Deferred Compensation plans may be classified as "funded" and "non-funded." The value of these programs depends greatly upon the taxation benefits in most cases. To start, the IRS states that an employer may deduct all ordinary and necessary business expenses including "a reasonable allowance for salaries or other compensation for personal services actually rendered."214 "Reasonable" compensation is defined as such amount as would ordinarily be paid for like services by like enterprises under like circumstances.215 Therefore, a salary that exceeds what is customarily paid for such services is considered unreasonable or excessive. Compensation does not necessarily mean "cash" as courts have ruled that, for example, forgiveness of a loan is considered as compensation.
If the IRS decides that compensation is unreasonable, then they may consider it as "dividends" and they have a tendency to so rule where there is a sole owner or a group of unusually highly paid executives. Interestingly, there is an upper limit that a corporation can deduct for compensation paid to certain executives—$1 million—paid to one of the covered employees (defined further as the corporation's chief executive officer who is one of the four highest paid officers in the corporation).
For tax purposes for deferred compensation, "applicable employee remuneration" is the aggregate amount of remuneration paid to the employee for services performed that would be deductible if not for this limitation. This does not include amounts not considered as "wages" under FICA, including payments to a qualified plan, SEP or 403(b) tax sheltered annuity; or amounts that are considered as salary reduction contributions (contributions by an employer to a qualified plan on behalf of the employee ).
Specifically excluded from this definition are commission payments, stock options, stock appreciation rights, and other compensation based solely upon at least one performance goal.
"Parachute Payments" are agreements that provide a generous package of severance and benefits to top executives and key personnel in case of a takeover or merger (also called "Golden Parachutes). Excess parachute payments are subject to no employer deduction for tax purposes, and the recipient may be subject to a 20% penalty tax.216
The Code defines a parachute payment as any payment in the nature of compensation to a disqualified individual (see below) who is either (1) contingent on a change in ownership or control of the corporation or its assets and the present value of the payments contingent upon these changes equals or exceeds three times the individual's average annual compensation from the corporation in the five taxable years ending before the date of the change, or (2) the payment is the result of an agreement which violates any securities laws or regulations. A transfer of property will be treated as a payment and taken into account at its fair market value.217
A "disqualified individual" is an employee, independent contractor, or other such person who performs personal services for a corporation, and is an officer, shareholder or highly compensated individual of such corporation. For this purpose, a "highly compensated individual" would be an individual who is a member of the group which consists of the highest paid 1% of the employees of the corporation or, if less, the highest paid 250 employees of the corporation.
As a general rule, a payment will not be considered as contingent if it is substantially certain at the time of change that the payment would have been made whether or not the change occurred, unless the payment is made under a contract entered into within one year of change, then it would be considered as a parachute payment.218
Just to make it clear (?) the IRS states that "parachute payment" does not include any payment to a disqualified individual with respect to a small business corporation (having not more than l class of stock and not more than 100 stockholders, all individuals (and not nonresident aliens). It also does not include payments made to a disqualified individual if immediately prior to the change, there was no stock readily tradable on an established securities market or otherwise, and shareholder approval of the payment was obtained after adequate and informed disclosure by a vote of persons who, immediately before the change, owned more than 75% of the voting power of all outstanding stock of the corporation—or—any payment to or from a qualified pension, profit sharing, or stock bonus plan, or tax sheltered annuity plan, or simplified employee pension plan.219
The "official" definition of excess amount for these purposes is "the amount of a parachute payment which is nondeductible and subject to the excise tax and is the amount in excess of that portion of the base amount allocable to that payment.
To calculate this further, the "base amount" is defined in the regulations, and the base amount is then multiplied by the ratio of the present value of the parachute payment to the present value of all parachute payments expected, the result of which is then subtracted from the amount of the parachute payment. Further details of this calculation are beyond the scope of this text.
The general rule, which is mentioned elsewhere in this text, for taxation of employees and employers in respect to premiums paid by the employer under a nonqualified annuity plan, or on contributions to a non-exempt employee's trust, is that the employee is currently taxed on a contribution to a trust or a premium paid for an annuity contract to the extent that his interest is substantially vested when the payment is made. An interest is "substantially vested" if it is transferable or not subject to a substantial rise of forfeiture.220
A partner is immediately taxable on his distributive share of contributions made to a trust in which the partnership has a substantially vested interest, even if the partner's right is not substantially vested.
If the employee's rights change from substantially nonvested to substantially vested, the value of his interest in the trust or annuity on the date of change must be included in his gross income for the taxable year when the change occurs. If the trust was exempt under IRC 502(a) regulations, then the employee would not be taxed on the value of his vested interest in the trust.
