Funded Deferred Compensation

March 13, 2024

3532 / What are the tax consequences for the employee of a Section 83 funded deferred compensation agreement?

<div class="Section1">Under IRC Section83, 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 August1, 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 Section83 substantial risk of forfeiture. Under Section83, an interest is transferable if it can be transferred free of a substantial risk of forfeiture ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>).<a href="#_ftn1" name="_ftnref1">1</a> On May29, 2012, the IRS released proposed regulations clarifying the definition of “substantial risk of forfeiture” under Section83,<a href="#_ftn2" name="_ftnref2">2</a> and incorporating its ruling in Revenue Ruling 2005-48 as to Section83 equity plans (for details on the changes see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>). On February25, 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 January1, 2013, and the proposed regulations may be relied on as to transfers after May30, 2012.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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 August1, 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 withholding<a href="#_ftn5" name="_ftnref5">5</a> and for purposes of FICA and FUTA ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3576">3576</a>). The value of an annuity contract is its cash surrender value.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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 Section501(a).<a href="#_ftn8" name="_ftnref8">8</a> Special rules apply to trusts that lose their tax qualification because of a failure to satisfy the applicable minimum participation or minimum coverage tests.<a href="#_ftn9" name="_ftnref9">9</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3928">3928</a>) participating in trust-funded nonqualified plans that fail the minimum participation or minimum coverage tests applicable to qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3848">3848</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3861">3861</a>), which most nonqualified plans will fail ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3534">3534</a>). 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 August1, 1969) change from forfeitable to nonforfeitable. Prior to August1, 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.<a href="#_ftn10" name="_ftnref10">10</a> 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 August1, 1969.<a href="#_ftn11" name="_ftnref11">11</a> Where an employer amended its Section451 “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.<a href="#_ftn12" name="_ftnref12">12</a> In July2015, the IRS proposed new regulations that would eliminate the requirement to file a Section83(b) election with the IRS by attaching a copy to a federal income tax return (since this requirement generally prohibits an electronic filing.)<a href="#_ftn13" name="_ftnref13">13</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3539">3539</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. 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). <a href="#_ftnref2" name="_ftn2">2</a>. 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3550">3550</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3601">3601</a>. <a href="#_ftnref3" name="_ftn3">3</a>. Proposed Treas. Reg. § 1.83-3, 59012., made final in TD 9659, 2014-12 IRB (Mar.17, 2014) with minor modification on Example 4. <a href="#_ftnref4" name="_ftn4">4</a>. U.S. v. Basye, 410 U.S. 441 (1973). <a href="#_ftnref5" name="_ftn5">5</a>. Temp. Treas. Reg. § 35.3405-1T, A-18; Let. Rul. 9417013. <a href="#_ftnref6" name="_ftn6">6</a>. IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§1.402(b)-1(b), 1.403(c)-1(b). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. §§ 1.402(b)-1(b)(4), 1.403(c)-1(b)(3). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.402(b)-1(b)(1). <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 402(b)(4). <a href="#_ftnref10" name="_ftn10">10</a>. IRC §§ 402(b) and 403(b), prior to amendment by P.L. 91-172 (TRA ’69). <a href="#_ftnref11" name="_ftn11">11</a>. Treas. Reg. §§ 1.402(b)-1(d), 1.403(c)-1(d). <a href="#_ftnref12" name="_ftn12">12</a>. Let. Rul. 9713006. This transaction would now likely be subject to Section409A, and the change to the plan would constitute a violation as a prohibited “substitution” by way of an alternative benefit. <a href="#_ftnref13" name="_ftn13">13</a>. Prop. Treas. Reg. § 1.83(c). </div></div>

December 08, 2017

3536 / What are the tax consequences to an employer that uses a secular trust to fund a deferred compensation plan for employees?

