The deferred compensation time bomb
EmptyWhen Enron imploded, everything it had done was held suspect, and one of those things was to permit employees to avoid current taxation by deferring compensation to future taxable years.
In the anti-Enron fervor that swept Congress, it passed IRC Section 409A, which imposes substantial penalties on deferred compensation unless it complies with very strict requirements. Unfortunately, there are several common practices in the entertainment industry that will fall unwittingly into the snare of Section 409A, including (a) all participations and residuals, (b) the use of loan-out companies, and (c) the grant of stock-based compensation for employees of film companies.
In April, the IRS issued hundreds of pages of regulations explaining some of the workings of Section 409A. This article summarizes Section 409A and these regulations, with a focus on the entertainment industry. For brevity and simplicity, many of the details in the regulations are omitted here.
In summary, Section 409A provides that Permitted Plans will be respected and a Service Provider will not be taxed until the receipt of Deferred Compensation under such Plans. On the other hand, Non-Permitted Plans are subject to the following severely adverse tax consequences:
• The Deferred Compensation is taxable when it becomes Vested (or when the Plan becomes a Non-Permitted Plan if it is initially a Permitted Plan).
• The Service Provider is subject to an additional 20% tax on the Deferred Compensation when it becomes Vested.
• The Service Provider is subject to an interest charge on the total tax liability commencing from the date of Vesting if the Deferred Compensation becomes taxable after that date, like when a Permitted Plan becomes a Non-Permitted Plan.
The regulations do not yet address how to apply these penalties to contingent payments, such as participations and residuals, under a Non-Permitted Plan. But the short answer is that you don't want your client to be the guinea pig that finds out. There are other analogous regulations that effectively exclude participations and residuals from treatment as deferred compensation for other purposes, but the IRS has expressly stated that those regulations do not apply under Section 409A.
Thus, you either want to find an exception to Section 409A or make sure you have a Permitted Plan, both of which are discussed below.
The regulations provide a number of exceptions from Section 409A for certain Compensation that might otherwise be treated as Deferred Compensation and for certain Service Providers:
• Perhaps the most important exception for the entertainment industry is for Service Providers that use the accrual method of accounting. Thus, a loan-out corporation can avoid the application of Section 409A to Deferred Compensation it receives -- including participations and residuals -- by adopting the accrual method of accounting, though this might require the corporation to accrue participations at the end of each relevant accounting period, even if payment is received later. However, this exception won't apply to payments by the loan-out corporation to its shareholder/employee, which are discussed below.
• Another important exception for the entertainment industry is for Service Providers that (a) are actively engaged in a trade or business as an independent contractor (like a loan-out corporation) and (b) render significant services during one taxable year to two or more unrelated Payors. There is a safe harbor if the Service Provider earns less than 70% of all Compensation during any one taxable year from one Payor. Most individual talent are treated as employees, not independent contractors, so they would not qualify for this exception.
• There is an exception for Compensation that is not subject to U.S. tax, such as income paid to a nonresident alien for services rendered outside the U.S. or Compensation that is excluded by treaty or that is excluded as a fringe benefit.
• There is a "short term deferral" exception for Compensation payable within two and one-half months after the end of the later of the Payor's or the Service Provider's tax year in which the Compensation Vested, as long as it is not part of an otherwise Non-Permitted Plan.
• There is an exception for Compensation (subject to certain limits) payable upon involuntary Termination.
• There is an exception for the transfer of property (like stock) to the Service Provider if the property is not Vested upon receipt.
• There is an exception for the grant of Stock Rights if all of the following requirements are met:
1)The exercise price (for a stock option) or beginning value (for a stock-appreciation right) cannot be less than the market value of the stock on the date of grant, disregarding any restrictions on transfer of the stock that will lapse in time. Thus, all the back-dated stock options reported in the news recently will blow this requirement, resulting in the options being part of a Non-Permitted Plan. Ouch.
2)The relevant stock must be common stock of a corporate Payor (or its controlled or controlling affiliates). The exception does not apply to interests in other entities, like limited liability companies.
3)The stock to be acquired cannot be subject to (a) any mandatory redemption (other than a right of first refusal) or (b) a put or call right that does not lapse, in both cases only if the purchase price is other than the market value at the time of purchase.
4)There can be no subsequent material modification of the Stock Right to benefit the Service Provider, other than acceleration of Vesting or the exercise date.
If the Stock Right does not meet all these requirements, then (a) the exception from Section 409A does not apply and (b) the usual right of the Service Provider to elect when to exercise the Stock Right violates the Requirements discussed below, resulting in the penalties of Section 409A applying to the Service Provider.
Earliest Payment Date
A Permitted Plan must provide that Deferred Compensation is payable only on or after the earliest of one of the following events:
• Termination. However, if the Service Provider is an officer of a public company, the Plan must provide that any Deferred Compensation cannot be paid before the earliest of (a) six months after Termination or (b) death of the Service Provider.
• A disability of the Service Provider estimated to last for at least 12 months.
• Death of the Service Provider.
• A Change of Ownership.
• An unforeseen emergency.
• If the Plan fails to meet the Requirements.