If the employee's rights in the value of a trust or annuity change from forfeitable to nonforfeitable, there is no tax liability for him.
Sometimes an employer may offer the employees a choice of either to provide those participants in pay status of a lump sum payment of the present value of their future benefits or an annuity securing their rights to the remaining payments under the plan, or a corresponding tax gross-up payment. Those who would choose the annuity contract would include in gross income the purchase price for such participant's benefits under the contract and the tax gross-up payment in the year paid (or made available, if earlier). (Employee taxation of annuity proceeds discussed elsewhere.) 231
Basically, the employer can take a deduction for a contribution or premium paid in the year in which an amount attributable thereto is includable in the employee's gross income.232 If an employee includes only part of a contribution or premium in income in a given tax year, then the employer can deduct that part of the contribution or premium in that tax year.
For an independent contractor, contributions or premiums paid or accrued on behalf of an independent contractor may be deducted only in the year in which amounts attributable thereto are includable in the independent contractor's gross income.233
If contributions are made to annuity contracts held by a corporation, partnership, or trust, the income of the contract for the tax year of the policyholder is generally treated as ordinary income received or accrued by the contract owner during such taxable year.234
Note: Corporate ownership of life insurance may result in exposure to the corporate alternative minimum tax. This is rather complicated but unless the corporation qualified for the small corporation exemption, a corporation may be subject to this tax as one element of the alternative minimum tax, known as the adjusted current earnings adjustment, which has a potential effect on corporate owned life insurance. If this situation arises, expert tax advice is required.
A secular trust is an irrevocable trust established to formally fund and secure nonqualified deferred compensation benefits (and to distinguish it from a Rabbi trust [discussed later]). Funds that are placed in a secular trust are not subject to the claims of the employer's creditors. Unlike the Rabbi trust, a secular trust can protect its participants against both the employer's future unwillingness to pay promised benefits and the employer's future inability to pay promised benefits. These trusts are not as popular as Rabbi trusts as there are some taxation questions.
Contributions to a secular trust are immediately included in the income of the employee to the extent that they are substantially vested. Further, in any tax year in which any part of an employee's interest in the trust changes from substantially nonvested to substantially vested, the employee will be required to include that portion in income as of the date of the change.235 An interest is substantially vested if it is transferable, or not subject to a substantial risk of forfeiture.
The taxation "question" centers around the approach where distributions would be taxable except to the extent that they represent amounts previously taxed—therefore a highly compensated employee who has been taxed on his entire vested accrued benefit would not be taxed again upon receipt of a lump sum distribution. On the other hand, the IRS has questioned applying this measure—relying upon an IRC Section 72 rule mostly pertaining to annuities—to secular trusts to highly compensated employees (HCEs), therefore they may adopt the stance that HCEs will be taxed on vested contributions AND on vested earnings on those contributions. Also, the IRS believes that any right to receive trust payments in compensation for these taxes will also be taxable as part of the vested accrued benefits.236
There can be a 10% penalty for certain premature annuity distributions per IRC Section 72(q) (which, again, pertain nearly entirely to annuities) that may apply to distributions from employer-funded secular trusts if the deferred compensation plan behind the trust is considered to be an annuity, i.e. provides for benefits to be paid in a series of periodic payments over a fixed period of time, or a lifetime.
If the fund is employee funded, and the employee establishes the trust but it is administered and contributed to by the employer, then the situation is different for taxation. The employee usually has a choice between receiving cash or equivalent, or cash contribution to the trust, and oftentimes, the employee has the choice of withdrawing funds or leaving them in the trust. When this occurs, the IRS takes the position that the employee constructively received the employer-contributed cash and then assigned it to the trust, therefore the employee is currently taxed on employer contributions to the trust.
In keeping with IRC Section 72, an employee who establishes and is considered to be the owner of an employee-funded secular trust under the grantor-trust rules, should not have to include the income on annuity contracts held by the trust in income each year.237
An employer can take a deduction for a contribution to an employer-funded secular trust in the year in which it is includable in employee income, but limited to the amount of the contribution, it can never include earnings on that amount between contribution and inclusion in the employee's income.238
If the secular trust covers more than one employee, the employer will be able to take a deduction only if the trust maintains separate accounts for the various employees. Also, the IRS has granted employers immediate deductions for trust contributions where participants could choose between receiving current contributions from the trust or leaving them in the trust.