<div class="Section1">It is the position of the IRS that an employer can take a deduction for a contribution to an employer-funded secular trust in the year in which it is includable in employee income.<a href="#_ftn1" name="_ftnref1">1</a> The rules of IRC Section404(a)(5) limit the employer’s deduction to the amount of the contribution; it never can include “earnings” on that amount between contribution and inclusion in the employee’s income.<a href="#_ftn2" name="_ftnref2">2</a> Moreover, these deductions potentially may be subject to certain limitations based on aggregations of defined “nonqualified deferred compensation,” depending on the type of sponsor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3519">3519</a>).An employer cannot increase its “contributions” and thus its deductions by drafting the trust agreement to require that the trust distribute its earnings to the employer and that the trustee retain those earnings as “recontributions” to the trust. The IRS has indicated that it will not recognize such deemed distributions and recontributions.<a href="#_ftn3" name="_ftnref3">3</a> If a secular trust covers more than one employee, the employer will be able to take a deduction for contributions only if the trust maintains separate accounts for the various employees. According to the IRS, the separate account rule is satisfied only if the trust document requires that the income earned on participants’ accounts be allocated to the accounts.<a href="#_ftn4" name="_ftnref4">4</a> The IRS also has granted employers immediate deductions for trust contributions where participants could choose between receiving current compensation outright or having it contributed to a trust, and where trust participants could choose between withdrawing contributions from the trust or leaving them in the trust. The IRS regarded these situations as employee-funded trusts and gave the employers deductions for the payment of compensation.<a href="#_ftn5" name="_ftnref5">5</a> Moreover, these deductions potentially may be subject to certain limitations based on aggregations of defined “nonqualified deferred compensation” depending on the type of sponsor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3519">3519</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Let. Ruls. 9502030, 9417013, 9302017, 9212024, 9212019. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.404(a)-12(b)(1); Let. Ruls. 9502030, 9417013, 9302017, 9212024, 9212019. <a href="#_ftnref3" name="_ftn3">3</a>. Let. Rul. 9302017. <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.404(a)-12(b)(3); Let. Ruls. 9502030, 9302017, 9212024. <a href="#_ftnref5" name="_ftn5">5</a>. Let. Ruls. 9548015, 9548014. See also Let. Rul. 9450004 (employer allowed immediate deduction where employee could keep or contribute cash to employee-funded trust). See also Treas. Reg. § 1.404(a)-12(b)(1); Let. Ruls. 9502030, 9417013, 9302017, 9212024, 9212019. </div></div>

December 08, 2017

3534 / What is a “secular trust” and how is it taxed?

<div class="Section1">A secular trust is an irrevocable trust established to formally fund and secure nonqualified deferred compensation benefits and is referred to as a secular trust to distinguish it from a grantor rabbi trust ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3567">3567</a>). Funds placed in a secular trust are not subject to the claims of the employer’s creditors. Thus, unlike a rabbi trust, a secular trust can protect its participants against both the employer’s future unwillingness to pay promised benefits and the employer’s future inability to pay promised benefits, including sponsor insolvency or bankruptcy situations.Secular trusts have not been as popular as rabbi trusts, in part because of questions surrounding their taxation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3535">3535</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3537">3537</a>), but they have historically received more consideration during severe economic downturns when companies are more at risk to fail, or the future for success of an industry appears unclear or highly volatile (such as the airline industry during the first decade of the 21st century). ERISA Implications Use of a secular trust (at least other than an employee-grantor trust) probably will cause a deferred compensation plan subject to ERISA to be funded for ERISA purposes.<a href="#_ftn1" name="_ftnref1">1</a> Funded plans generally are required to meet ERISA’s Title I requirements. Section409A Inapplicable Section409A generally is inapplicable to a secular trust arrangement because the contributions and earnings are made subject to current annual income taxation to a plan participant and thus the plan is eligible to claim the Section409A short term deferral exception for current compensation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>). In effect, the plan is an after-tax plan that involves current compensation, not Section409A nonqualified deferred compensation. Whether this is entirely true as to a plan participant when a nontaxable investment vehicle is used inside the trust to shelter any earnings growth from taxation as to the plan sponsor is not entirely clear as of the date of this publication. <hr> Planning Point: Although essentially an “after-tax” technique, the secular trust technique is usually used when an employer wants to provide a supplemental retirement benefit that is protected against the claims of the employer’s creditors. In private companies, the Section162 bonus life insurance or annuity technique is often used as an inexpensive substitute for a secular trust. <hr> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. See, e.g., Dependahl v. Falstaff Brewing Corp., 653 F.2d 1208 (8th Cir. 1981) (plan is funded when employee can look to property separate from employer’s ordinary assets for satisfaction of benefit obligations), aff’g in part, 491 F. Supp.1188 (E.D. Mo. 1980), cert. denied, 454 U.S. 968 (1981) and 454 U.S. 1084 (1981). </div></div>

December 08, 2017

3538 / What is “a substantial risk of forfeiture” under IRC Section 83?

