Tax Facts
3532 / What are the tax consequences for the employee 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), or other “transfer of property” to the extent that the interest is substantially vested when the contribution or transfer is made.
An interest is substantially vested if it is transferable or not subject to a Section 83 substantial risk of forfeiture. Under Section 83, an interest is transferable if it can be transferred free of a substantial risk of forfeiture ( Q 3538).1 On May 29, 2012, the IRS released proposed regulations clarifying the definition of “substantial risk of forfeiture” under Section 83,2 and incorporating its ruling in Revenue Ruling 2005-48 as to Section 83 equity plans (for details on the changes see Q 3538). On February 25, 2014, the IRS issued final regulations that are substantially similar to the proposed regulations. These regulations will apply to all transfers of property on or after January 1, 2013, and the proposed regulations may be relied on as to transfers after May 30, 2012.3
A partner is immediately taxable on the partner’s 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.4
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 withholding5 and for purposes of FICA and FUTA ( Q 3576). The value of an annuity contract is its cash surrender value.6
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, only that corresponding part is includable in gross income for the year.7
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).8
Special rules apply to trusts that lose their tax qualification because of a failure to satisfy the applicable minimum participation or minimum coverage tests.9 The IRS has taken the controversial position that these special rules apply to nonexempt trusts that were never intended to be tax qualified. As a result, the IRS would tax highly compensated employees (“HCEs”) ( Q 3928) participating in trust-funded nonqualified plans that fail the minimum participation or minimum coverage tests applicable to qualified plans ( Q 3848 through Q 3861), which most nonqualified plans will fail ( Q 3534).
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.10 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, 1969.11
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.12
In July 2015, the IRS proposed new regulations that would eliminate the requirement to file a Section 83(b) election with the IRS by attaching a copy to a federal income tax return (since this requirement generally prohibits an electronic filing.)13 These regulations were finalized in 2016. Individuals are still required to keep records sufficient to show basis of the property and the original cost (if any).
For taxation of annuity payments to an employee, see Q 3539.
1. IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(a)(1), 1.403(c)-1(a), 1.83-1(a)(1), 1.83-3(b), 1.83-3(d).
2. It is important to note that there multiple definitions of “substantial risk of forfeiture” under different Internal Revenue Code Sections (there are seven definitions now since the release of the new proposed 457/409A integration regulations), and they are not exactly the same so it is important to follow the definition required for the section applicable to the tax question. For example, compare Q 3538, Q 3550 and Q 3601.
3. Proposed Treas. Reg. § 1.83-3, 5-29-2012., made final in TD 9659, 2014-12 IRB (Mar. 17, 2014) with minor modification on Example 4.
4. U.S. v. Basye, 410 U.S. 441 (1973).
5. Temp. Treas. Reg. § 35.3405-1T, A-18; Let. Rul. 9417013.
6. IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(b), 1.403(c)-1(b).
7. Treas. Reg. §§ 1.402(b)-1(b)(4), 1.403(c)-1(b)(3).
8. Treas. Reg. § 1.402(b)-1(b)(1).
9. IRC § 402(b)(4).
10. IRC §§ 402(b) and 403(b), prior to amendment by P.L. 91-172 (TRA ’69).
11. Treas. Reg. §§ 1.402(b)-1(d), 1.403(c)-1(d).
12. Let. Rul. 9713006. This transaction would now likely be subject to Section 409A, and the change to the plan would constitute a violation as a prohibited “substitution” by way of an alternative benefit.
13. Prop. Treas. Reg. § 1.83-2(c).
An interest is substantially vested if it is transferable or not subject to a Section 83 substantial risk of forfeiture. Under Section 83, an interest is transferable if it can be transferred free of a substantial risk of forfeiture ( Q 3538).1 On May 29, 2012, the IRS released proposed regulations clarifying the definition of “substantial risk of forfeiture” under Section 83,2 and incorporating its ruling in Revenue Ruling 2005-48 as to Section 83 equity plans (for details on the changes see Q 3538). On February 25, 2014, the IRS issued final regulations that are substantially similar to the proposed regulations. These regulations will apply to all transfers of property on or after January 1, 2013, and the proposed regulations may be relied on as to transfers after May 30, 2012.3
A partner is immediately taxable on the partner’s 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.4
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 withholding5 and for purposes of FICA and FUTA ( Q 3576). The value of an annuity contract is its cash surrender value.6
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, only that corresponding part is includable in gross income for the year.7
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).8
Special rules apply to trusts that lose their tax qualification because of a failure to satisfy the applicable minimum participation or minimum coverage tests.9 The IRS has taken the controversial position that these special rules apply to nonexempt trusts that were never intended to be tax qualified. As a result, the IRS would tax highly compensated employees (“HCEs”) ( Q 3928) participating in trust-funded nonqualified plans that fail the minimum participation or minimum coverage tests applicable to qualified plans ( Q 3848 through Q 3861), which most nonqualified plans will fail ( Q 3534).
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.10 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, 1969.11
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.12
In July 2015, the IRS proposed new regulations that would eliminate the requirement to file a Section 83(b) election with the IRS by attaching a copy to a federal income tax return (since this requirement generally prohibits an electronic filing.)13 These regulations were finalized in 2016. Individuals are still required to keep records sufficient to show basis of the property and the original cost (if any).
For taxation of annuity payments to an employee, see Q 3539.
1. IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(a)(1), 1.403(c)-1(a), 1.83-1(a)(1), 1.83-3(b), 1.83-3(d).
2. It is important to note that there multiple definitions of “substantial risk of forfeiture” under different Internal Revenue Code Sections (there are seven definitions now since the release of the new proposed 457/409A integration regulations), and they are not exactly the same so it is important to follow the definition required for the section applicable to the tax question. For example, compare Q 3538, Q 3550 and Q 3601.
3. Proposed Treas. Reg. § 1.83-3, 5-29-2012., made final in TD 9659, 2014-12 IRB (Mar. 17, 2014) with minor modification on Example 4.
4. U.S. v. Basye, 410 U.S. 441 (1973).
5. Temp. Treas. Reg. § 35.3405-1T, A-18; Let. Rul. 9417013.
6. IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(b), 1.403(c)-1(b).
7. Treas. Reg. §§ 1.402(b)-1(b)(4), 1.403(c)-1(b)(3).
8. Treas. Reg. § 1.402(b)-1(b)(1).
9. IRC § 402(b)(4).
10. IRC §§ 402(b) and 403(b), prior to amendment by P.L. 91-172 (TRA ’69).
11. Treas. Reg. §§ 1.402(b)-1(d), 1.403(c)-1(d).
12. Let. Rul. 9713006. This transaction would now likely be subject to Section 409A, and the change to the plan would constitute a violation as a prohibited “substitution” by way of an alternative benefit.
13. Prop. Treas. Reg. § 1.83-2(c).
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