The Ressentiment Tax

The tax bill that Congress passed on Monday (called, with customary inattention to truth in labeling, the “American Jobs Creation Act of 2004”) could have been a straightforward resolution of an unnecessary quarrel. Several years ago, the World Trade Organization ruled that U.S. tax reductions on earnings generated by exports violated its rules. After much backing and forthing, the European Union last year imposed retaliatory tariffs, carefully calibrated to have their greatest impact on goods manufactured in “red” states. The purpose of the new law is to remove the offending “tax subsidies” in order to bring an end to the EU levies.

The legal merits of the WTO decision can be debated, but, if the reasoning may have been wrong, the result was right. Government favoritism of goods produced for export over those for the home market are minor league “industrial policy”, leading only to distorted resource allocations and reduced wealth. Getting rid of them is in our best interests, not Europe’s. Instead of retaliating, the EU would have been cleverer to encourage the continuance of this subvention from the American taxpayers.

The simple option for Congress would have been an across-the-board cut in business tax rates to replace the export incentives. Our lawmakers do not, however, like simplicity, which limits their ability to get credit for handing out favors. Hence, AJCA is a heap of narrow rate decreases, credits and deductions, balanced by a slew of tax hikes and enforcement initiatives to achieve a zero net revenue loss for the feds. Among the money raisers is a set of new rules governing the tax treatment of unfunded deferred compensation, an area within my direct sphere of professional interest.

What is most interesting about the new rules isn’t their technical details, but the impulse behind them. As a source of revenue, they are trivial, scored by that Joint Tax Committee staff at $1 billion over ten years, a figure that is probably an overstatement. Under pre-AJCA law, a for-profit company’s naked promise of future compensation, backed by nothing by its own word, is not a taxable event. Until the promise is fulfilled, the company gets no deduction and the employee recognizes no income. Hence, these transactions are of virtually no financial interest to the U.S. Treasury. No matter when the compensation is paid, the employee’s income is usually offset by the employer’s deduction. The only advantage to the government from earlier recognition of income comes when the payor is in a lower tax bracket than the recipient. If, for instance, a corporation in the 34 percent tax bracket pays $100,000 to an executive in the 35 percent bracket, the former owes $34,000 less income tax and the latter $35,000 more. It’s in the government’s interest to collect the difference sooner rather than later, but the revenue effect isn’t dramatic. (N.B. The tax consequences are different if the payor is tax-exempt. There being no balancing deduction, the government takes its tax bite from the executive as soon as his rights are not contingent upon continued rendition of substantial services.)

At the moment, the top individual and corporate tax rates are an identical 35 percent. Next year, selected manufacturing corporations will pay only 32 percent. That differential means that discouraging the deferral of compensation will accelerate the government’s cash flow, if only to a paltry extent. I’m fairly confident, based on the tentative reactions of my own clients, that the effect will be even smaller than the Joint Committee projects. The new law penalizes a few gimmicks that have become popular in recent years (notably options with exercise prices below fair market value at the date of grant and “haircut” provisions that allow employees to elect early distribution of deferrals in exchange for forfeiture of part of the amount deferred) and eliminates a couple of shady practices (such as setting up “rabbi trusts”, supposedly subject to the claims of the employer’s creditors, in out-of-the-way jurisdictions where creditors may be unable to enforce their rights), but none of those features is essential to any company’s compensation planning. There’s no reason to anticipate that their demise will have much real impact on executives’ propensity to accept postponement of the receipt of pay.

If that is so, why did Congress go to the trouble of enacting “reforms”? An examination of the changes shows that they lack rational coherence, either as revenue raisers or policy tools. Some of their consequences are anomalous by any standard.

If a company promises an executive in 2005 that it will him $100,000 in 2010, with the proviso that he can elect an earlier distribution by giving up ten percent of his entitlement, AJCA will tax him in 2005 at a top rate of 55 percent, compared to 35 percent for current compensation. Why should income in prospect be taxed more heavily (especially that much more heavily) than income in hand?

Another oddity is the disparate treatment of stock options and stock appreciation rights. A stock appreciation right is economically indistinguishable from a stock option issued at the money, yet AJCA (or its legislative history, to be more precise) characterizes SAR’s as deferred compensation, bound by the new rules, while exempting options on employer stock. (Options on property other than employer stock are not exempt, again for no discernible reason.)

The more one looks at AJCA’s deferred compensation rules, the more forcefully it appears that they are not thought-out tax policy but a simple concession to envy. For years, deferred compensation packages, such as Richard Grasso’s at the New York Stock Exchange, have been targets of faux-populist outrage, not because of the minutiae of the arrangements but because they involve lots of money and therefore are assumed to be evil. That is, unfortunately, the mentality of many Congressional and IRS staffers. People who are rich enough that they don’t mind putting off payday need to be slapped in the face, and a 20 percent surtax is a satisfying slap. That the punishment bears no relationship to any offense and won’t actually be incurred by anyone (save the occasional unwary executive who tries to act without an expensive tax advisor) doesn’t make much difference.

Ineffectual posturing is more irritating than injurious. I’m grateful that Envy has such inept champions in the federal government. On the other hand, I’m annoyed that it has any influence at all. Don’t we elect conservatives to office in order to cleanse the government of the spirit of ressentiment?

