4 Pages Posted: 20 Aug 2010 Last revised: 27 Aug 2010
Date Written: November 5, 2007
The article reviews the tax historical background that led to enactment of Internal Revenue Code Section 409A, particularly the history of weak judicial enforcement of the constructive receipt doctrine which had left open the door to significant tax timing abuse. The author argues, however, that in Section 409A Congress nonetheless overreacted, creating a statute whose overbreadth and penalty structure imposed its own societal cost (in the form of compliance and transaction expenses) that possibly outweighs the cost of the tax abuse the section was designed to correct. More generally, he argues that "binary," high-risk enforcement schemes, where the only two possible taxpayer states are full compliance and ruinous noncompliance, lead to inefficient results and are bad tax policy. Two other examples of this type of binary enforcement approach in U.S. employee benefits law are the qualified retirement and prohibited transaction regulatory regimes. The article shows that under such a regime it will be rational for a taxpayer to undertake a transaction only if the probability, P, that the transaction fully complies with all Code requirements satisfies: P x B > (1-P) x C, where B is the benefit expected from the transaction and C is the expected cost should the transaction be found not to be fully tax-compliant. In the 409A context, if one makes the assumptions, for example, that the benefits associated with deferring compensation have value equal to 15% of the amount deferred, and the penalty associated with violation of 409A is 2,000% of the amount deferred (plausible assumptions, given the 409A penalty structure), it will be rational to defer compensation only if the probability of full compliance is at least 99.3%, which approaches absolute certainty and is in practice often unattainable at reasonable cost.
Keywords: 409A, tax policy, employee benefits, deferred compensation, prohibited transactions, qualified retirement plans, tax penalties
JEL Classification: K34
Suggested Citation: Suggested Citation
Morrison, Andrew Stumpff, Deferred Compensation and the Policy Limitations of the Nuclear Option (November 5, 2007). Tax Notes, Vol. 117, November 5, 2007. Available at SSRN: https://ssrn.com/abstract=1660709