-enacted Section 409A. Please feel free to contact me should you have any questions or need further clarification.

The purpose of this letter is to bring to your attention an area of uncertainty that is an appropriate subject for transitional guidance under new Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"), which was enacted as part of the American Jobs Creation Act of 2004 (the "Jobs Act"), and will govern the taxation of deferred compensation effective January 1, 2005. Section 885(f) of the Jobs Act instructs the Treasury and Internal Revenue Service to provide transitional guidance within a 60-day time frame after enactment. The Conference Committee report also indicates that the Secretary may provide exceptions to certain requirements of the provision during the transition period but after the issuance of guidance, and the Act also empowers the Secretary to "prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section" (Section 409A(e)).

Our particular area of concern relates to the treatment during the transition period of subsequent elections concerning the form of payment (e.g. lump sum or installments) with respect to pre-January 1, 2005 deferred amounts that are grandfathered by the new legislation. Under the law in effect prior to the Jobs Act, participants in a deferred compensation arrangement could under appropriate circumstances make an election to change the form of payment at some time after the initial deferral election was made. Generally, if the subsequent election was made before the deferred amounts were payable, and the amount to be received was not definitely ascertainable or was subject to a substantial limitation or restriction, the election to change the method of payment did not trigger constructive receipt of income to the participant. See, Martin v. Commissioner, 96 T.C. 814 (1991); cf. Veit v. Commissioner, 8 TC 809 (1947), acq. 1947-2 C.B. 4. We believe that guidance should be issued to continue this treatment during a transition period.

Both the Veit and Martin decisions addressed the tax consequences of a provision in a nonqualified deferred compensation arrangement that permitted the taxpayers to elect, subsequent to making the original deferral election, to change the selected form or timing of deferred compensation payments. The decisions indicate that constructive receipt may be avoided if the subsequent election concerning the form or time of payment was made before the compensation was due to be paid to the taxpayer and before the amount of compensation was definitely ascertainable. For example, in Veit, the Tax Court, in a decision in which the IRS has acquiesced, held that a taxpayer was not in constructive receipt of a profit sharing bonus when the taxpayer and his employer negotiated a new employment agreement under which payment of a bonus was deferred beyond the date payment was originally promised. See also, Oates v. Commissioner, 18 T.C. 570 (1952), aff'd 207 F.2d 711 (7th Cir. 1953) (retired insurance agents were not taxable on the amount of renewal insurance commissions which were due them under a prior contract which was amended just days before the agents retired to provide for a longer payout period based upon the estimated amount of renewal premiums to be received).

Furthermore, under prior law, subsequent elections to change the form of payment were permitted (provided constructive receipt principles were satisfied) even in the absence of specific authorization allowing such election change under the deferred compensation arrangement in effect at the time the initial deferral election was made. This was the situation in Martin. Martin involved a phantom stock plan under which employees were awarded phantom stock units which entitled them to the net income or loss which was attributed to the units. Under the initial arrangement, the employer entered into separate agreements with each of its executives which provided for payment upon the employee's surrender of the phantom stock units in ten equal annual installments without interest. A new plan was instituted in 1981 as a substitute for the individual agreements previously in place, which allowed an employee to elect a lump sum payment, instead of installments, and provided for payment of interest on the unpaid balance after the first installment was payable. Participants were given the choice of continuing under the existing agreement with the employer or opting into the new plan. Pursuant to procedures adopted by the committee administering the new plan, a participant could change his or her election as to the form of payment, but the change would not be effective until the year following the year in which the change was elected.

The taxpayers, two participants in the company's existing plan, elected to participate in the new plan and elected to receive installment payments. When the two participants subsequently terminated their employment, the IRS took the position that they were in constructive receipt of the amount that each of them could have received in a lump sum under the new plan. The Tax Court refused to apply the doctrine of constructive receipt, citing several relevant factors. First, the payment method was elected before any payments were due to the taxpayers and, because the value of the phantom shares was only determined as of the last day of the month preceding the surrender date, before the benefit amount was definitely ascertainable. The court also found that the participants' right to receive income was subject to substantial limitations or restrictions, i.e., although the participants had the right to surrender their phantom stock units during their employment, if they did so, valuable rights would be forfeited, including the right to receive future contributions of phantom stock units and the right to benefit from the company's future equity growth. The court's conclusion was further supported by the fact that the plan was unfunded, the participants' rights thereunder were unsecured, and no interest accrued on the unpaid balances until after the first installment date.

Congress' intent in the new legislation is to grandfather treatment under prior law for amounts deferred prior to January 1, 2005, provided the plan under which the deferral is made is not materially modified. The purpose of a grandfather rule is to promote fairness and avoid changing fundamental rules with respect to existing transactions. Since under prior law a participant under a deferred compensation plan could generally change the participant's election with respect to the time or manner of payment provided the subsequent election was made before the compensation was due to be paid and before the amount of compensation was definitely ascertainable, such election changes should continue to be permitted during the transition period if these conditions are satisfied.

Furthermore, the subsequent elections should not be considered a "material modification" of the original deferred compensation plan. The Conference report indicates that a material modification relates to the addition of a "benefit, right or feature," such as accelerating vesting under the plan or adding a "haircut" provision entitling the participant to obtain immediate distributions. The essence of Congress' concern is that plan changes should not be permitted that either increase the amount of compensation to which the participant is entitled or give the participant an ongoing right to accelerate benefits at any time. The proposed transition relief that we are recommending is consistent with prior law and does not violate these parameters with respect to plan modifications. We recommend that participants be allowed a one-time election during a limited period of time, say 12 months after guidance is issued, to change an election as to form of payment of their deferred compensation. To ensure that the principles of constructive receipt are respected, we suggest that the transitional guidance require that a minimum period, such as 12 months, must transpire before the subsequent election will be effective (except in the case of death, disability or unforeseeable circumstances).

Finally, we believe that appropriate transition relief should make clear that changes in payment terms of the type described are not subject to the limitations in new Code Sections 409A(a)(3) (precluding "accelerations") or 409A(a)(4)(C) (imposing a 5-year "redeferral" rule).

We hope that these comments are helpful to you in providing guidance during the transition period under Code Section 409A. Please contact the undersigned if we can answer any further questions you may have.