The IRS maintains that a security trust can never be an employer-granted trust, therefore an employer-funded secular trust is a separate, taxable entity. Unless security trust earnings are distributable or are distributed annually, the trust will be taxed on those earnings.239It is possible to avoid trust taxation—and thereby avoiding double taxation—by using employee-funded secular trusts as they are usually treated as employee-grantor trust, because the trust income is generally held solely for the employee's benefits with the result that the trust income is usually taxed to the employee only.
Using a secular trust will probably cause a deferred compensation plan subject to ERISA to be funded for ERISA purposes.
Annuity payments are taxable to the employee under the general rule (in IRC 72) relating to the taxation of annuities. Basically, the employee's investment in the contract, for purposes of calculating the exclusion ratio, consists of all amounts attributable to employer contributions that were taxed to the employee and premiums paid by the employee (if any). Investment in the annuity includes the value of the annuity taxed to the employee when his interest changed from nonvested to vested.
Payments under a nonexempt trust are also usually taxed under the rules relating to annuities extent that distributions of trust income before the annuity starting date are subject to inclusion in income under the "interest first" rule, but without regard to the "cost recovery" rule retained in certain cases. For distribution from the trust before the "annuity starting date" is treated as distributed under 5 scenarios, starting with income earned on employee contributions.
If the distribution consists of an annuity contract, the entire value of the annuity, less the investment in the contract, is include in gross income.240
A properly planned deferred compensation agreement postpones payment for currently rendered services until a future date, thus having the effect of postponing the taxation of such compensation until it is received. These agreements consist of an employer promising to pay an employee fixed or variable amounts for life or for a guaranteed number of years. When the deferred amount is received, the employee may be in a lower tax bracket. Also, many employers use this type of plan to provide benefits in excess of the limitations placed on qualified plan benefits.
Nonqualified deferred compensation plans may be broken into two broad categories, pure deferred compensation plans and salary continuation plans, and both funded and unfunded deferred compensation plans may be divided into these categories, but the taxation of each plan are so much alike that the differences are miniscule.
A "pure deferred compensation plan" is an agreement between the employer and the employee where the employee defers receipt of some part of his present compensation (or increase in pay or bonus) in exchange for the employer's promise to pay a deferred benefit in the future.
A "salary continuation plan" is a benefit plan provided by the employer in addition to all other forms of compensation whereby the employer promises to pay a deferred benefit, but there is no corresponding reduction in the employee's present compensation, raise or bonus.
A private deferred compensation plan is a plan entered into with any employer other than a governmental organization or an organization exempt from tax. They are usually entered into with employees of corporations, but they can be entered into with employees of other business organizations or independent contractors.
If an employer or service recipient transfers his payment obligations to a third party, efforts to defer payments from the third party may not be effective.
The employer may pay deferred amounts as additional compensation, or employees may voluntarily agree to reduce current salary. The plan must provide that the participants have the status of general unsecured creditors of the employer, and that the plan constitutes a mere promise by the employer to pay benefits in the future. The plan should also state that it is the intention of the parties that it be unfunded for tax and ERISA purposes, and it must define the time and method for paying deferred compensation for each event that would entitle a participant to a distribution of benefits.
In 2004, Congress came up with new additional requirements to avoid constructive receipt. A participant may only receive a distribution of previously deferred compensation upon one of six events happening:
- separation from service;
- the date of disability of the participant;
- a fixed time or according to a fixed schedule, so specified in the plan at the date of deferral;
- a change in ownership or effective control of the corporation or assets of the corporation, to the extent provided in the regulations; or
- the occurrence of an unforeseeable emergency.
The regulations (IRC Section 409) go into detail in definitions of terminology, such as "change in ownership," "effective control," unforeseeable emergency," etc.
Participants must make deferral elections prior to the end of the taxable year of the first year in which the participant becomes eligible to participate in a plan. In the case of performance based compensation coverage in a period of at least 12 months, a participant must make an election no later than 6 months prior to the end of the covered period.241
A participant may elect to delay distribution or change the form of distribution from a plan as long as the plan required the new election to be made at least 12 months in advance. Any election to delay a distribution must delay the distribution at least five years from the date of the new election except when made because of death, disability or unforeseen emergency. Otherwise, an election related to a scheduled series of distributions made according to a fixed schedule must be made 12 months in advance of the first of the scheduled payments.
