Employee Benefits and Taxes, Pt. 1: Tax Treatment of Section 83 Deferred Comp

From Tax Facts Online, a look at tax consequences to both employees and employers on Section 83 funded deferred compensation agreements.

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As part of AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March 2012, we are partnering with our Summit Business Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In this, the third article, we look at the tax treatment of Section 83 funded deferred comp agreement

Q. What are the tax consequences to employees and employers of a Section 83 funded deferred compensation agreement? 

Employee Taxation
Under IRC Section 83, as a general rule, an employee is currently taxed on a contribution to a trust or a premium paid for an annuity contract (paid after August 1, 1969) to the extent that his or her interest is substantially vested when the payment is made. 

An interest is substantially vested if it is transferable or not subject to a Section 83 substantial risk of forfeiture. An interest is transferable if it can be transferred free of a substantial risk of forfeiture. 

A partner is immediately taxable on his or her 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 an employee’s rights change from substantially nonvested to substantially vested, the value of the employee’s interest in the trust or the value of the annuity contract on the date of change (to the extent such value is attributable to contributions made after August 1, 1969) must be included in the employee’s gross income for the taxable year in which the change occurs. The value on the date of change also probably constitutes “wages” for the purposes of withholding and for purposes of FICA and FUTA. The value of an annuity contract is its cash surrender value. 

If only part of an employee’s interest in a trust or an annuity contract changes from substantially nonvested to substantially vested during any taxable year, then only that corresponding part is includable in gross income for the year. 

An employee is not taxed on the value of a vested interest in a trust attributable to contributions made while the trust was exempt under IRC Section 501(a). 

Special rules apply to trusts that lose their tax qualification because of a failure to satisfy the applicable minimum participation or minimum coverage tests.[7] The IRS has taken the controversial position that these special rules apply to non-exempt trusts that were never intended to be tax qualified. As a result, the IRS would tax highly compensated employees (“HCEs”) participating in trust-funded nonqualified plans that fail the minimum participation or minimum coverage tests applicable to qualified plans, which most nonqualified plans will fail. 

There is no tax liability when an employee’s rights in the value of a trust or annuity (attributable to contributions or premiums paid on or before August 1, 1969) change from forfeitable to nonforfeitable. Prior to August 1, 1969, an employee was not taxed when payments were made to a nonqualified trust or as premiums to a nonqualified annuity plan if the employee’s rights at the time were forfeitable. Thus, the employee did not incur tax liability when the employee’s forfeitable rights later became nonforfeitable. This old law still applies to trust and annuity values attributable to payments made on or before August 1, 1969.

Where an employer amended its Section 451 “unfunded” nonqualified deferred compensation plan (one subject to the claims of the employer’s general creditors in bankruptcy) to provide those participants with a choice between a lump sum payment of the present value of their future benefits or an annuity contract securing their rights to the remaining payments under the plan (with a corresponding tax gross-up payment from the employer), any participant who chose the annuity contract would be required to include the purchase price for such participant’s benefits under the contract in gross income (as well as the tax gross-up payment) in the year paid or made available, if earlier.

Employer Taxation
Whether a cash or accrual basis taxpayer, an employer can take a deduction for a contribution or premium paid in the year in which an amount attributable thereto is includable in an employee’s gross income. This deduction cannot be more than the amount of the contribution and it cannot include any earnings on the contribution before they are included in the employee’s income.If more than one employee participates in a funded deferred compensation plan, the deduction will be allowed only if separate accounts are maintained for each employee.The employer is not allowed a deduction at any time for contributions made or premiums paid on or before August 1, 1969, if the employee’s rights were forfeitable at the time. 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.[15] 

With respect to contributions made after February 28, 1986, to annuity contracts held by a corporation, partnership, or trust (i.e., a nonnatural person), the “income on the contract” for the tax year of the policyholder generally is treated as ordinary income received or accrued by the contract owner during such taxable year. 

Corporate ownership of life insurance also may result in exposure to the corporate alternative minimum tax. 

The IRS has taken the position that a nonexempt employee’s Section 83 funded trust deferred compensation agreement cannot be considered an employer-grantor trust. As a result, the employer will not be taxed on the trust’s income, but it also cannot claim the trust’s deductions and credits.Proposed regulations have affirmed the position of the IRS. 

Funded deferred compensation may take the form of either a salary continuation or pure deferred compensation/ 

The fact that a trust to fund a previously unfunded deferred compensation agreement was established as part of a nontaxable (IRC Section 337) corporate liquidation did not alter its treatment as an employee trust.

A nonqualified deferred compensation plan funded by a trust or annuity other than an “excess benefit plan” must provide for minimum vesting generally comparable to that required in qualified retirement plans. Government plans and many church plans, however, are exempt from ERISA. 

The above rules do not apply to nonqualified annuities purchased by tax-exempt organizations and public schools or to individual retirement accounts and annuities.

For further details and citations on this topic, we invite you to sign up for a 15-day free trial of Tax Facts Online by clicking here.

To purchase the 2012 Tax Facts on Insurance & Employee Benefits books, please click here. And to sign up for a free Tax Facts Online product demonstration webinar on March 28 at 2 PM EST, please click here.

See all six articles from Tax Facts Online, part of AdvisorOne's 22 Days of Tax Planning for 2012 Special Report.

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