3563 / What is the “economic benefit” theory and how does it apply to nonqualified deferred compensation plans?

An employer can establish a reserve for satisfying its future deferred compensation obligations while preserving the “unfunded and unsecured” nature of its promise, provided that the reserve is wholly owned by the employer and remains subject to the claims of its general creditors. A mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income.² Unfunded plans do not confer a present, taxable economic benefit.³ An unfunded and unsecured promise of future payment is specifically excluded from coverage under IRC Section 83, which codifies the economic benefit theory.⁴

It generally has been accepted that deferred compensation benefits can be backed by life insurance or annuities (or any other assets) in a general asset reserve of the employer without creating a currently taxable economic benefit to a participant.⁵

In the old Goldsmith case,⁶ the court found that the promises of preretirement death and disability benefits provided the employee with a current economic benefit – current life insurance and disability insurance protection – even though the corporation was the owner and beneficiary of the policy, which was subject to the claims of its general creditors. The court did not find constructive receipt of the promised future deferred compensation payments, but ruled that the portion of the premium attributable to life, accidental death, and disability benefits was taxable as a current economic benefit to the employee. The Goldsmith case appears to be anomalous. Since it was decided, the IRS has not treated pre-retirement death or disability benefits paid out as ordinary income under a nonqualified deferred compensation plan as creating a currently taxable economic benefit.⁷ This income tax treatment can be compared with that intended by Congress for deferred compensation plans under IRC Section 457 ( Q 3600).

It should be noted that the economic benefit tax theory has not been eliminated by the enactment of Section 409A, because Section 409A is additive law and actually further defines constructive receipt. Therefore, the IRS still can apply this theory and all other pre-409A income taxation theories (e.g., assignment of benefit) to impose taxation on deferred compensation when supported by the facts of any nonqualified deferred compensation arrangement situation, regardless of whether it is covered by, grandfathered, or excepted from Section 409A coverage. Therefore, the nonassignability and unfunded plan provisions commonly placed in nonqualified deferred compensation, whether covered by or excepted from 409A coverage, remain a necessity to reduce the chance of the IRS applying the economic benefit as well as assignment of benefit tax theories to impose premature income taxation on plan participants.