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Guest Article

409A Proposed Regs Are Tour de Force-- But Grandpa Is Still In Hiding

By Alvin D. Lurie
December 7, 2005


The proposed regulation on the nonqualified deferred compensation rules of Code section 409A, released at the end of September, is not a page turner (though it's a lot of pages to turn, at 238 pages); but that didn't stop this reader from furiously (if wearily) turning its pages to search for the grandfather rules that I had found so elusive in December when the initial official guidance under the statute, Notice 2005-1, was released by the Service (as earlier recounted in my piece in another venue, Tax Notes, 1/10/05 at p. 229). Alas, my search of the just-proposed regs has proved unenlightening.

In fact, I was dismayed when, on page 101 of the preamble to the regs (the preamble alone is 123 pages!), I found what appeared at first blush to be a repudiation of the thesis I had confidently developed in the aforesaid piece-- that the grandfather protection could extend as late as November 30, 2005 in case of a fiscal year taxpayer, notwithstanding the general wisdom that the statute became effective at all events on 1/1/05, thus ending any grandfather period for deferral compensation vesting on or after that date. I must admit that my conclusion was a bit shaky, based on a stitching together of statute, legislative history and the 2005-1 notice. But the case for that conclusion seemed very sound to me then, and still does. So I was plagued with doubt and disappointment on reaching the statement on page 101 that "an amount... considered deferred before January 1, 2005... thus is not subject to section 409A", without qualification of any kind for fiscal year taxpayers.

So I pressed on into the dense prose of the preamble, only to find even more unforgiving language, such as--

...these regulations are consistent with the legislative intent that deferred amounts that were not earned, or were not vested, as of December 31, 2004, are subject to the provisions of section 409A.

Nota Bene: not that such amounts "may" be subject, or "generally will be subject", just a flat "are" subject.

The preamble goes on to the ultimate indictment of all post-12/31/04 deferrals, intoning its irremediable judgment that even "contractual arrangements entered into before the enactment of the statute" will fall within the reach of the statute inasmuch as the "statutory effective date is tied to the date the amount is deferred... [and] for these purposes 'an amount is considered deferred before January 1, 2005, if the amount is earned or vested before such date.'." (Emphasis is mine.)

Driving the last nail in the arrangement, the preamble requires the grandfathered amount to be calculated in reference to the "vested balance as of December 31, 2004," and in various other contexts only that hard date of December 31, 2004 is stated as the terminal point for prestatutory calculations and other purposes. I was then forced to resort to that standby canon of statutory construction: when in doubt, go to the actual statutory text (or, in this case, the actual regulatory language, not its paraphrased version in the preamble), where, fully 125 pages later in the document, deep into the body of the actual terms of the reg, what to my bleary eyes appeared but these very words: "[S]ection 409A is effective with respect to amounts deferred in taxable years beginning after December 31, 2004."

"Yeah," I almost shouted at the sheaf of pages before me, "taxable years beginning after 12/31/04, not just calendar years." That would exclude, for example, as much as 334 days on which a deferral could occur in 2005-- through November 30, in case of a taxable year that began on December 1, 2004-- without being affected by 409A.

But wait, for later in the same paragraph this appears: "Accordingly, section 409A is not effective with respect to earnings on amounts deferred before January 1, 2005." What about earnings on amounts deferred before 12/1/05 where the taxable year begun after 12/31/04 in which the statute first became operative is 12/1/05? The regs say nothing of that circumstance, unless they are meant to confine the limitation on nonreachable earnings to those accruing on amounts deferred before 1/1/05.

One searches in vain through succeeding pages of explication of the myriad rules governing the statutory effective date as applicable to various circumstances and arrangements with nary a reference to any date other than December 31, 2004 (or January 1, 2005, as may be required in the context) or any hint that a different date or dates is to apply for fiscal year plan sponsors. Any number of arcane arrangements, and variations on same, are dealt with, but the not-so-uncommon fiscal year taxpayer is not given even the lightest of brushes. Nevertheless, it seems without doubt that, in case of plans of service recipients on a fiscal year, the later date in 2005 that I have postulated above is meant to be substituted.

This assumes, of course, that it is the service recipient, not the service provider, whose taxable year is controlling. There is another curiosity of the statute. Unlike the Internal Revenue Code provisions added by ERISA, where the tax effects are keyed to the plan sponsor, section 409A has its principal impact on the employee (the service provider), although in most cases it is the defective (i.e., nonconforming) provisions of the compensation plan or arrangement established by the service recipient that are the triggering cause of the undesired tax effects for the service provider. But the taxable year issue under 409A, as regards the effective date of the statute, is most certainly bottomed on the taxable year of the plan sponsor, although here again the regulations, which painstakingly spell out almost every conceivable permutation (some, indeed, only dimly conceivable to most practitioners, who do not spend their professional lives pondering such things as the intricacies of equity-based compensation arrangements), says not a word that I have been able discover concerning whose taxable year. Presumably that was deemed by the draftsman too obvious to require articulation. Indeed, that would not be unreasonable inasmuch as, were the taxable year of the service provider to be controlling, it would have been sufficient to state the effective date to be "January 1, 2005" rather than "taxable years beginning after December 31, 2004" because for the overwhelming number of service providers whose taxable years are the calendar year (as required for individual taxpayers) the hard date of January 1, 2005 would accomplish the desired legislative intent.

