Nonqualified deferred compensation arrangements are commonplace among executives in the American workforce. These arrangements raise tax timing issues for our cash-basis accounting system. When should the compensation be determined to have been “constructively received” by the worker, and thus subject to taxation? Our policy on the issue was originally too lenient in the wake of Martin v. Commissioner. ((96 T.C. 814 (1991).)) However, many view the Congressional response in enacting Internal Revenue Code (IRC) Section 409A as an over-correction that is too stringent. ((See, e.g., Andrew W. Stumpff, Deferred Comp. and the Policy Limitations of the Nuclear Option, 117 Tax Notes 611, 612)) With any luck, there will be another adjustment to this constructive receipt issue, and much like Goldilocks’ trial and error with the Three Bears, it will be just right.
Opening the Floodgates – Martin v. Commissioner
Professor Andrew Stumpff, who tried to get the DOJ to appeal Martin after the Tax Court’s ruling, provides a succinct synopsis of the pre-Martin constructive receipt world. ((Id. at 611)) The doctrine essentially prevented a worker from “‘turning his back” on income that has been ‘made available,’ thus choosing the tax year of inclusion.” ((Id.)) However, if the worker and his employer originally agreed (before a payment was earned) that the payment would be deferred, it would not be subject to constructive receipt and would instead be taxed upon actual receipt ((Id.)) Martin raised the case where a worker and his employer entered such an arrangement and later elected for further deferral before the payment was scheduled to be made ((Id.)) The Tax Court in Martin decided that such an election would not implicate the constructive receipt doctrine, allowing the tax to be further deferred. ((Id.))
Enter the glory days of gamesmanship for deferred compensation. Popularity soared for so-called “hair-cut” provisions, which gave executives significant control over tax timing, as long as they gave up approximately 10 percent of the deferred compensation amount. ((Kathryn J. Kennedy, A Primer on the Taxation of Executive Deferred Compensation Plans, 35 J. Marshall L. Rev. 487, 522 (2002) )) This kind of tax planning went on swimmingly for years until “an anti-Enron fervor swept Congress” in the early 2000s. ((Schuyler Moore, The deferred compensation time bomb, Hollywood Reporter (2007), https://www.hollywoodreporter.com/news/deferred-compensation-time-bomb-148769)) After Enron’s demise, “everything it had done was held suspect, and one of those things was to permit employees to avoid current taxation by deferring compensation to future taxable years.” ((Id.)) Congress responded with IRC Section 409A.
Over-Correcting – IRC Section 409A
Section 409A and its associated Treasury regulations are lengthy and complex. Section 409A was originally intended to “eliminate ‘haircut’ distributions” and “bring order to the general constructive-receipt rules.” ((Michael Doran, Time to Start Over on Deferred Compensation, Va. Tax Rev. 223, 224)) However, possibly due to the anti-Enron sentiment, the ultimate provision ended up being much more punitive. ((Id. at 225)) As Stumpff put it, “Congress, in short, went nuclear on us with section 409A.” ((Stumpff, supra note 2, at 613)) Among the harshest features is a “20% penalty tax on ‘bad’ deferred compensation. . .” ((Doran, supra note 11, at 226)) This 20% penalty is in addition to current inclusion of all deferred amounts under the plan with penalty interest. ((26 U.S.C. § 409A(a)(1).)) As Michael Doran stated, this penalty leads to “nonsense outcomes” where an executive “whose deferred compensation is protected fully from the corporation’s creditors incurs a smaller tax than a manager whose deferred compensation, although not compliant with section 409A, remains exposed to the corporation’s creditors.” ((Doran, supra note 11, at 226-27))
The high penalty on what was considered “bad” deferred compensation works to the detriment of shareholders. Executives with indemnification agreements will simply shift the risk and potential cost of the penalty onto the shareholders. ((Id.)) Additionally, the complexity of Section 409A’s requirements create only two possible options: (1) a plan that is in accordance with all of the requirements and (2) one that violates at least one of the many requirements and is subject to the penalties. ((Stumpff, supra note 2, at 613)) Thus, a corporation instituting a deferred benefit plan also has to incur significant legal costs of compliance.
A Possible Balance
Section 409A could be adjusted in several ways that would provide net societal benefits from a tax policy standpoint. First, it could set up a system that uses accrual-based taxation, as recommended by Doran. ((Doran, supra note 11, at 225)) While such an accrual-based system departs from our cash-basis method of individual taxation, the former provides clear benefits. First, taxing income when it is earned allows for a more bright-line rule, dramatically decreasing costs of compliance. Second, there would be no incentive for executives to engage in intricate tax planning devices, which would allow for time and money to be put to more productive uses. And Third, a benefit of accrual-basis accounting generally is that it removes sources of arbitrariness.
Admittedly, there would also be issues to overcome in an accrual-based 409A, such as liquidity concerns and potentially greater complexity for individuals than cash-basis accounting. However, Congress could create exemptions for certain situations. Although this may bring back some of the undesirable current costs of Section 409A, it could be on a much lower scale.
Another option, as indicated by Stumpff, would be to change from a binary enforcement system to one on a continuum for violations. ((Stumpff at 613)) Doing so would provide more certainty for those plans that Congress was not targeting with Section 409A. It would also allow those plans to make more rational decisions in weighing costs and benefits of adopting various plans ((Id. at 613-14)). A disadvantage of this enforcement scheme, however, could be increased difficulty for the IRS making its case in court, especially to the extent that a taxpayer’s motivation or intent is implicated.
Despite their disadvantages, both the accrual-based option and the continuum-of-enforcement option are better than the current system. The next time Congress revisits adjustments to the Code, hopefully they take a closer look at the roller coaster constructive receipt doctrine.
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