<div class="Section1"> A person’s rights in a Section83 funded plan, where there has been a “transfer of property,” are subject to a substantial risk of forfeiture<a href="#_ftn1" name="_ftnref1">1</a> requirement under the IRC Section83 definition. Full enjoyment of the property must be conditioned on the future performance (or the refraining from performance) of substantial services by any individual.<a href="#_ftn2" name="_ftnref2">2</a>On February25, 2014, the IRS issued final regulations<a href="#_ftn3" name="_ftnref3">3</a> clarifying the Section83 definition of “substantial risk of forfeiture” as follows: A risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer. Both the likelihood of a forfeiture event and the likelihood the forfeiture will be enforced must be considered in evaluating whether a service condition is related to a purpose of the transfer in establishing whether there is a Section83 substantial risk of forfeiture. Property is not transferred subject to a Section83 substantial risk of forfeiture to the extent that an employer is required to pay the fair market value of a portion of such property to the employee if the employee returns the property. In other words, the risk that the value of the property will decline during a period of time is not a Section83 substantial risk of forfeiture. A nonlapse restriction, by itself, will not result in a Section83 substantial risk of forfeiture. In the case of equity compensation primarily, transfer restrictions mandated under the securities laws, including lock-up agreement restrictions, and restrictions related to insider trading under Rule10b-5 under the Securities Exchange Act of 1934 [except as specifically outlined in Treasury Regulation Sections 1.83-3(j) and (k)] do NOT create a substantial risk of forfeiture. These final regulations apply to property transferred on or after January1, 2013. The proposed regulations can be relied upon for property transferred after May30, 2012. <hr> Planning Point: Planners should review the final regulations for the final guidelines that must be followed in order to create a valid Section83 “substantial risk of forfeiture” for a Section83 plan after January1, 2013. For transfers made prior to this date, they may rely on the proposed regulations. It should be noted that the regulations appear to be an attempt by the IRS to better integrate the definitions of “substantial risk of forfeiture” under Sections 83 and 409A. In doing so, the clarifications do potentially have special implications for plans involving majority or sole shareholders of closely-held companies as noted herein. In addition, planners must now consider the proposed regulations, released in 2016, integrating Section457 with Section409A that address top hat457(f) “ineligible” plans specifically covered by Section409A (and other plans, like severance plans) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3602">3602</a>). 457(f) plans formerly looked to Section83 regulations for their definition of a “substantial risk of forfeiture” and now, unexpectedly,<a href="#_ftn4" name="_ftnref4">4</a> have their own separate and unique definition. This unique new 457 definition is generally a positive for the creation of most types of 457(f) plans, especially those involving deferral of vested compensation (for example, salary) as well as severance plans covered by 457. <hr> Even with this clarification, however, whether there is a risk of forfeiture and whether it is substantial still largely depends on the facts and circumstances at the time the plan is created.<a href="#_ftn5" name="_ftnref5">5</a> Because the inquiry remains so fact-based, little definitive guidance as to the sorts of services considered substantial existed prior to the release of the proposed Section83 regulations, and even this guidance may now need to be considered in light of the new final Section83 regulations. The regularity of performance and the time spent in performing the required services tend to indicate whether they are substantial.<a href="#_ftn6" name="_ftnref6">6</a> Furthermore, it is not clear how far into the future an arrangement must require substantial services to require adequate “future performance.” Nonetheless, the regulations’ examples describe arrangements requiring employees to work for periods as short as one or two years as imposing substantial risks of forfeiture, although two full tax years is probably the safe choice.<a href="#_ftn7" name="_ftnref7">7</a> Some things are clear. Requiring that property be returned if the employee is discharged for cause or for committing a crime will not create a substantial risk of forfeiture.<a href="#_ftn8" name="_ftnref8">8</a> The IRS has indicated that benefits would be taxable once a participant has met age and service requirements under an IRC Section457 governmental plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3584">3584</a>). Although the benefits remained forfeitable if participants were fired for cause, the IRS noted that forfeiture on termination for cause was not sufficient to constitute a substantial risk of forfeiture.<a href="#_ftn9" name="_ftnref9">9</a> A covenant not to compete will not ordinarily result in a substantial risk of forfeiture unless the particular facts and circumstances indicate otherwise.<a href="#_ftn10" name="_ftnref10">10</a> Similarly, the requirement that a retiring employee render consulting services on the request of a former employer does not result in a substantial risk of forfeiture, unless the employee is, in fact, expected to perform substantial consulting services.<a href="#_ftn11" name="_ftnref11">11</a> Special scrutiny will be applied in determining whether the risk of forfeiture is substantial if the case involves a property transfer from a corporation to a controlling shareholder-employee. In such situations, a restriction that would otherwise be considered to impose a substantial risk of forfeiture will be considered to impose such a risk only if the chance that the corporation will enforce the restriction is substantial.<a href="#_ftn12" name="_ftnref12">12</a> <hr> Planning Point: To the extent these new regulations are drawing down Section409A concepts into the Section83 definition of substantial risk of forfeiture with regard to the likelihood forfeiture conditions will be enforced, sole or majority shareholders (and perhaps even the relatives of such persons) in closely-held companies may have a difficult time creating plans for themselves under Section83. This is because the control they exercise over such a plan raises the issue of whether any forfeiture provision is likely to be enforced, as in the Ludden case. In addition, under Section409A, a noncompete and a consulting agreement can never constitute a substantial risk of forfeiture under Section83 as compared with Section457(f) under the new proposed 457/409A regulations. However, the more stringent definition of “substantial risk of forfeiture” in Section409A is used only to define the scope of the short term deferral exception under Section409A to define the scope of the application of Section409A coverage (and not the incidence of taxation) under the current regulations. In contrast, the phrase is now used to determine incidence of deferral or taxation under Section83. This could mean a substantive transfer of the narrower 409A