Participants may elect to delay distribution or change the form of the distribution from a plan as long as the plan requires the new election to be made at least 12 months in advance. Any election to delay a distribution must delay the distribution at least five years from the date of the new election (except for death, disability or unforeseen circumstance). Otherwise, all election related to a scheduled series of distributions must be made at least 12 months in advance of the first scheduled payment.242
A plan can provide for acceleration of payments under certain circumstances:
- to comply with a domestic relations order,
- to comply with a conflict-of-interest divesture requirement;
- to pay income taxes due upon a vesting event subject to IRC 457(f),
- to pay the FICA or other employment taxes imposed on compensation that is deferred under the plan;
- to pay any amount included in income under IRC Sec. 409(a),
- to terminate a deferral election following an unforeseeable emergency, or
- to terminate a participant's interest in the plan
- after separation from service where the payment is not more than $10,000,
- where all arrangements of the same type are terminated,
- in the 12 months following a change in control event, or
- upon a corporate dissolution or bankruptcy.
Short-term deferrals, i.e., when amounts are paid within 2 ½ months after the end of the year in which the employee obtains a legal and binding right to the amounts, this is not considered as a deferral of compensation.
Also, these rules do not generally apply to amounts deferred under an arrangement between a service recipient and an unrelated independent contractor, if, during the contractor's taxable year in which the amount is deferred, the contractor provides significant services to each of two or more service recipients that are unrelated, both to each other and to the independent contractor.243
This section of the Code includes substantial penalties for failing to meet the statutory requirements when deferring compensation. Any violation of these regulations results in retroactive constructive receipt, with the deferred compensation being taxable to the participant as of the time of the intended deferral.244 In addition to the normal income tax on the compensation, the participant must pay an additional 20%, as well as interest at a rate 1% higher than the normal underpayment.245
"Constructive Receipt" is an important concept for tax purposes, not only for deferred compensation, but it applies as well to annuities. The tax deferment under the regulations, will not be allowed if the employee is in constructive receipt of the income under the agreement prior to the actual receipt of the payments.
Income is considered as constructively received if the employee can draw on it at any time, but if there are substantial limitations or restrictions upon the ability of the employee to so draw upon the funds, it will not be considered as constructively received. Also, as long as the employee's rights can be forfeited, there can be no constructive receipt.
As expected, there are (always) exceptions, e.g., an employee will not be in constructive receipt of income even through his rights are nonforfeitable if the agreement is entered into before the compensation is earned and the employer's promise to pay is not secured in any way.246
The 2004 Act created new requirements for elections to defer compensation, with the result that the IRS now maintains that a deferral election after the earning period commences will result in constructive receipt of the deferred amounts, even if made before the deferred amounts are payable. There are other situations where the opposite seems to hold, such as in the case of Rabbi trusts (discussed later).
Courts are more lenient than the IRS, it seems, as they look more favorably upon elections to defer compensation after the earning period commences but before the compensation was payable. There are several IRS rulings in such cases, and court rulings that appear contrary. One rather interesting case was where the court ruled that participants in a shadow stock plan who chose—after earning their deferred benefits but before those benefits were payable—to extend the deferral of their benefits by taking them in 10 installment payments, rather than in one lump sum, did not constructively receive all of their benefits when they received their first installments. The court considered that most significant factor to be that the participants never had unrestricted rights to a lump sum payment of benefits, because access to their benefits was conditioned upon their cashing in their shares and giving up future participation in the plan.247 Even with this ruling, many experts believe that this case cannot be relied up too strongly.
If there is a provision in an unfunded deferred compensation plan that permits hardship withdrawals upon an unforeseeable emergency, it will not necessarily result in constructive receipt.248 Such a provision will generally be acceptable by the IRS in avoiding constructive receipt if it defines "unforeseeable emergency" as "an unanticipated event beyond the participant's (or beneficiary's)control, which would cause severe financial hardship if early withdrawal were not permitted."249 The plan should provide that any withdrawal will be limited to the amount necessary to meet the emergency.
F Employees who were permitted to transfer assets from Rabbi trusts to segregated bank accounts under their control or to employee-funded security trusts, but declined to do so, were in constructive receipt of the amounts that could have been transferred.250
There are special concerns (by the IRS) if compensation is deferred for a controlling shareholder. For instance, if the shareholder can (because he controls the corporation) effectively remove any restrictions on his immediate receipt of the money, the IRS just might argue that he is in constructive receipt because nothing really stands between him and the money. It is very difficult to eliminate these problems in advance as the IRS will not issue advance rulings on the tax consequences of a controlling shareholder-employee's participating in a nonqualified deferred compensation plan. The courts, however, may be less willing to impose constructive receipt in these situations.251
Another problem: If a nonqualified deferred compensation plan is subject to registration as a security with the SEC, failure to register the plan may have tax implications, particularly if the participant has the right to rescind the deferral of his compensation—which may cause this to be considered as constructive receipt by the IRS. Good news, for now, is that the IRS has not resolved this problem so action has not been taken as yet. Bad news is that it probably will in the future and in the meantime, the SEC has NOT formally clarified which nonqualified plans are subject to the registration requirement.
