IRC Section 409A and Nonqualified Deferred Compensation Rules Hit Hollywood

IRC Section 409A and Nonqualified Deferred Compensation Rules Hit Hollywood

Recently I heard an interview with the musician and actor Jon Bon Jovi.  In the interview, Mr. Bon Jovi was belaboring the high cost of health insurance and the fact that as an independent artist he does not have group health insurance benefits.  He said he even went so far as to quit smoking to lower his health insurance premiums.   Given the current economic climate, and the publicity surrounding our already low-paid teachers being asked to take additional pay cuts (see "Wisconsin Governor to Narrow Budget Gaps With Cuts to Employee Benefits, Entitlements, 23 DTR H-1 (Feb. 3, 2011)), it may be hard to have sympathy for highly paid celebrities grumbling about health insurance premiums.  The grumbling has also been heard lately in Hollywood in the context of nonqualified deferred compensation (NQDC) plans.

With final regulations in place and correction programs established for initial lapses in compliance, the dust has settled a bit on IRC § 409A and the IRS is perhaps ready to put NQDC issues behind them.  But Hollywood's tax attorneys are not quite ready to let 409A go and may be pushing for regulatory fixes to address some IRC § 409A issues that they say are adversely affecting actors and the entertainment industry.   Entertainment tax attorneys say that Section 409A is affecting the practice of providing profit potential in years after an actor or producer's services have been provided (e.g., royalty payments).  Under Section 409A, this arrangement is a NQDC plan that must adhere to the Section 409A rules for NQDCs.  To get around the potential 409A issue, lawyers say they are compelled to create accrual method loan-outs because Section 409A does not apply to taxpayers who follow the accrual method.  See "Actors May Lobby IRS for Changes to Nonqualified Deferred Compensation Rules," 2011 TNT 17-11 (Jan. 26, 2011).

Under IRC Section 409A, if a compensation arrangement with an actor, producer, or other entertainment professional includes a deferral of compensation, which basically means compensation paid after the year in which the actor obtains a legally binding right to the compensation, the arrangement must meet stringent requirements including specific elections made in a timely fashion and a very short list of permissible distributions.  See IRC §§ 409A(4)(B)(i), (a)(2)(i)-(vi); Treas. Reg. § 1.409A-2(a)(3).  Failure to meet Section 409A's requirements can lead to heavy penalties for the actor or producer involved:   inclusion of the deferred compensation in income with interest at the underpayment rate plus an additional 1 percent, and a 20 percent penalty based upon the includable amount.  See IRC § 409A(a)(1).

In this writer's opinion, Section 409A was drafted to be extremely broad and to capture a great deal of deferred compensation.  If something fits the definition of "deferred compensation" and  "deferred compensation plan" under Section 409A and the accompanying regulations, then it is compensation subject to the rules under Section 409A.  See LexisNexis Tax Advisor - Federal Topical § 1C:6.04[1]. While Section 409A was enacted in part to address the practice of Enron executives accelerating payments under their deferred compensation plans in order to beat the company's bankruptcy, it was also enacted in part to address tax timing abuses and to quell limited enforcement of the constructive receipt tax doctrine.  See 1-13 Federal Income Taxation of Retirement Plans § 13.01.  The fact that many forms of compensation are brought into Section 409A's reach is not a coincidence.

The film industry is not the only industry facing challenges due to Section 409A.  Faced with shrinking state tax credits and packages, businesses and individual professionals everywhere are feeling the pinch.   Crafting creative arrangements around Section 409A is all a part of the game right now.  Hopefully the Internal Revenue Service will not be star-struck into taking time away from other important issues of tax reform.  I would personally prefer to see the issue of affordable health care insurance take priority over the difficulties facing Hollywood actors when crafting their long term compensation plans.  Let's not let Hollywood give good tax policy a bad name.

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