3535 / What are the tax consequences to an employee when a secular trust is used to provide deferred compensation?

An interest is substantially vested if it is transferable or not subject to a substantial risk of forfeiture ( Q 3538).⁴

With respect to the taxation of distributions from an employer-funded secular trust, the IRS previously has indicated that the rules of IRC Section 72 (except IRC Section 72(e)(5)) apply ( Q 3539). Under this approach, distributions would be taxable except to the extent that they represent amounts previously taxed. Consequently, it would seem that a highly compensated employee who has been taxed on his or her entire “vested accrued benefit” would not be taxed again on receipt of a lump sum distribution.

The IRS has questioned the applicability of IRC Section 72 to distributions from employer-funded secular trusts to highly compensated employees (“HCEs,” as defined in IRC Section 414(q) ( Q 3930)) participating in plans that fail the minimum participation or the minimum coverage tests applicable to qualified retirement plans (which most nonqualified plans will fail). The IRS has adopted the controversial position that a special rule under IRC Section 402(b)(4) should be applied to tax HCEs each year on their “vested accrued benefit” in the trust (minus amounts previously taxed). Thus, HCEs will be taxed on vested contributions and on vested earnings on those contributions. Apparently, the IRS would tax HCEs on their vested earnings even where they consist of unrealized appreciation of capital assets or nominally tax-free or tax deferred income (e.g., from municipal bonds or life insurance). Further, the IRS has ruled that any right to receive trust payments in compensation for these taxes also will be taxable as part of the vested accrued benefit.⁵

According to the IRS, as long as a failure to satisfy the minimum participation test or the minimum coverage test is not the only feature of the plan that keeps the secular trust from being treated as a tax-qualified trust (and it generally will not be so treated), then any participants who are not highly compensated will be taxed under the general rules of IRC Section 402(b)(1), described above.

The 10 percent penalty for certain early (premature) annuity distributions under IRC Section 72(q) 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., if it provides for the payment of benefits in a series of periodic payments over a fixed period of time, or over a lifetime).⁶

Employee-funded secular trusts (where the employee establishes the trust, but the employer administers it and contributes to it) are analyzed differently. The employee generally has a choice between currently receiving cash or its equivalent, e.g., an annuity that can be surrendered immediately or life insurance policy, or a cash contribution to the trust. Sometimes the employee has the choice between withdrawing contributions from the trust or leaving them in. In these situations, the IRS generally has ruled that the employee constructively received the employer-contributed cash and then assigned it to the trust. Thus, the IRS generally has held the employee to be currently taxable on employer contributions to the trust.⁷

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 ( Q 513).⁸