These situations plus the fact that the IRS will not issue an advance ruling on many of these situations, or even issue a private ruling in some cases (such as where an employer retained the right to pay deferred compensation benefits in either a lump sum or periodic payments) amplify and explain why expert tax advice is needed when a deferred compensation plan is established and maintained.
One more instance to illustrate this rather confusing situation—employees wanted to exchange their unfunded nonqualified deferred compensation plan for equal and substitute interests in a qualified plan. (Makes sense, doesn't it?) But the IRS, in a private letter ruling, held that employees who elect to cancel their interest in an unfunded nonqualified deferred compensation plan in exchange for substitute interests in a qualified plan would be taxable on the present value of the accrued benefits in the qualified plan upon the funding of those new interests, and would have to include the value of future benefits attributable to future compensation when the cash (otherwise receivable under the nonqualified plan) would have been includable.252
A "top hat" plan is an unfunded plan maintained primarily to provide deferred compensation for a select group of management or highly compensated employees.253
Whether a plan is a "top hat" plan is determined only by the facts and circumstances. Where a plan was offered to 15% of employees, all management or highly compensated employees, this was a top hat plan, but where all management employees were eligible for a plan, it was held not to meet the select group requirement.254
A top hat plan can be used as a temporary holding device for 401(k) elective deferrals.255
In addition to the Constructive Receipt theory, another rule that can create a tax problem to a deferred compensation plan is the "Economic Benefit" theory. This states that an employee is taxed when he receives something other than cash that has a determinable, present economic value. In respect to deferred compensation plans, an arrangement for providing future benefits will be considered to provide the employee with a current economic benefit capable of valuation. Current taxation arises when the assets are unconditionally and irrevocably paid into a fund or a trust to be used for the sole benefit of the employee.256
An employer may establish a reserve for the purpose of satisfying its future deferred compensation obligation and at the same time preserving the unfunded and unsecured nature of its promises, provided that the reserve is wholly owned by the employer and remains subject to the claims of its general creditors. "A mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income."257
Deferred compensation benefits can be backed by life insurance or annuities without creating a currently taxable economic benefit.258
However, in another case, a court found that the promises of pre-retirement death and disability benefits provided the employee with a current economic benefit —current life insurance and disability insurance protection—even though the corporation was owner and beneficiary of the policy, which was subject to the claims of its general creditors. The court did not find constructive receipt of the promised future payments, but ruled that the portion of the premium attributable to life, accidental death, and disability benefits was taxable to the employee.259
A deferred compensation plan cannot be formally funded—the employee cannot be given an interest in any trust or escrowed fund or in any asset, such as an annuity or life insurance policy—without there being adverse tax consequences. However, the agreement can be informally funded without losing the tax deferral, such as setting aside assets in a Rabbi trust (discussed below) to provide funds for payment of deferred compensation obligations—as long as the employees have no interest in those assets and they remain the employer's property (subject to the claims of the employer's general creditors).260
An employer may informally funds its obligations by setting aside a fund composed of life insurance policies, annuities, mutual funds, securities, etc., without adverse tax consequences to the employee, as long as the fund remains the unrestricted asset of the employer and the employee has no interest in it.261
If the securing or distributing of deferred compensation plans are triggered by the failing financial status of the employer, including setting aside assets in an offshore trust, the otherwise deferred compensation is immediately taxable and in some cases, subject to a 20% additional tax.262
Keeping in mind that if an unfunded deferred compensation plan is not subject to ERISA requirements, exclusive purpose rule and minimum vesting and funding standards, a court has ruled that a death benefit only plan backed by corporate-owned life insurance is "funded" for ERISA purposes.263 This result has been criticized, but if adopted by other courts, could have far-reaching tax implications. Once a plan is "funded" for ERISA purposes, and once these requirements are met, the plan is no longer informally funded for tax purposes, and adverse tax consequences may follow. Again, a good reason to bring in expert tax advice when installing or creating a private deferred compensation plan.