definition down into Section83 more broadly. Lack of a substantial risk of forfeiture under Section409A means only that a plan cannot escape 409A coverage (as under the “short-term deferral” exception) and must comply fully with 409A to achieve deferral and avoid taxation, which then largely controls the incidence of taxation for constructive receipt purposes. Under Section83 as to funded plans, it actually governs the incidence of deferral of taxation in the first place. This situation may cause great confusion for planners and attorneys. <hr> Imposing a sufficient condition on the full enjoyment of the property is not in itself enough to create a substantial risk of forfeiture; the possibility of forfeiture if the condition is not satisfied must be substantial. This possibility may be substantial even if there are circumstances under which the failure to satisfy the condition will not result in forfeiture of the property. For example, the possibility of forfeiture is substantial where an employee would generally lose his or her deferred compensation on termination of employment before completing the required services, but would not forfeit those benefits if his or her early termination were due to death or permanent disability.<a href="#_ftn13" name="_ftnref13">13</a> The possibility that a forfeiture might not be enforced in the event of normal or early retirement before the satisfaction of the condition might not undermine the substantial risk of forfeiture. The risk that property will decline in value over time does not create a substantial risk of forfeiture. The example below, taken from the final regulations, illustrates. Example: Employer, ABC Corp., gives its employee, in connection with his performance of services for ABC Corp., a bonus of 100 shares of ABC Corp. stock. Under the terms of the agreement, employee is required to return the stock to ABC Corp. if he terminates his employment for any reason. However, for each year occurring after January1, 2010, during which employee remains employed with ABC Corp., employee ceases to be obligated to return 10 shares of stock. Employee’s rights in 10 shares each year for 10 years cease to be subject to a substantial risk of forfeiture in each year he remains employed. Example 2: Same facts as above, except for each year that employee remains employed after January1, 2010, ABC Corp. agrees to pay, in redemption of the bonus shares given to the employee if he terminates employment for any reason, 10 percent of the fair market value of each share of stock on the date of termination. Since ABC Corp. will pay employee 10 percent of the value of his bonus stock for each year (up to 10 years when the stock becomes 100 percent vested) he remains employed with ABC Corp., and the risk of decline in value is not a substantial risk of forfeiture, employee’s interest in 10 percent of the bonus stock becomes substantially vested in each of those years.<a href="#_ftn14" name="_ftnref14">14</a> It is not clear whether one can effectively extend a substantial risk of forfeiture. One letter ruling has concluded that as long as the future services required of the employee were and would continue to be substantial, an agreement between the employer and the employee postponing the vesting date of restricted stock would not in itself trigger taxation of the stock.<a href="#_ftn15" name="_ftnref15">15</a> The ruling generated controversy, particularly with respect to efforts to extend this reasoning to ineligible Section457(f) plans prior to the release of the proposed 457/409A integration regulations. To the extent that the narrower Section409A definition of substantial risk of forfeiture was substituted for the one in 457(f) by Notice 2007-62, it could not necessarily be used, because Section409A prohibits extensions of the risk of forfeiture. The proposed 457/409A integration regulations (which did not follow Notice 2007-62) now allow for a continuation of a substantial risk of forfeiture, but under a narrow and restricted set of requirements that would not generally support this specific extension interpretation. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3602">3602</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Note that there are currently seven definitions of “substantial risk of forfeiture” and “substantial limitation” (which is usually referred to a substantial risk of forfeiture) contained in the Internal Revenue Code and that they are not all the same. This can be very confusing to planners and attorneys alike. They are in IRC Sections: a.) 409A, b.) 83, c.) 457(f), d.) 457A, e.) 312, f.) 451 and g.) 61. “Substantial limitation,” is commonly referred to as a “substantial risk of forfeiture,” applicable to unfunded unsecured plans and is the least burdensome standard of the seven. However, to the extent an unfunded plan is also covered by 409A, its more restrictive form and operational requirements must be considered. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 83(c)(1); Treas. Reg. § 1.83-3(c)(1). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.83-3. <a href="#_ftnref4" name="_ftn4">4</a>. It was thought that the final 457/409A integration regulations would follow the IRS’s preliminary position on this important definition stated in IRS Notice 2007-62, which downloaded the 409A definition rather than the Section83 definition of “substantial risk of forfeiture,” for use with 457(f) plans. However, the IRS proposed regulations covering 457 plans unexpectedly have an additional and unique definition of “substantial risk of forfeiture” for use with 457(f) plans, even though the proposed regulations note that a 457(f) plan must generally comply with both 457(f) as well as 409A form and operational requirements to achieve and maintain income tax deferral for plan participants. <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.83-3(c)(1). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.83-3(c)(2). <a href="#_ftnref7" name="_ftn7">7</a>. See Treas. Reg. § 1.83-3(c)(4), Ex. 1 and Ex. 3. For examples of service requirements that have constituted a substantial risk of forfeiture in the context of Section457(f) plans prior to the current proposed 457 regulations ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3602">3602</a>), see generally Letter Rulings 9642046, 9642038, 9628020, 9627007, 9623027. However, these older rulings must now be considered in light of the new proposed 457 regulations. <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.83-3(c)(2). <a href="#_ftnref9" name="_ftn9">9</a>. TAM 199902032. <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.83-3(c)(2); see also Let. Ruls. 9548015, 9548014. <a href="#_ftnref11" name="_ftn11">11</a>. Treas. Reg. § 1.83-3(c)(2). <a href="#_ftnref12" name="_ftn12">12</a>. See Treas. Reg. § 1.83-3(c)(3). Compare Ludden v. Comm., 68 TC 826 (1977) (possibility of forfeiture did not amount to a substantial risk of forfeiture because there was too little chance that the shareholder-employees would cause themselves to be fired), aff’d on other grounds, 620 F.2d 700, 45 AFTR 2d 80-1068 (9th Cir. 1980). <a href="#_ftnref13" name="_ftn13">13</a>. Rev. Rul. 75-448, 1975 CB 55. <a href="#_ftnref14" name="_ftn14">14</a>. Treas. Reg. § 1.83-3(c)(4), Ex. 3 and 4. <a href="#_ftnref15" name="_ftn15">15</a>. Let. Rul. 9431021. </div></div>

