Opinion ID: 681060
Heading Depth: 3
Heading Rank: 2

Heading: Deferred Compensation Agreements

Text: 12 1. Background. Deferred compensation agreements (DCAs) are agreements in which certain employees and independent contractors (DCA participants) agree to wait a specified period of time (deferral period) before receiving bonuses, salaries, or director's fees for services already rendered (deferred compensation). During the deferral period, the employer uses the deferred compensation as an inexpensive source of working capital. At the end of the deferral period, the employer pays the participating individuals the deferred compensation and an additional amount (additional amount) for the time value of the deferred compensation. 13 Prior to 1982, Albertson's entered into DCAs with eight of its top executives and one outside director. The parties agreed that they would be paid deferred compensation plus an additional amount as calculated by a predetermined formula. 9 The DCA participants would be eligible to receive the total sum (the deferred compensation plus the additional amount) upon their retirement or termination of employment with Albertson's. The DCA participants also had the option of deferring payment of the total sum for up to fifteen years thereafter. During that extra period, the additional amounts would continue to accrue on an annual basis. 14 In 1982, Albertson's requested permission from the IRS to deduct currently the additional amounts (but not the deferred compensation), instead of waiting until the end of the deferral period. 10 In 1983, the IRS granted Albertson's request. Accordingly, Albertson's claimed deductions of $667,142 for the additional amounts that had already accrued, even though it had not yet paid the DCA participants anything. In 1987, the IRS changed its mind, however, and sought a deficiency for those amounts. Albertson's filed a petition with the Tax Court, claiming that the additional amounts constituted interest and thus could be deducted as they accrued. 15 In a sharply divided opinion, the Tax Court rejected Albertson's position. The court found that the additional amounts were not interest, but rather compensation. Under section 404 of the Internal Revenue Code, compensation was not deductible until the end of the deferral period. Accordingly, the court prohibited Albertson's from deducting its expenses relating to the additional amounts until the end of the deferral period. See Albertson's, 95 T.C. at 430. 11 We reluctantly reverse the judgment of the Tax Court. 16 2. Discussion. This issue raises two related questions. First, we must decide whether the tax court erred in finding that the additional amounts were not interest within the meaning of the Code. Second, if so, we must decide whether section 404's restrictions against making deductions prior to the end of the deferral period (the timing restrictions) applied to interest expenses. We answer the first question in the positive and the second in the negative. 17 a. Albertson's Additional Payments. Albertson's argues that the Tax Court erred in holding that the additional amounts were not interest within the definition of I.R.C. Sec. 163. We agree. Section 163(a) allowed a deduction for all interest paid or accrued within the taxable year on indebtedness. Although neither section 163 nor the regulations relating to it specifically defined interest, the Supreme Court has held that interest is the measure of the value of the use of money over time. See Dickman v. Commissioner, 465 U.S. 330, 337, 104 S.Ct. 1086, 1091, 79 L.Ed.2d 343 (1984). The additional amounts specified in the DCAs were a direct reflection of what Albertson's would have paid on the open market in order to borrow such amounts. See 2 B. Bittker & L. Lokken, Federal Taxation of Income, Estate and Gifts, p 60.2.1 (2d ed.1990) (describing the interest component of DCAs, which reflect[s] the time value of money). Accordingly, they were a fair measure of the time value of the monies loaned to Albertson's by the DCA participants, and they qualified as interest under the Code. 12 18 The Commissioner argues that the additional amounts were not interest because Albertson's never properly borrowed the deferred compensation from the DCA participants. According to the Commissioner, Albertson's could not have borrowed the deferred compensation because the DCA participants never had a legal right to possess such compensation until the end of the deferral period. 13 We disagree. As the Tax Court concurrence points out, this approach is anachronistic. Albertson's, 95 T.C. at 431 (Halpern, J., concurring). 14 Circuit precedent clearly holds that a legal right to possession of the assets on which the additional amounts are earned is not necessary in order for those earnings to qualify as interest. For example, in Starker v. United States, 602 F.2d 1341 (9th Cir.1979), we recognized interest that accrued in exchange for the ability to make deferred payments over a five-year period. We recognized interest in Starker even though the interest payee had no legal right to possess the deferred payments in full until the end of the five-year period. The controlling principle was not possession, but rather compensation for the use or forbearance of money. Id. at 1356. We find this case indistinguishable from Starker. Accordingly, the Commissioner's argument fails. 19 The Commissioner further argues that the additional amounts were not interest, but rather additional deferred compensation. We disagree. The predetermined rate for calculating the additional amounts did not depend in any way upon the amount or type of services performed by the participants. The rate was simply a function of the time that had elapsed since the signing of the DCAs. Under the DCA, participating employees performed the same services and received the same salary as their non-participating colleagues. The only difference between the two groups was the delay in payment and the additional amount received at the end of the deferral period. Accordingly, the additional amounts were not additional compensation, and the Commissioner's argument fails. 20 Upon a participant's termination of employment with Albertson's, he could still elect to defer payment of the additional amount for up to fifteen years, even though he was no longer providing services to the corporation. Again, the participants were not required to perform any services in return for compensation. The additional amount was calculated at the same rate at which the interest had accrued prior to the employee's termination. Accordingly, the additional amounts were not compensation, and the Commissioner's argument fails. 