A couple of other points: An insurance policy used to informally fund a plan should be held by the employer and not distributed to the employee at any time; otherwise the employee will be taxed on the value of the contract when he receives it. Also, an employee is not taxable on the premiums paid by the employer or on any part of the policy or annuity provided the employer applies for, owns, is beneficiary of, and pays for the policy or annuity contract and uses it only for a reserve for the employer's obligations under the deferred compensation agreement.
However, an employee can purchase indemnification insurance to protect his deferred benefits without causing immediate taxation.264
Whether a promise to pay, either by the employer or a third party, may or may not create a "funded" situation for the plan, depending upon the details and a wide-ranging group of court cases, IRS Letter Rulings and IRS regulations. Again, expert advice is required.
A "Rabbi trust" is a method of accumulating assets to support unfunded deferred compensation obligations. The trust, generally an irrevocable trust, is established by the employer using an independent trustee and it is designed to provide the employees with some sense of security that their money will be there when promised and at the same time, it preserves the tax deferral that is the principal reason for the existence of the plan. The special feature of a Rabbi trust is that its assets remain subject to the claims of the employer's general creditors in case the employer becomes insolvent or enters bankruptcy. (The reason it is called a "Rabbi" trust, in case you were wondering, is that the first one that was approved by the IRS was set up for a Rabbi).
The tricky part of a Rabbi trust is that there must be no "trigger" when deferred compensation was either being secured or distributed because of the failing financial status of the employer. There have been attempts to create a "hybrid" Rabbi/secular trust where assets are distributed from the Rabbi trust to secular trusts when triggered by the failing financial difficulties of the employer. Doesn't work. Under such arrangements, the deferred compensation is taxable and subject to 20% additional tax plus interest on underpayment of taxes at the normal rate plus 1%.265
A Rabbi trust can protect an employee against the employer's future unwillingness to pay promised benefits, but it cannot protect an employee against the inability of the employer to pay for promised benefits. This, plus the tax deferral, has made Rabbi trusts quite popular. It is so popular, in fact, that the IRS has released a model Rabbi trust instrument to aid taxpayers and to assist in the processing of requests for advance rulings on these arrangements. This model is to be used as a "safe harbor" for employers, but it will not, by itself, cause employees to be in constructive receipt of income, or to incur an economic benefit. To obtain this model, see Rev. Proc. 92-64, 1992-2CB 422.
Other items to be taken into consideration when creating a Rabbi trust:
- The IRS will continue to issue advance rulings on the tax treatment of unfunded deferred compensation plans that do not use a trust and unfunded deferred compensation plans that use the model trust, but they will not longer (except in rare circumstances) issue advance rulings on unfunded deferred compensation arrangements that use a trust other than the model trust.
- The model trust language contains all of the provisions that are necessary for the trust to operate except for language describing the trustee's investment powers, which must be provided by the parties, and the investment powers of the trustee must include some investment discretion.
- Interestingly, the employer may add additional text to the model language, as long as it is "not inconsistent with" the model trust language.
- The rights of plan participants to trust assets must be merely the rights of unsecured creditors and cannot be alienable or assignable; further, the assets of the trust must be subject to the claims of the employer's general creditors in case of insolvency or bankruptcy.
- The board of directors and the highest ranking officer of the employer must be required to notify the trustee of the employer's insolvency or bankruptcy, and the trustee must be required to cease benefit payments upon the company's insolvency or bankruptcy.
- If the model trust is used properly, it should not cause a plan to lose its status as "unfunded—contributions to a Rabbi trust should not cause immediate taxation to employees; employees should not have income until the deferred benefits are received or otherwise made available. Contributions to a Rabbi trust should not be considered as "wages" subject to income tax withholding until benefits are actually or constructively received.
- The IRS has, in the past, allowed a Rabbi trust in conjunction with a deferred compensation plan that permits hardship withdrawals, such withdrawals limited to the amount needed to satisfy the emergency needs.
The trust must provide that, if life insurance is held by the trust, (a) the trustee will have no power to name any entity other than the trust as beneficiary, (b) assign the party to any entity other than a successor trustee, (d) or to loan to any entity the proceeds of any borrowing against the policy.