December 08, 2017

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

<div class="Section1">The IRS takes the position that IRC Section402(b)(1) through IRC Section402(b)(4) govern the taxation of employee-participants in an employer-funded secular trust.<a href="#_ftn1" name="_ftnref1">1</a> Under the general timing rule of IRC Section402(b)(1), contributions to a secular trust are immediately included in the income of the employee to the extent that they are substantially vested.<a href="#_ftn2" name="_ftnref2">2</a> Further, in any tax year in which any part of an employee’s interest in the trust changes from substantially nonvested to substantially vested, the employee will be required to include that portion in income as of the date of the change.<a href="#_ftn3" name="_ftnref3">3</a>An interest is substantially vested if it is transferable or not subject to a substantial risk of forfeiture ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>).<a href="#_ftn4" name="_ftnref4">4</a> With respect to the taxation of distributions from an employer-funded secular trust, the IRS previously has indicated that the rules of IRC Section72 (except IRC Section72(e)(5)) apply ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3539">3539</a>). 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 Section72 to distributions from employer-funded secular trusts to highly compensated employees (“HCEs,” as defined in IRC Section414(q) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3930">3930</a>)) 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 Section402(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.<a href="#_ftn5" name="_ftnref5">5</a> 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 Section402(b)(1), described above. The 10 percent penalty for certain early (premature) annuity distributions under IRC Section72(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).<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="513">513</a>).<a href="#_ftn8" name="_ftnref8">8</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Let. Ruls. 9502030, 9302017, 9212024, 9212019, 9207010, 9206009. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.402(b)-1(a)(1). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 402(b)(1); Treas. Reg. §§ 1.402(b)-1(b)(1), 1.402(b)-1(b)(4). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. §§ 1.402(b)-1(a)(1), 1.83-3(b). <a href="#_ftnref5" name="_ftn5">5</a>. Let. Ruls. 9502030, 9417013, 9302017, 9212024, 9212019, 9207010. <a href="#_ftnref6" name="_ftn6">6</a>. Let. Ruls. 9502030, 9212024, 9212019. <a href="#_ftnref7" name="_ftn7">7</a>. See Let. Ruls. 9548015, 9548014. See also Let. Rul. 9450004 (employee who could keep or contribute cash to trust was currently taxable on amounts contributed, although keeping cash would jeopardize future contributions and benefits). <a href="#_ftnref8" name="_ftn8">8</a>. Let. Ruls. 9322011, 9316018. </div></div>

December 08, 2017

3533 / What are the tax consequences of a Section 83 funded deferred compensation agreement for the employer?

