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?
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. 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.