15 21 The Commissioner finally argues that the additional amounts were not interest because they were not payments for true indebtedness by Albertson's. See I.R.C. Sec. 163(a) (allowing interest only on payments for indebtedness). We disagree. The Tax Court has held that indebtedness is an unconditional legally enforceable obligation for the payment of money. Horn v. Commissioner, 90 T.C. 908, 923, 1988 WL 44098 (1988). In this case, the DCAs were bona fide, nonforfeitable contracts, and Albertson's was unconditionally and legally obligated to pay the DCA participants for deferring their compensation upon the rendering of their services. 16 Accordingly, the additional amounts were payment for indebtedness, and the Commissioner's argument fails. 22 b. Section 404 and Interest Expenses. Having held that the additional amounts are interest within the meaning of section 163, we now turn to the question whether the timing restrictions of section 404 applied to interest expenses--in other words, did section 404 prohibit Albertson's from deducting such expenses prior to the time the participants were required to recognize the additional amounts as income? Based on a plain-language reading of the statute in effect during the taxable year at issue, we conclude that the answer is no--the timing restrictions did not apply to interest expenses. Albertson's was therefore free to deduct such expenses as they accrued. Accordingly, we reverse the judgment of the Tax Court. 23 Prior to 1942, corporations were allowed to deduct DCA-related expenses as they accrued each year, even though employees did not recognize any income until a subsequent taxable year. In 1942, Congress abolished this preferential treatment for certain deductions relating to unqualified DCAs such as the ones at issue in this case. 17 In so doing, Congress forced employers to wait until the end of the deferral period before they could deduct expenses relating to their unqualified DCAs. See I.R.C. Secs. 404(a)(5) & 404(d) (1983). 18 This is because section 404 of the Code prohibited an employer from deducting certain expenses until they were includible in the income of the DCA participants, which was usually not until the end of the deferral period. 19 See id. 24 In the taxable year at issue, the Code and regulations specified two categories of deductions to which the timing restrictions of section 404 applied. First, section 404 applied to section 162 deductions, see I.R.C. Sec. 162, which included all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. See I.R.C. Sec. 404(a)(5) (1983). Second, section 404 applied to section 212 deductions, see I.R.C. Sec. 212, which included all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income. See id.; see generally Treas.Reg. Sec. 1.404(a)-1(b) (1983). 20 25 The interest accrued under the DCAs in this case did not fall within either of the above categories. Interest deductions, which included all interest paid or accrued within the taxable year on indebtedness, were covered by section 163 of the Code. See I.R.C. Sec. 163. They were not subject to either section 162 or section 212. Compare I.R.C. Sec. 163 (pertaining to interest) with I.R.C. Secs. 162 & 212 (not pertaining to interest). Because we must not add to or alter the words employed to effect a purpose which does not appear on the face of the statute, Hanover Bank v. Commissioner, 369 U.S. 672, 687, 82 S.Ct. 1080, 1089, 8 L.Ed.2d 187 (1962), we hold that, in the taxable year at issue, the timing restrictions of section 404 were inapplicable to interest deductions. 26 The legislative history of section 404 lends support to our conclusion. There is absolutely no indication that Congress intended section 404 to apply to interest deductions. Section 404 was codified in its present form in 1954. At that time, Congress was fully aware of the differences between the predecessors to sections 162 (trade or business expenses), 163 (interest), and 212 (production of income expenses) of the Code. See, e.g., H.R.Rep. No. 1337, 83d Cong., 2d Sess., reprinted in 1954 U.S.C.C.A.N. 4017, 4181 (discussing the relationship between the predecessors to sections 162, 163, and 212). If Congress had intended section 404 to govern the timing of interest deductions, it could have made specific reference to the predecessor of section 163 as well. See, e.g., I.R.C. Sec. 267 (1983) (explicitly referring to section 163 as well as sections 162 and 212). To the contrary, the legislative history of section 404 mentions only compensation. See, e.g., S.Rep. No. 1631, 77th Cong., 2d Sess. (1942), reprinted in 1942-2 Com.Bull. at 504, 607-09. Accordingly, there is no indication in the legislative history of section 404 that Congress intended it to apply to interest. 27 The Commissioner argues that a 1986 clarifying amendment to section 404, which eliminated the references to sections 162 and 212 in order to make clear the broad scope of the statute, evidenced Congressional intent, ab initio, to include interest under that section. We reject this argument. According to the legislative history of the 1986 amendment, it is true that Congress intended to clarify section 404 to include all forms of compensation for services rendered. However, there is insufficient indication that Congress intended to include anything other than compensation. See, e.g., S.Rep. No. 313, 99th Cong., 2d Sess. 1, 1013 (1986) (referring repeatedly to compensation). 21 As we have noted, for DCA purposes, compensation and interest are two very different concepts. Accordingly, we reject the Commissioner's argument that the 1986 amendment evidenced an intent by Congress to include interest expenses under the timing restrictions of section 404. 28 Finally, the Commissioner argues that, notwithstanding the plain language of the statute, Congress must have intended to include interest expenses within the scope of section 404 because Congress enacted timing restrictions with respect to compensation expenses. We do not agree that simply because Congress determined to treat compensation in a particular manner it necessarily intended to treat interest in that same manner. Congress' decisions with respect to tax policy do not always fit a neat and logical pattern. Sometimes they are even influenced by less-than-objective forces. Still, we sympathize with the Commissioner's policy arguments regarding Congress' intent. It is quite possible that, had Congress considered this problem in 1942 and 1986, it would have modified the wording of section 404 to cover deductions for interest as well as for compensation. Permitting the deduction of interest may simply have resulted from a glitch in the Code. Even if that is the case, however, Code changes are for Congress to make--not the courts. 29 In sum, we hold that the timing restrictions of section 404 do not apply to expenses relating to interest that is paid pursuant to a DCA. Accordingly, Albertson's may properly deduct such expenses as they accrue, and we reverse the Tax Court on this issue.