<div class="Section1">Editor’s Note: The 2017 tax reform legislation created a new Section83(i), which permits tax deferral with respect to certain broad-based employee stock options and restricted stock units of private companies, especially start-ups, on an attractive basis. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for details.Whether a cash or accrual basis taxpayer, an employer can take a deduction for a contribution or premium paid in the year in which an amount attributable thereto is includable in an employee’s gross income.<a href="#_ftn1" name="_ftnref1">1</a> This deduction cannot be more than the amount of the contribution and it cannot include any earnings on the contribution before they are included in the employee’s income.<a href="#_ftn2" name="_ftnref2">2</a> If more than one employee participates in a funded deferred compensation plan, the deduction will be allowed only if separate accounts are maintained for each employee.<a href="#_ftn3" name="_ftnref3">3</a> The employer is not allowed a deduction at any time for contributions made or premiums paid on or before August1, 1969, if the employee’s rights were forfeitable at the time.<a href="#_ftn4" name="_ftnref4">4</a> Contributions or premiums paid or accrued on behalf of an independent contractor may be deducted only in the year in which amounts attributable thereto are includable in the independent contractor’s gross income.<a href="#_ftn5" name="_ftnref5">5</a> With respect to contributions made after February28, 1986 to annuity contracts held by a corporation, partnership, or trust (i.e., a nonnatural person), the “income on the contract” for the tax year of the policyholder generally is treated as ordinary income received or accrued by the contract owner during such taxable year ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="513">513</a>).<a href="#_ftn6" name="_ftnref6">6</a> Prior to the 2017 tax reform legislation, corporate ownership of life insurance could result in exposure to the corporate alternative minimum tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="316">316</a>), although the corporate AMT was permanently repealed beginning in 2018. The IRS has taken the position that a nonexempt employee’s Section83 funded trust deferred compensation agreement cannot be considered an employer-grantor trust. As a result, the employer will not be taxed on the trust’s income, but it also cannot claim the trust’s deductions and credits.<a href="#_ftn7" name="_ftnref7">7</a> Proposed regulations have affirmed the position of the IRS ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3534">3534</a>).<a href="#_ftn8" name="_ftnref8">8</a> Funded deferred compensation may take the form of either an employer-paid supplemental or voluntary deferred compensation plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3540">3540</a>), although supplemental plans using equity or SARs are most common. The fact that the addition of a trust to fund a previously unfunded deferred compensation agreement was established as part of a nontaxable<a href="#_ftn9" name="_ftnref9">9</a> corporate liquidation did not alter its treatment as an employee trust.<a href="#_ftn10" name="_ftnref10">10</a> A nonqualified deferred compensation plan funded by a trust or annuity other than an “excess benefit plan” ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3608">3608</a>) must provide for minimum vesting generally comparable to that required in qualified retirement plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3869">3869</a>).<a href="#_ftn11" name="_ftnref11">11</a> Government plans and many church plans, however, are exempt from ERISA. The above rules do not apply to nonqualified annuities purchased by tax-exempt organizations and public schools ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4032">4032</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4093">4093</a>) or to individual retirement accounts and annuities ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3641">3641</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3699">3699</a>). IRC Section404(a)(11) If vacation pay is paid to an employee within 2½ months after the end of the applicable tax year, it generally is deductible for the tax year in which it is earned (vested) and is not treated as deferred compensation.<a href="#_ftn12" name="_ftnref12">12</a> Employers may not deduct accrued vacation or severance pay unless it actually is received by employees.<a href="#_ftn13" name="_ftnref13">13</a> Actual receipt is not: (1) a note or letter evidencing the employer’s indebtedness (whether or not guaranteed by an instrument or third party); (2) a promise to provide future service or property (whether or not evidenced by written agreement); (3) an amount transferred by a loan, refundable deposit, or contingent payment; or (4) amounts set aside in a trust for an employee.<a href="#_ftn14" name="_ftnref14">14</a> The IRS provided settlement options for taxpayers who had accelerated the deduction of accrued employee benefits (primarily vacation pay, disability pay, and sick pay) secured by a letter of credit, bond, or similar financial instrument, in reliance on Schmidt Baking Co., Inc. v. Comm.,<a href="#_ftn15" name="_ftnref15">15</a> which Section404(a)(11) expressly overturned for years ending after July22, 1998.<a href="#_ftn16" name="_ftnref16">16</a> The IRS also has published guidance explaining the automatic accounting method change necessary to comply with IRC Section404(a)(11).<a href="#_ftn17" name="_ftnref17">17</a> IRC Section409A Section409A covers “inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.”<a href="#_ftn18" name="_ftnref18">18</a> This definition of “nonqualified deferred compensation plans” is so expansive that it generally applies to most arrangements of deferred fringe benefits, including funded arrangements covered by Section83, and is not limited to cash payments, unless the arrangement is outside certain statutory exemptions or regulatory exceptions to Section409A. Plan sponsors should routinely seek to design their fringe benefit and incentive compensation arrangements covered by Section83 to fall within these Section409A exemptions and exceptions whenever possible, especially those involving equity that impose strict Section409A requirements to claim an exception. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 404(a)(5); Treas. Reg. § 1.404(a)-1(c). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.404(a)-12(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.404(a)-12(b)(3). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.404(a)-12(c). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 404(d); Temp. Treas. Reg. §1.404(d)-1T. <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 72(u). See also H.R. Rep.99-426 (TRA ’86), reprinted in 1986-3 CB (vol. 2) 703, 704; the General Explanation of TRA ’86, at658. <a href="#_ftnref7" name="_ftn7">7</a>. Let. Rul. 9302017. <a href="#_ftnref8" name="_ftn8">8</a>. Prop. Treas. Reg. § 1.671-1(g). <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 337. <a href="#_ftnref10" name="_ftn10">10</a>. Teget v. U.S., 552 F.2d 236, 77-1 USTC ¶ 9315 (8th Cir. 1977). <a href="#_ftnref11" name="_ftn11">11</a>. ERISA § 201. <a href="#_ftnref12" name="_ftn12">12</a>. Temp. Treas. Reg. § 1.404(b)-1T, A. <a href="#_ftnref13" name="_ftn13">13</a>. IRC § 404(a)(11). <a href="#_ftnref14" name="_ftn14">14</a>. IRSRRA ’98, § 7001, H.R. Conf. Rep. No.105-599. <a href="#_ftnref15" name="_ftn15">15</a>. 107 TC 271 (1996) (employer allowed to deduct accrued vacation liabilities because it had obtained an irrevocable letter of credit guaranteeing such obligation within 2½ months of the year of deduction). <a href="#_ftnref16" name="_ftn16">16</a>. Rev. Proc. 996, 1999-1 CB 1244. <a href="#_ftnref17" name="_ftn17">17</a>. Notice 99-16, 1999-1 CB 501. <a href="#_ftnref18" name="_ftn18">18</a>. See generally Treas. Reg. §§ 1.409A-1(b)(9)(v) and 1.409A-3(i)(1)(iv); see also Notice 2007-34, 2007-17 IRB 996 (governing split dollar life insurance as to the limited types of split dollar arrangements excepted from Section409A). </div></div>

