Deferred and Contingent Compensation

• Author: Lionel S. Sobel
• Pages: 201-256

201

CHAPTER 9

Deferred and Contingent

Compensation

Deferred Compensation and the Enactment

of Internal Revenue Code §409A

Does §409A Apply to the Compensation Arrangement?

Does the Plan Comply with §409A’s Requirements?

Are Corrections Possible?

What Are the Consequences of Failing to Comply?

Deferred Compensation and

the Enactment of Internal

Revenue Code §409A

Entertainers are commonly paid (or at least promised) deferred or

contingent compensation.

A deferred compensation clause in a contract between a movie

production company and an actor would specify the amount the actor

was to be paid and would provide that payment of specified amount

“shall be deferred” until some specific event occurs, such as the pro-

duction company actually receiving money from a distributor.1 In this

type of clause, the amount to be deferred would be specific, fixed,

and agreed to in advance. The payment would depend on just one

thing: the production company actually receiving money from the

movie’s distribution.

A contingent compensation clause is somewhat different from a

deferred compensation clause. A contingent compensation clause

in a contract between a movie production company and an actor

would specify a specific amount that the actor would be paid, and

1. See, e.g., Deferment Agreement–Second Position, Entertainment Industry Contracts,

Form 11-9 (LexisNexis).

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202 CHAPTER 9

the contract would say that in addition to that specific amount (often

referred to as “guaranteed compensation”), the production company

also would pay the actor “contingent compensation” in an amount

equal to a stated percentage (perhaps 5 percent or 10 percent) of the

movie’s proceeds or profits. In this type of clause, the amount of the

contingent compensation is not fixed or agreed to. The amount is an

agreed-upon percentage of the movie’s proceeds or profits.2 The word

“proceeds” or “profits” will itself be defined, at length, in the contract

(it is not a tax or accounting term). And the amount of contingent

compensation provided for by this clause could range from nothing

to many millions of dollars, depending on how financially successful

the movie is and depending on how “proceeds” or “profits” is defined in

the contract.

You saw in Chapter 2 that deferred and contingent compensation

is “income” to entertainers who receive it. And you saw in Chapter

4 that entertainers are cash-basis, calendar-year taxpayers, so that

deferred and contingent compensation is “income” to them in the

year in which they actually receive it. Why then, you may wonder,

is this chapter necessary? To answer that question, some background

is necessary.

Deferred compensation clauses usually are used by produc-

tion companies to finance the making of their movies and television

programs. By getting entertainers to agree to postpone the dates on

which they are entitled to be paid, production companies need less

cash than they otherwise would to get their productions made.

Contingent compensation clauses usually are used by production

companies to reduce the amount they have at risk in the project, and

are used by entertainers to share in the project’s financial success if it

is successful.

Sometimes, though, deferred and contingent compensation

clauses are used for tax-related reasons. You saw an example of that

in Chapter 1, where you read about director William Wyler reducing

his income taxes by deferring a portion of his contingent compensa-

tion for the movie Ben Hur (in a way that may have deprived him of

much of that compensation, for reasons he did not anticipate).

Wyler’s deferral of his contingent compensation probably

would not have been considered “abusive” by the IRS. But the use

of deferred compensation by executives outside the entertainment

industry has been considered abusive, by Congress as well as the IRS.

2. See, e.g., Long Form Performer Agreement (Studio Version), Entertainment Industry

Contracts, Form 11-1A (LexisNexis).

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Deferred and Contingent Compensation 203

As a result, since the mid-1980s, Congress has enacted several tax

penalty provisions aimed at abusive executive compensation arrange-

ments. The most recent of these provisions is § 409A of the Internal

Revenue Code, which was enacted in 2004 as one part of the lengthy

American Jobs Creation Act.3

Section 409A was Congress’s response to abuse by Enron execu-

tives of that company’s executive compensation plan in the run-up to

Enron’s bankruptcy.4 This chapter is about §409A’s impact on enter-

tainers. That impact was not immediately apparent to most entertain-

ment lawyers, because even though Enron was involved in a lot of

businesses, entertainment wasn’t one of them, and Enron executives

were anything but entertainers.

Section 409A itself is just four pages long, and the portions that

are particularly relevant to entertainers are even shorter. In a nutshell,

§409A provides that if a “nonqualified deferred compensation plan”

fails to satisfy certain specified requirements, then the compensation

that is deferred by the plan must be included in the entertainer’s gross

income immediately, even though the entertainer hasn’t received the

income yet because it was in fact deferred.5

There are three requirements, relevant to entertainers, that must

be satisfied in order to avoid this draconian result:

• The plan must prohibit distribution of deferred compensation

earlier than the date the plan specified for distribution.6

• The plan must prohibit the acceleration of the time for pay-

ment of deferred compensation.7

• Any election to participate in a deferred compensation plan

must be made within 30 days of the date the participant

becomes eligible to participate in the plan.8

3. American Jobs Creation Act of 2004, Pub. L. No. 108-357, §885 (2004).

4. Joy Sabino Mullane, Incidence and Accidents: Regulation of Executive Compensation

Through the Tax Code, 13 L & C L. R. 485 (2009); William A. Drennan, The

Pirates Will Party On! The Nonqualified Deferred Compensation Rules Will Not Prevent

CEOs from Acting like Plundering Pirates and Should Be Scuttled, 33 V. L. R. 1 (2009);

William A. Drennan, Einstein’s Theory of Taxation Explains the Nonqualified Deferred

Compensation Rules!, 40 U. T. L. R. 53 (2008).

5. I.R.C. §409A(a)(1)(A)(i).

6. Id. §409A(a)(2)(A)(iv).

7. Id. §409A(a)(3).

8. Id. §409A(a)(4)(B)(ii).

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