3542 / What is the doctrine of constructive receipt and how does it apply to nonqualified deferred compensation plans?

Under pre-409A income tax law, tax deferment is not achieved if, prior to the actual receipt of payments, the employee is in constructive receipt of the income under the agreement. Income is constructively received if the employee can draw upon it at any time. Income is not constructively received if the employee’s control of its receipt is subject to substantial limitations or restrictions. Some agreements contain contingencies that may cause the employee to forfeit future payments. So long as the employee’s rights are forfeitable, there can be no constructive receipt.¹ The IRS has ruled, however, that the employee will not be in constructive receipt of income even though 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.²

IRC Section 409A created new requirements for elections to defer compensation for covered nonqualified deferred compensation plans.³ Under pre-IRC Section 409A income tax law (which is still applicable to amounts grandfathered and plans excepted from Section 409A coverage), there was some conflict between the IRS and the courts with respect to the consequences of an election to defer compensation after the earning period commences. The IRS always has seemed to believe that a deferral election made after the earning period commences will result in constructive receipt of the deferred amounts, even if made before the deferred amounts are payable.⁴

For example, in TAM 8632003, the IRS found constructive receipt where a participant in a shadow stock plan elected, just prior to surrendering his shares, to take the value of his shares in 10 installment payments rather than in one lump sum. The IRS refused to permit further deferral of amounts already earned and determinable, believing that the fact that the benefits were not yet payable at the time of the election was an insufficient restriction on the availability of the money.⁵ A plan allowing elections to defer bonus payments on or before May 31 of the year for which the deferral was effective did not cause constructive receipt. There was no express consideration of the effect of the election provision, however.⁶

In another ruling, contributions to a rabbi trust did not result in income to participants or beneficiaries until benefits would be paid or made available in the context of the plan allowing an election to further defer compensation through choice of the payout method after termination of services; there was no express consideration of the effect of the election provision.⁷

Pre-Section 409A, courts looked more favorably on elections to defer compensation after the earning period commenced but before the compensation was payable. For example, the Tax Court considered the same plan addressed in TAM 8632003, above, and reaffirmed its position that an election to further defer compensation not yet due under the original deferred compensation agreement does not necessarily result in constructive receipt.⁸ Although the IRS did acquiesce in Oates and in the first Veit case, it tried to distinguish those cases and the second Veit case in TAM 8632003.

The 409A general rule requires an election prior to the tax year in which the compensation is to be earned, which is the historic position of the IRS. Because the IRS was charged by Congress in the Congressional Commentary to Section 409A to pursue plans not conforming to Section 409A, it could be expected that the IRS likely will challenge plans excepted from Section 409A, and perhaps even grandfathered plans, that generally do not follow the income tax guidelines established by Section 409A, especially this one governing fundamental tax deferral.

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Planning Point: To date, the IRS has only continued to do some audits for general 409A compliance.⁹ Staffing problems at the IRS have forced it to forgo any broader enforcement beyond covered plans, and the focus is currently on FICA tax compliance.

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Whether Section 409A is applicable or not, special concerns are present if compensation is deferred for a controlling shareholder-employee, typically in the closely-held corporate situation. If a controlling shareholder-employee can (through control of the corporation) effectively remove any restrictions on immediate receipt of the money, the IRS can argue that he or she is in constructive receipt because nothing really stands between the shareholder-employee and the money.¹⁰ It is hard to eliminate these concerns in advance, because the IRS continues to refuse to issue advance rulings on the tax consequences of a controlling shareholder-employee’s participation in a nonqualified deferred compensation plan.¹¹ Courts seemed to be less willing to impose constructive receipt in such situations prior to Section 409A.¹²

Under Section 409A, the definition of “substantial risk of forfeiture” in the regulations embedded this IRS argument into law. The regulations to Section 409A prevent such a shareholder-employee from using the short term deferral exception to escape the coverage of Section 409A, even on a “vest and pay lump sum” Supplemental Executive Retirement Plan (“SERP”). However, they do not seem to prohibit such a nonqualified deferred compensation plan for such a shareholder-employee if the plan thereby fully complies with the documentary and operational requirements of the law. Such a plan could not claim the short term deferral exception to escape Section 409A coverage, even as to a SERP. Under the Section 409A regulations the shareholder’s control causes a loss of the substantial risk of forfeiture needed to claim the short term deferral exception. Even then, the IRS still might attempt to attack a plan for such a shareholder-employee, even if the plan is otherwise fully complying with the form and operational requirements of Section 409A. Therefore, special consideration and review must be applied to such a situation before implementing any plan, whether a voluntary deferral or employer-paid supplemental design.

Finally, a nonqualified deferred compensation plan that is subject to registration as a security with the SEC, but that fails to register, may suffer adverse tax consequences. In such a case, a participant may be able to rescind the deferral of compensation under SEC rules. A right to rescind could cause the participant to be in constructive receipt of the deferred amounts. Currently, the IRS has not resolved either the nature or extent of any tax implications arising from a failure to register a plan with the SEC, and this is further complicated by the enactment of Section 409A. Further complicating matters, the SEC has not formally clarified in detail the nonqualified deferred compensation plans that are subject to the “security” registration requirements and has provided little useable informal guidance in this area, except to suggest that contemporary voluntary multi-account deferral designs might require registration.¹³