The Internal Revenue Service is asking for public comments about treatment of older split-dollar life insurance arrangements in a draft of new rules for nonqualified deferred compensation plans.[@@]

The IRS is developing the rules because the American Jobs Creation Act of 2004 created a new section of the Internal Revenue Code, Section 409A, that spells out when employees, independent contractors and other affected “service providers” can postpone paying taxes on deferred compensation.

“Service providers” who violate Section 409A could end up having to pay interest and a 20% penalty along with the regular income tax due on the compensation that was deferred, according to the text of Section 409A.

The proposed Section 409A regulations and the preamble explaining the regulations fill 238 pages.

The lead author of the preamble to the proposed regulations, Stephen Tackney, is the same IRS tax-exempt official who tried to give taxpayers some idea about how Section 409A would work in December 2004, in IRS Revenue Ruling 2005-1.

The revenue ruling consisted of 38 questions and answers about how Section 409A would work.

The IRS plans to let most parts of the proposed 409A regulations take effect Jan. 1, 2007, but it could start applying some provisions to some taxpayers, such as taxpayers who appear to be acting in bad faith, starting in 2006, Tackney writes

Section 409A does not apply to 401(k) plans, health plans, paid vacation plans or many other benefit plans. It also does not apply to ordinary bonuses or other deferred compensation if there is a substantial risk that the “service provider” will end up not getting the compensation.

Section 409A does apply to supplemental executive retirement plans, discounted stock options, phantom stock, excess benefit plans, and Section 457(f) plans at government and nonprofit employers.

A 401(k) plan is called a “qualified plan” because it qualifies for special tax breaks as a result of falling under the jurisdiction of the Employee Retirement Income Security Act of 1974.

“Nonqualified plans,” such as phantom stock plans, are not ERISA plans, but, in many cases, members of those plans still can use the plans to defer collecting and paying taxes on a portion of their income.

The IRS will not treat compensation as deferred compensation if the money simply comes in a little late or the “service provider” makes a serious effort to collect money from a client who is taking a long time to pay or refusing to pay, Tackney writes.

But, in some cases, the IRS might think of separation pay as deferred compensation, if the employer or other “service recipient” has some kind of obligation to make the separation payments, Tackney writes.

Section II(H) of the preamble discusses split-dollar life insurance.

Members of the public who commented on the December 2004 guidance “suggested that split-dollar life insurance arrangements should be excluded from the requirements of section 409A,” Tackney writes. “However, the Treasury Department and the IRS believe that in applying the general definition of deferred compensation to split-dollar life insurance arrangements, the requirements of section 409A may apply to certain types of such arrangements.”

Section 409A should not apply to split-dollar arrangements that provide only death benefits for an employee, independent contractor or other service provider, and it should not apply when the employer or other service recipient is treating assistance with paying for split-dollar insurance as a loan, Tackney writes.

“However, policies structured under the endorsement method, where the service recipient is the owner of the policy but where the service provider obtains a legally binding right to compensation includible in income in a taxable year after the year in which a substantial risk of forfeiture (if any) lapses, may provide for a deferral of compensation,” Tackney writes.

“Where a service recipient enters into an endorsement method split-dollar life insurance arrangement with respect to a service provider, and irrevocably promises to pay premiums in future years, the arrangement may provide for a deferral of compensation within the meaning of section 409A,” Tackney writes.

Members of the public complained about the damage Section 409A might do to older split-dollar life arrangements. Section 409A might force administrators of some of those plans to change the plans in ways that would force the plans to comply with Section 409A, commentators said.

The IRS is looking for public comments about how Section 409A should or should not apply to older split-dollar arrangements.

A link to a press release that includes a link to the text of the proposed regulation is on the Web at http://www.treasury.gov/press/index.html