December 08, 2017

3537 / If a secular trust is used to fund employer-provided deferred compensation, is the trust itself subject to taxation?

<div class="Section1">The IRS has ruled that a secular trust can never be an employer-grantor trust. Thus, an employer-funded secular trust is a separate, taxable entity. Unless secular trust earnings are distributable or are distributed annually, the trust will be taxed on those earnings.<a href="#_ftn1" name="_ftnref1">1</a>Proposed regulations have affirmed this position.<a href="#_ftn2" name="_ftnref2">2</a> Because the IRS generally would tax highly compensated employees each year on vested trust earnings (and generally would tax other employees on at least some trust earnings when a substantially nonvested interest becomes substantially vested), double taxation of trust earnings is a very real possibility. Funding secular trusts with life insurance may eliminate this by eliminating taxation of the trust. The IRS has not considered the use of life insurance in secular trusts, but under generally applicable tax rules, the inside build-up (or “earnings”) on life insurance should not be taxed to the trust while it holds the policies. The use of life insurance probably will not save employees from taxation on trust earnings, however. It also is possible to avoid trust (and therefore double) taxation by using employee-funded secular trusts. Employee-funded trusts generally are treated as employee-grantor trusts, because the trust income generally is held solely for the employee’s benefit. As a result, the trust income generally is taxed to the employee only.<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Let. Ruls. 9502030, 9417013, 9302017, 9212024. <a href="#_ftnref2" name="_ftn2">2</a>. Prop. Treas. Reg. § 1.671-1(g) (employer not treated as an owner of any portion of a domestic, nonexempt employees’ trust under IRC Section402(b) if part of a deferred compensation plan, regardless of whether the employer has power of interest described in IRC Section673 through IRC Section677). <a href="#_ftnref3" name="_ftn3">3</a>. See Let. Ruls. 9548015, 9548014, 9450004. Compare Let. Rul. 9620005 (group of secular trusts, each with a separate employee grantor, pooled investment resources together to form a master trust, will be taxed as a partnership, thereby avoiding double taxation applicable to corporations). </div></div>

