Yesterday the NYU Tax Policy Colloquium featured a paper by Dan Halperin of Harvard Law School and Ethan Yale of Georgetown Law School concerning deferred compensation and recently enacted Internal Revenue Code section 409A.
For a bit of background flavor, this provision responded to one of Enron's more outrageous scams. Various Enron senior executives had special deferred comp deals that did not have to be disclosed in their financial statements under rules applying at the time or treated as currently taxable. The ground for non-taxability was that individuals using cash accounting don't have to report income currently if it hasn't been paid by the employer and remains unfunded and subject to credit risk.
Leaving aside for the moment the reason for having such doctrines in the cash accounting rules, the Enron deals' compliance with them was a sham. In particular, the moment Enron entered potential financial crisis the amounts were promptly paid (presumably a borderline fraudulent conveyance at the expense of creditors), plus offshore entities may have been used to make sure creditors couldn't actually get at the money.
As one might guess from Enron's association with these deals, the deferred compensation problem actually goes more to corporate governance (concealing and understating executive compensation) than to tax planning. Halperin and Yale show that there is very little tax advantage to deferred compensation if the applicable marginal tax rates are the same for (a) the employer as compared to the employee, and (b) one possible year of inclusion and deduction as compared to another year.
The authors argue that the big tax planning issue is taxpayers using deferred compensation deals to lower the tax rate on the investment return during the period before the compensation is paid. They propose a possible special tax to address this. I argued that the bigger issue might be effective electivity with respect to statutory changes in the tax rate, i.e., using the arrangements to put taxation of the compensation in the most tax-favorable year. The instability of U.S. tax policy and the use of phase-ins, phase-outs, and sunsets arguably increases the importance of this angle. From this perspective, requiring credit risk by strengthening the cash accounting doctrines that Enron flouted can be seen as burdening effective electivity, albeit in an arbitrary and imperfect way, by causing exercise of the when-to-realize election to bear a positive price. This is the same as the rationale for deterring tax sheltering via economic substance rules.
All agreed that current Code section 409A is a mess and that simply barring deferred compensation (i.e., allowing the arrangements to be made, but treating them as giving rise to current tax liability) might be best but is presumed to be politically unavailable.