• If the Plan is terminated because of a liquidation or bankruptcy of the Payor.
• Most importantly, a fixed payment schedule put in place at the time of Deferral. A fixed payment schedule requires payment dates and amounts that are non-discretionary to either party and objectively determinable at the time of Deferral. Most important to the entertainment industry, the schedule can be based on income received by the Payor if the income is not paid to the Payor by its affiliates.
This rule might permit participations and residuals to be treated as Permitted Plans, as long as the other Requirements are met. However, most participations and residuals include income received by a studio from its affiliates (including income from television, video, merchandising and soundtrack), and the inclusion of this income would make the entire participation a Non-Permitted Plan.
A Permitted Plan may not provide for any acceleration of payment of Deferred Compensation prior to the dates provided for by the Plan at the time of Deferral. An advance, loan (even from a third party), or other payment that may be recouped out of the Deferred Compensation is treated as an impermissible acceleration.
In addition, a sale, transfer, garnishment, or pledge of the Deferred Compensation is treated as an acceleration of payment. Thus, advances or "loans" against a participation owed to talent will violate this Requirement, resulting in the entire participation for that film being treated as a Non-Permitted Plan, triggering the penalties of Section 409A discussed above.
An exception provides that a Plan may subsequently be amended at any time to accelerate payments upon the death, unforeseen emergency or disability that is expected to last for at least six months with respect to the Service Provider, or to accelerate payment as a result of the Payor's decision to accelerate Vesting.
If the Service Provider has a choice of receiving current compensation or Deferred Compensation, the Service Provider must make an irrevocable election to receive Deferred Compensation before specified dates. If the Deferred Compensation is Vested at the time of Deferral, the election must be made prior to the start of the tax year of the Payor during which Deferral will occur.
If the Deferred Compensation is not Vested at the time of Deferral, the election must be made by the earlier of (a) 30 days after the date of Deferral or (b) 12 months before Vesting. However, for the first year of service, the election may be made within 30 days of the date such services commence, but it can then only apply to Compensation earned after the date the election is made.
If the Plan provides that the Service Provider may subsequently elect to further defer any Deferred Compensation, this additional election must (a) be irrevocably made at least one year prior to the date the Deferred Compensation was initially scheduled to be paid and (b) defer such payment for an additional five years from the initial scheduled payment date, except in the case of disability, death or unforeseeable emergency.
Date of Actual Payment
In order to constitute a Permitted Plan, the Payor is required to pay the Deferred Compensation no earlier than 30 days before the scheduled payment date and no later than the later of (a) the end of the taxable year of the Payor during which the payment is due or (b) within 2 1/2 months after the payment is due.
This Requirement gives the Payor the ability to disqualify an otherwise Permitted Plan, even though the resulting tax burden falls on the Service Provider. Thus, Service Providers should contractually require the Payor to indemnify them for this additional tax burden if the Payor fails to meet this Requirement.
A Permitted Plan may not provide for any funding of the Deferred Compensation through placement of assets in a foreign trust. Further, the Plan may not provide that particular assets will be set aside and "restricted" to the Deferred Compensation based on any reduction in the Payor's financial health.
The Plan must be "established" and specify the time and form of payment of Deferred Compensation by the date of Deferral or the date the Service Provider elects Deferral, if Deferral is optional. This Requirement will be deemed met as long as the terms of the Plan are mutually agreed to by the required date and the Plan is put in writing by the end of the tax year (or within two and one-half months after the end of the tax year if payment is deferred beyond the subsequent tax year).
Payments to Controlling Shareholder/Employee
Section 409A applies even to payments from a corporation to its controlling shareholder/employee. This is a trap that will catch many unsuspecting taxpayers.
In the entertainment industry, it is common for loan-out corporations to drain out their income from participations and residuals by paying it as compensation to their shareholder/employee. This type of arrangement is a Deferred Compensation Plan, and all the Requirements must be complied with in order to avoid the Deferred Compensation being subject to the penalties of Section 409A.
Section 409A applies to (a) Deferred Compensation that Vests in tax years beginning after December 31, 2004 and (b) Deferred Compensation that Vested prior to that date if the Plan is materially modified in favor of the Service Provider after that date.
It thus appears that 409A should not apply to participations and residuals that Vested based on services rendered prior to December 31, 2004 as long as the Plan is not materially modified in favor of the Service Provider after that date, even if the amounts become quantifiable and are paid after that date.
In summary, any time there is Deferred Compensation, including (a) Stock Rights Plans (b) participations and residuals and (c) payments by a corporation to its shareholder/employee in a tax year after the services are rendered, the Plan must meet one of the exceptions or all the Requirements must be carefully complied with through a written Permitted Plan, or the Service Provider is in for a world of hurt.
*About the author: Schuyler Moore is the author of "The Biz: The Basic Business, Legal and Financial Aspects of the Film Industry," "Taxation of the Entertainment Industry" and "What They Don't Teach You in Law School." An adjunct professor at UCLA Law School and the UCLA Anderson School of Management, he is a partner in the corporate entertainment department of Stroock & Stroock & Lavan in Los Angeles. He is a frequent contributor to THR, ESQ.