3573 / When are deferred amounts under an unfunded nonqualified account and nonaccount balance plan deductible by the employer?

The IRS has confirmed that payments made under an executive compensation plan within 2½ months of the end of the year in which employees vest do not constitute deferred compensation and thus may be deducted in the year in which employees vest, rather than the year in which the employees actually receive the payments.³ Previously, there was some controversy over the proper timing of an accrual basis employer’s deduction for amounts credited as “interest” to employee accounts under a nonqualified deferred compensation plan. The weight of authority currently holds that IRC Section 404(a)(5) governs the deduction for such amounts, which must be postponed until such amounts are includable in employee income. Amounts representing “interest” cannot be currently deducted by an accrual basis employer under IRC Section 163.⁴

To be deductible, deferred compensation payments must represent reasonable compensation for the employee’s services when added to current compensation. The question of what is reasonable is question of fact in each case. One factor considered in determining the reasonableness of compensation is whether amounts paid are intended to compensate for past, under-compensated services ( Q 3519). Thus, deferred compensation for past services may be deductible, even if the total of such compensation and other compensation for the current year is in excess of reasonable compensation for services performed in the current year, as long as that total, plus all compensation paid to the employee in prior years, is reasonable for all of the services performed through the current year.⁵

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Planning Point: Substantiating the rationale behind the deferred compensation can be particularly important in a plan that is implemented for the benefit of an owner-operator nearing retirement in a closely-held company, because this substantiation can make the difference between whether the post-retirement payments are considered tax deductible compensation, rather than a nondeductible dividend. This is especially true in light of the increases in dividend tax rates for clients in the highest income tax bracket, which took effect beginning January 1, 2013. Future reductions in income tax rates may change this.

Historically, best practice dictated documenting that the deferred compensation is partial compensation to make up for past “under compensation” in board resolutions and supporting materials, as well as the plan document itself (if written as a separate individual agreement) in order to support it as reasonable compensation. This also suggests the wisdom of creating such a plan for an owner-operator as far in advance of retirement as possible, so as to make the deferred compensation part of compensation for as many tax years as possible, thereby helping establish its long-term reasonableness, even if resources to initially fund it are not readily available.

However, if the desired plan design is 409A covered, under the current regulations the IRS may be expected to take the position that the deferral of taxation is not effective because of the unlikelihood that the 409A plan operational requirements will be followed by a majority or controlling shareholder with respect to his or her own benefit.

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Reasonableness of compensation is usually not an issue as to non-shareholder or minority shareholder employees. A finding of unreasonableness in the case of a controlling shareholder is more likely. In one case, benefits paid to a surviving spouse of a controlling shareholder of a closely-held corporation were held not reasonable compensation where:

(1)   the controlling shareholder had not been under-compensated in previous years;

(2)   the controlling shareholder’s compensation exceeded the amounts paid by comparable companies;

(3)   the payments were not part of a pattern of benefits provided to employees; and

(4)   there was an absence of dividends.⁶

In a second case, deferred compensation payments were held to be reasonable where the controlling shareholder was inadequately paid during the controlling shareholder’s life and the surviving spouse, to whom payments were made, did not inherit a controlling stock ownership.⁷ Proper documentation (e.g., board of directors’ minutes) is important to help substantiate the reasonableness of the compensation.

Publicly-traded corporations generally do not run into the reasonable compensation issue. This is because public companies are not permitted to deduct compensation in excess of $1 million per tax year to certain top-level employees (note that the exception for performance-based incentive compensation was eliminated for tax years beginning after 2017 ( Q 3519)).⁸

Golden parachute rules may limit the amount of the deduction for deferred compensation payments that are contingent upon a change in ownership or control of a corporation or made under an agreement that violates a generally enforced securities law or regulation ( Q 3530).⁹