There is a lot of "fine print" in the establishing of a Rabbi trust—the "model" does not do it all. There are several other requirements before the IRS will issue a letter ruling that are too lengthy to discuss in this text but which can be provided by the IRS.266
Basically, the employer can take a deduction for deferred compensation only when it is includable in the employee's income whether the employer is on a cash or accrual basis, and, further, deduction of amounts deferred for an independent contractor can be taken only when they are includable in the independent contractor's gross income.267
Payments made under an executive compensation plan within 2 ½ months of the end of the year in which employees vest do not constitute deferred compensation, and thus may be deducted in the year in which employees vest, rather than the year in which the employees actually receive the payments.268
For amounts credited as "interest," under a nonqualified deferred compensation plan, such deduction for interest must be postponed until such amounts are includable in employee income, and amounts representing such "interest" cannot be currently deducted by an accrual basis employer.269
To be deductible, deferred compensation payments must represent reasonable compensation for the employee's service when added to current compensation—definition of "reasonable" determined in each case based on fact.
F Payments from deferred compensation are taxed as ordinary income to the recipient when they are actually or constructively received. They are considered as "wages" and are, therefore, subject to regular income tax withholding and not the special withholding rules that apply to pensions, etc.270
Payments made to a beneficiary are considered as "income in respect of a decedent" and therefore, are taxed as they would have been taxed to the employee. Benefits that are assigned by an employee to an ex-spouse in a divorce agreement will be taxed to the employee, not to the ex-spouse.
Under what is called "the general timing rule," amounts taxable as wages are generally taxed when paid or constructively received. Another rule, the "special timing rule," applies to amounts deferred by an employee under a regular deferred compensation plan of an employer covered by FICA. The special timing rule is applicable to salary reduction plans and supplemental plans, funded plans and unfunded plans, private plans and IRC Section 457 plans, but not to excess or golden-parachute plans.
FUTA rules are similar to FICA rules except that the taxable wage base for FUTA is $7,000.
The following plans and benefits are not considered deferred compensation for FICA and FUTA purposes:
- Stock options, stock appreciation rights, and other stock value rights, but not phantom stock plans or other similar arrangements in which an employee is awarded the right to receive a fixed payment equal to the value of a specified number of shares of stock;
- Certain restricted property received in connection with the performance of services;
- Compensatory time, disability pay, severance pay and death benefits;
- Certain benefits provided in connection with impending termination, including window benefits;
- Excess (golden parachute) payments;
- Benefits established 12 months before an employee's termination, if there was an indication that benefits were provided in contemplation of termination;
- Benefits established after termination of employment; and
- Compensation paid for current services.
In order to determine the amount that is deferred for a given period of time, it depends upon whether the deferred compensation plan is an account balance plan or a nonaccount balance plan.
A plan is considered as an account balance plan if under the terms of the plan (a) a principal amount is credited to an employee's individual account; (b) the income that is attributed to each principal amount is credited or debited to the individual account; and (c) the benefits that are payable to the employee are based entirely upon the balance that is credited to his individual account.271
If the plan is an account balance plan, the amount deferred for a period equals the principal amount credited to the employee's account for the period, increased or decreased by any income or loss attributed through the date when the principal amount must be taken into account as wages for FICA and FUTA purposes.
"Income attributable to the amount taken into account" is defined as any amount, that under the terms of the plan, is credited on behalf of an employee and attributed to an amount previously taken into account, but only if the income is based on a rate of return that does not exceed either the actual rate of return on a predetermined actual investment; of a reasonable rate of interest, if no predetermined actual investment has been specified.
A nonacccount balance plan is where the amount that is deferred for a given period equals the present value of the additional future payment or payments to which the employee has a legal binding right under the plan, during that period. The present value must be determined as of the date when the amount deferred must be taken into account as wages (using actuarial assumptions and methods that are reasonable as of that date).272
An employee may treat part of a nonaccount balance plan as a separate account balance plan if that part satisfied the definition of an account balance plan and the amount payable under that part is determined separately from the amount payable under the other part of the plan. Also, an amount deferred under the nonaccount balance plan does not have to be taken into account as wages under the special timing rule until the earliest date on which the deferred amount is reasonably determined-which means that when there are no actuarial or other assumptions needed to determine the amount deferred other than interest, mortality, or cost-of-living assumptions.273
Once an amount is treated as wages, plus any income that can be attributed to it, it will not be treated as wages for FICA or FUTA purposes in any later year.
Self-employed individuals pay social security taxes through self-employment (SECA) taxes, rather than FICA taxes. Deferred compensation of self-employed individuals is usually counted for SECA tax purposes when it is includable in income for income tax purposes. Deferred compensation of self-employed individuals is generally counted for SECA purposes when paid, or earlier, when it is constructively received.
Corporate directors who defer their fees generally count those fees for SECA purposes when paid or constructively received.
The taxable wage base for the old age, survivors and disability insurance (OASDI) portion of the FICA tax and the taxable earnings base for the OASDI portion of the SECA tax are both $94,200 for 2006 (was $90,000 for 2005).
