Achieving Tax Deferral In Non-Qualified Plans
By Maggie Mitchell
Non-qualified plans are a very popular planning tool. They are particularly attractive to highly paid employees who want to defer a portion of their current income and spread it out over later years, preferably retirement years.
Since income tax deferral is one of the primary design goals of any non-qualified plan, it is essential that the plan avoid the potential pitfall of the constructive receipt doctrine.
Failure to understand this tax doctrine and implement proper plan design can result in a very unhappy situation where the employee has no current access to the deferred funds, but is still taxed as though he had actually received the money.
Treasury regulations provide that a cash basis employee is considered to have taxable income when funds are made available without substantial restrictions. This is known as “constructive receipt” (Treas. Reg. 1.451-2(a)). Constructive receipt happens, for example, when the funds are:
–Credited to the employees account;
–Set apart for the benefit of the employee; or
–Otherwise made available so that they can be drawn upon at any time.
A deferred compensation plan will usually avoid constructive receipt either because the employee cannot get the money today or there are substantial limitations or restrictions on his or her ability to get the money today. Since the constructive receipt doctrine is essentially one of timing, a few simple but effective rules can help avoid tax problems in this area.
Agreement entered into before services are rendered.
The core of the IRS view on application of the doctrine of constructive receipt to nonqualified plans is found in Rev. Rul. 60-31. There the IRS said constructive receipt will not exist if:
1) The agreement to defer compensation is entered into before the services are rendered by the employee; and
2) The employers promise to pay is not secured in any way.
The employer can even elect to finance the liabilities of the deferred compensation plan by purchasing life insurance or annuity contracts without the plan being regarded as secured and without the employee being deemed to be in constructive receipt of the deferred monies.
Although the determination of whether the doctrine of constructive receipt is applicable must be made on each specific cases factual situation, the IRS has indicated that certain requirements must be met for it to issue a favorable letter ruling. Those requirements are set forth in Rev. Proc. 92-65 (which amplifies Rev. Proc. 71-19) and can be found in the sidebar on page 12.
Agreement entered into after services have been rendered
Several court cases have held that there was no constructive receipt even where services were previously performed if the employee and the employer agreed to defer the compensation prior to the time the compensation was payable.
For example, in Veit v. Commr, 8 T.C. 809 (1947), the taxpayer amended an agreement to defer compensation to provide for further deferral of benefits. The court found no constructive receipt and held that the amounts to be paid under the agreement were indefinite and not determinable at the time the amendment was made. The IRS acquiesced in this result.
In Commr v. Oates, 207 F.2d 711 (7th Cir. 1953), the court held that commissions were income in the year received despite the fact that the services were performed before the agreement to defer receipt of the commissions was entered into. This conclusion was reached because the amount of the commissions was not ascertainable at the time of the agreement and the agreement was entered into before the amounts became payable. Therefore, the amount was includable as income only when received and not when credited to an account that the employee could not immediately draw upon. The IRS has acquiesced to this result.
However, the IRS has never acquiesced to the result in Martin v. Commr, 96 T.C. 814 (1991). In that case, the court ruled that employees in a shadow stock plan who, after earning their deferred benefits but before those benefits were payable, chose to extend deferral by choosing 10 installment payments in lieu of a lump sum payment, did not constructively receive all of their benefits when they received the first installments.
This issue remains unresolved and there is no assurance that amendments extending deferral after the services have been rendered will go unchallenged by the IRS.
Controlling shareholder deferrals
Controlling shareholders of closely held corporations have a unique constructive receipt problem. In Congeleton v. Commr, 38 T.C.M. 584 (1979), the taxpayer, who was the president and controlling shareholder of a closely held corporation, was held to be in constructive receipt of salary deferred, since nonpayment of such salary was determined to be at the taxpayers personal choice.
The IRS reached a similar conclusion in TAM 88-28004, and although the IRS discourages the use of a nonqualified plan where a controlling shareholder is involved, it is important to remember that many cases and rulings have been decided with varying results based on the particular facts and circumstances of the situation.
Where the decision is made to implement a nonqualified plan, take care to ensure that your plan design and administration are consistent with avoidance of the constructive receipt doctrine.
If your non-qualified plan includes a controlling shareholder, steps should be taken to build a paper trail that can support the finding that the controlling shareholder is not in a position to direct the plan. A few of the tools that can be utilized to evidence this “objectivity” include an executive committee that implements and approves all executive compensation plans; similarity in plan benefits for top executives and the controlling shareholder; and third party implementation and maintenance of the plan.
Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.