The foregoing criticisms-- implied or reasonably inferable-- from the preceding discussion should not lead the reader to assume that I mean to write a bad review of these regulations. In a very real sense they are a brilliant piece of work-- a veritable tour de force , as I mean my title to convey. The depth of exploration and analysis of the myriad issues arising under this statute is awesome. The writing is at the very highest level of the scrivener's art, if prolix and exceedingly abstract for ready comprehension and retention. (One could easily outdo, by a factor of 100, the dismay of the writer of a recent Wall Street Journal editorial bemoaning the present length of the Internal Revenue Code (12 times the King James Bible), where just this one section of the Code calls forth a regulation of 238 pages.) By the same token it is not my purpose here to praise the work (praiseworthy though it be), but to shed light on one small corner of the document that reveals the statute's ambiguities regarding the treatment of nonqualified deferred compensation arrangements in force before the statute's effective date, that I found to have remained obscure even after the "guidance" provided by Notice 2005-1. Sadly, the proposed regulations have, if anything, intensified matters.

There was more solid support for my thesis in Notice 2005, when threaded together with the legislative history, than can be confidently posited on the proposed regulations. But it is to be underscored that these are proposed regulations, not presently projected to become effective until taxable years beginning on or after January 1, 2007; and until that time (or later if the regs do not become final by that date) the proposed regulation states explicitly that the applicability of Notice 2005-1 is not affected. Indeed, it would be inconceivable that an effective date for the statute that is operative for the years 2005 and 2006 would be retroactively pushed back under the final regulations.

A caveat might be in order. While the preamble to the proposed regulations specifies that "a plan is not required (emphasis added) to comply with either the proposed or final regulations prior to January 1, 2007," it then adds, somewhat contradictorily, that in those cases where good faith compliance with the statute is ordained during the period before the written plan or arrangement has been amended to conform to 409A's requirements, conformity with either the proposed or final regulations will constitute such good faith compliance. Is that to be read as only conformity with the regulations is satisfactory in such a case? I doubt it.

This illustrates a problem for practitioners created by the confluence, if not congruence, of several layers of rules potentially operative during the same time period, resulting from the existence of the statute itself, the Notice, the proposed regulations, and even the regulations in their final form (unknowable, of course, in the meantime). The point to be emphasized is that while these regulations in their present form are not final, only proposed, and will continue as such until becoming final on 1/1/07 (as presently projected), there is the added wrinkle that they may be relied upon even before being finalized and that Notice 2005-1 continues in force until the regs are made final. Contrary to the frequent practice of the Service to issue proposed regs, accompanied by a mirror copy that is denominated a "temporary" reg that is immediately in force, the 409A proposed regs have only an immediate reliance element-- in effect a one-way street-- available at the option of taxpayers, but not enforceable by the IRS. That, of course, is greatly to the taxpayer's advantage, but it carries a price of complexity and concomitant risk for pension practitioners, who now must juggle, in advising clients, another layer of rules having possible bearing on deferral arrangements consummated before the proposed 1/1/07 effective date of these regs.

By my reckoning, these are the applicable rules now obtaining: (1)the old "grandfathered" law for pre-statutory deferrals; (2) the continued applicability of old law even for post-statutory deferrals where not contradictory with 409A; (3) the Notice 2005-1 rules for arrangements under which deferral occurs after the effective date of section 409A; (4) the ambiguous applicable law if an old plan is modified after October 3, 2004; (5) the transitional rules available for old plans that choose to conform to the new law before 1/1/06 under an option conferred in the Notice; (6) the modified transitional rule for such old plans, as established by the proposed regs that extend conformance to 12/31/06, but only for certain kinds of arrangements, with a possible further optional change in the requirements for such conformance if there is any variation in the application of the new law as between Notice 2005-1 and the proposed regs; (7) in case of a deferral that occurs after the effective date of the statute and before finalization of the regulations, and where there is an inconsistency between the rules of the Notice and of the proposed or final regulations, a choice between the two sets of rules; (8) even absent a showing of inconsistency, where the particular arrangement is one which, under the Notice and proposed regs, may be treated under the "good faith compliance" principle because the plan is not adopted or amended until December 31, 2006 at the latest (requiring operation of the plan in conformance with the new law commencing 1/1/05), the safe harbor rule requiring such operation to conform to the proposed or final regs, in lieu of the corresponding provision of the Notice; and (9) in case it is not clear whether the deferral has occurred before finalization of the regulations, under the rules fixing the time a deferral will be deemed to have occurred, a dilemma as to the applicable rule as among the Notice, the proposed regs and the final regs. That list might not even exhaust the full range of possible conflict of rules (but surely has exhausted all but the most indefatigable of my readers).

Conclusion. I would not want to trade places with Lay and Skilling, who are still untried for their alleged misdeeds in the management of the rise and fall of Enron; but the irony is that we in the pension business are now being sorely tried almost daily for the sins of that energy colossus as we expend the energy needed to cope with this legislation that was a direct response to the Enron debacle. Words such as "overkill" come quickly to mind, but then I suppose one can be comforted by the knowledge that where laws are excessive, so are the legal actions and concomitant fees associated with coping. Section 409A is destined to become the very model of such an exercise.


Copyright 2005, A. D. Lurie
Alvin D. Lurie has spent many years as a practicing pension attorney, and was appointed as the first person to administer the IRS' ERISA program in the National office in Washington. He is back in practice and can be contacted at Alvin D. Lurie P.C. in New Rochelle, New York, telephone (914) 235-6575.

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above, adapted from an earlier treatment of the subject published last week in Tax Notes.
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