There is no taxable wage base cap for the Medicare hospital insurance portion of the FICA tax so all deferred compensation counted as wages for FICA purposes is subject to at least the hospital portion of the FICA tax, nor is there an earnings base cap for the hospital insurance part of the SECA tax.274
Section 457 plans (government and tax-exempt employers) allow for participants to have receipt and taxation of compensation for services performed for a state or local government to be deferred. The Code does not provide for tax-exempt employers and government entitled to maintain SIMPLE IRA plans, but they may do so, according to the IRS.
Section 457 generally applies to deferred compensation agreements entered into with nongovernmental organizations exempt from tax under IRC Section 502, which are mostly nonprofit organizations serving some public or charitable purpose. There are several types of plans that are not subject to IRC Section 457 taxation and a list of requirements. These requirements are too complex and cumbersome for discussion in this text.
1. In a deferred compensation plan, if the IRS decides that the compensation is unreasonable,
A. they will consider it as reasonable compensation, deductible as a business expense.
B. they will request that the company restructure the plan and refile.
C. then all of the employee benefit plans will no longer be qualified.
D. the IRS may consider it as a "dividend" and tax it as such.
2. Any payment in the nature of compensation to an individual in anticipation of change in ownership of the company is
A. illegal and a federal offense.
B. considered just another type of deferred compensation and is taxed like any other plan.
C. a parachute agreement but there is no penalty with this type of program.
D. a parachute payment which may be subject to no employer deduction and the recipient
could be subject to a 20% penalty tax.
3. For taxation of employees and employers in respect to premiums paid by the employer under a nonqualified annuity plan or contributions to a non-exempt employee's trust,
A. the employee is taxed on a contribution to a trust or premium paid for an annuity
contract to the extent that his interest is substantially vested when the payment is made.
B. the employer may consider the total contribution that he made as immediate business
expense and is tax free.
C. as a general rule, such annuity or contribution to a trust are illegal in most states.
D. the employer and employee enjoy such annuity or contribution as tax-free.
4. An irrevocable trust that is established to formally fund and secure nonqualified deferred compensation benefits, is
A. a Rabbi trust.
B. a secular trust.
C. subject to the claims of the employer's creditors.
D. illegal in all states except California and New York.
5. In a nonqualified annuity, in order to determine the taxable portion of an annuity payment, the employee's investment in the contract consists of all amounts that can be attributed to the employer contributions
A. that were taxed to the employee and premiums paid by the employee.
B. that were taxed to the employee and premiums paid by the employer.
C. less a percentage of the employer contributions that relate to length of service.
D. discounted at an interest rate that fluctuates with the Dow Jones Averages.
6. The IRS Code is rather strict in respect to penalties for failing to meet the statutory requirements when deferring compensation. Any violations of the requirements may result in
A. a $10,000 fine for each month the plan has not been in compliance.
B. retroactive constructive receipt and taxed to the participant when compensation was
deferred, plus an additional 20% and interest at a rate 1% higher than the normal under
C. the employer and the employee having to forfeit the entire deferred compensation to the
IRS in penalties.
D. an immediate IRS audit of both the employer and the employee.
7. A deferred compensation plan that is unfunded and is maintained primarily to provide deferred compensation for a select group of management or highly compensated employees is
A. a parachute plan.
B. a key man plan where contributions from the employer and the employee are not taxed.
C. called a "top hat" plan.
D. often used as a vehicle for elimination any discrimination problems with a pension
8. A simple IRS rule that states than an employee is taxed when he receives something other than cash that has a determinable, present economic value, is known as
A. the Continuity Adjustable plan.
B. the economic benefit theory.
C. the constructive receipt definition.
D. individual leveling formulae.
9. When the amount of compensation that is deferred for a given period, equals the present value of the additional future payment(s) to which the employee has a legal binding right under the plan and during that period, it is called
A. the account balance plan.
B. the nonaccount balance plan.
C. economic benefit theory.
D. a pyramid scheme.
10. As a general rule, deferred compensation plans for self-employed individuals usually are counted for SECA tax purposes
A. when it is includable in income for income tax purposes when paid or constructively
B. and are reported on the individuals 1040A as capital gains and the income is reported on
C. when it is part of a deferred compensation plan that is qualified and has been in existence
for a period of at least 5 years.
D. when funded by annuities only.
ANSWERS TO STUDY QUESTIONS
1D 2D 3A 4B 5A 6B 7C 8B 9B 10A