Addendum: For those who would like to know the nitty-gritty, here is my concise summary of the new deferred compensation tax rules:

The rules are set forth in a new section 409A of the Internal Revenue Code, the scope of which is slightly murky. It clearly includes unfunded deferred compensation, severance pay plans and, by inference from the legislative history, stock options and stock appreciation rights. Except for the first, these arrangements have traditionally not been treated for tax purposes as deferred compensation.

Specifically excluded are qualified plans, various other tax-favored vehicles (section 403(b) annuity contracts, SEP’s, SIMPLE’s, section 457(b) plans, etc.), options to purchase stock of the recipient’s employer at a price no lower than fair market value on the date of grant, compensation paid no later than 2½ months after the end of the year in which it is earned, and bona fide accident, health, death benefit, disability and vacation plans. Presumably excluded are transfers of property taxed under section 83. (Including them would of course be pointless, but, as I’ve already noted, pointfulness is not the keynote of this statute.) My colleagues and I have been arguing merrily about various obscure and marginal cases.

In essence, section 409A lays out the perimeters of deferred compensation plan design in three areas: distributions, elections to defer and funding. Any plan that doesn’t meet its conditions is taxed so unfavorably that no one will knowingly set one up. Whatever the circumstances, a noncompliant plan is much worse than cash. I won’t bother describing the exact extent of the damage.

Plans that do comply are taxed in same manner as under current law. If the payor is a for-profit entity, the deferred amount, including all earnings credited to it, is taxed upon actual or constructive receipt. Deferred compensation for services to tax-exempt organizations is taxed as soon as there is no substantial risk of forfeiture, meaning, in practice, when no substantial future services are required as a condition to entitlement. If distribution is later than that time, subsequent earnings credits are taxed upon actual or constructive receipt, just as in a for-profit employer’s plan.

The most important portion of section 409A limits flexibility in selecting and changing the time and manner in which deferrals will be paid out.

• Distributions may be made only after one of six events: separation from service, disability, death, passage of a fixed period of time, change of corporate control or unforeseeable emergency.

• The time and manner of distribution must be designated at the time of the deferral. One or more of the permitted triggering events may be specified (such as, at age 65 or upon earlier death, disability or unforeseeable emergency). The manner of distribution may be a lump sum, annuity, installments or any other method that doesn’t give the parties discretion to alter the stream of payments.

• Once the time and method of payment are fixed, no acceleration is allowed (though the legislative history suggests a couple of exceptions that may be authorized in IRS regulations), nor can new triggering events be added.

• Distributions can, however, be postponed. Any postponement has to be for at least five years from the date when the payout would otherwise begin and doesn’t take effect until a year after it is made (that is, if any distribution event occurs within one year, the old election governs whether a distribution takes place).

Maneuvering within these bounds requires a little more foresight than working with the present, more lenient rules but does not demand precognition. The fact that someone can afford to leave his paychecks uncollected until a later date (and run the risk that his employer won’t still be around to pay) indicates that he isn’t living from hand to mouth and won’t be seriously inconvenienced by being unable to get hold of funds at will.

The limitations on deferral elections are pertinent only if there is a choice between immediate and deferred receipt. AJCA writes the IRS’s long-held ruling position into law: An election must to defer compensation must normally be made in the calendar year before the year in which the corresponding services are rendered. There are two exceptions: (i) When an individual first becomes eligible to participate in a plan, he has a 30-day window to elect to defer compensation earned later in the same year. (ii) If compensation is based on performance over a specified period (terms to be defined in IRS regulations), the election may be made up to six months before the end of the period.

Finally, a pair of “funding” rules are designed to thwart schemes that try to sidestep of the risk of employer insolvency without leading to constructive receipt.

• Assets to provide deferred compensation may not be set aside in a trust or similar vehicle located outside the United States, even if the assets of the trust are subject to the claims of the employer’s creditors (so that there is no constructive receipt of income). Targeted by this rule are trusts established in places like the Channel Islands where, according to the trust promoters, creditors will find it infeasible to bring suit. I suspect that there’s no real shortage of lawyers willing to spend a few weeks on Jersey or Sark to collect a lot of money for their clients, but shutting down this idea down doesn’t bother me. What is bothersome is that the prohibition is far more drastic than necessary. Even with an exception for trusts located in the foreign jurisdiction where the services are performed (e. g., a Canadian trust for a U.S. citizen working in Canada, there are plenty of innocent situations that will need relief in the regulations.

• A plan may not provide that assets will be placed beyond the reach of the employer’s creditors if the employer’s financial health deteriorates. This restriction was inspired by another scheme, but it is superfluous. The asset transfer would result in constructive receipt by the plan participants, which would amount to a distribution without a proper triggering event and horrific tax liability.

The biggest problem generated by section 409A arises from its effective date. It applies to all deferrals of compensation earned after December 31, 2004. Deferrals already made under existing plans are grandfathered, but only for plans that are not materially amended after October 3, 2004. Hence, new plan designs are needed very promptly. The Act instructs the IRS to issue transitional guidance by early next year, which will barely be soon enough. Meanwhile, I must get busy revising my BNA Portfolio on “Deferred Compensation Arrangements”.