December 08, 2017

3539 / How is an employee taxed on the payment received from a nonqualified annuity or nonexempt trust?

<div class="Section1"> Annuity payments are taxable to employees under the general rules in IRC Section72 relating to the taxation of annuities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a> as to payments in annuitization phase, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="515">515</a> as to payments in accumulation phase).<a href="#_ftn1" name="_ftnref1">1</a> An employee’s investment in the contract, for purposes of figuring the exclusion ratio, consists of all amounts attributable to employer contributions that were taxed to the employee and premiums paid by the employee, if any. Investment in the contract includes the value of the annuity taxed to the employee when the employee’s interest changed from nonvested to vested.<a href="#_ftn2" name="_ftnref2">2</a>Payments under a nonexempt trust are also generally taxed under the same rules relating to annuities, except that distributions of trust income before the annuity starting date are subject to inclusion in income under the generally applicable “interest first” rule without regard to the “cost recovery” rule retained (for certain cases) by IRC Section72(e)(5) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="527">527</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="515">515</a>).<a href="#_ftn3" name="_ftnref3">3</a> Furthermore, a distribution from the trust before the “annuity starting date” for the periodic payments will be treated as distributed in the following order: (1) Income earned on employee contributions made after August1, 1969 (2) Other amounts attributable to employee contributions (3) Amounts attributable to employer contributions (made after August1, 1969 and not previously includable in employee’s gross income) (4) Amounts attributable to employer contributions made on or before August1, 1969 (5) The remaining interest in the trust attributable to employer contributions<a href="#_ftn4" name="_ftnref4">4</a> The IRS has privately questioned whether the annuity rules of IRC Section72 are applicable to distributions to highly compensated employees from an employer-funded nonexempt trust under a plan that fails the minimum participation or the minimum coverage tests applicable to qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3841">3841</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3842">3842</a>); the taxation of such distributions is unclear ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3534">3534</a>).<a href="#_ftn5" name="_ftnref5">5</a> In fact, according to the IRS website, the tax treatment of an employee who has participated in a failed qualified plan is as follows: General Rule – Employees Include Contributions in Gross Income Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions. Exceptions: There are exceptions to the general rule (see IRC Section402(b)(4)): <ul> <li>If one of the reasons the plan is disqualified is for failure to meet either the additional participation or minimum coverage requirements (see IRC Sections 401(a)(26) and 410(b)) and the employee is a highly compensated employee (see IRC Section414(q)), then the employee would include all of her vested account balance (any amount that wasn’t already taxed) in her income. A non-highly compensated employee would only include employer contributions made to his or her account in the years that the plan is not qualified to the extent the employee is vested in those contributions.</li> <li>If the sole reason the plan is disqualified is that it fails either the additional participation or minimum coverage requirements, and the employee is a highly compensated employee, the employee still would include any previously untaxed amount of her entire vested account balance in her income. Non-highly compensated employees, however, do not include in income any employer contributions made to their accounts in the disqualified years in that case until the amounts are paid to them.</li> </ul> Note: Any failure to satisfy the nondiscrimination requirements (see IRC Section401(a)(4)) is considered a failure to meet the minimum coverage requirements.<a href="#_ftn6" name="_ftnref6">6</a> If a distribution consists of an annuity contract, the entire value of the annuity, less the investment in the contract, is included in gross income.<a href="#_ftn7" name="_ftnref7">7</a> For applications of FICA and FUTA to deferred compensation payments, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3576">3576</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 403(c). <a href="#_ftnref2" name="_ftn2">2</a>. Let. Rul. 7728042. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 402(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.402(b)-1(c)(2). <a href="#_ftnref5" name="_ftn5">5</a>. Let. Ruls. 9502030, 9417013. <a href="#_ftnref6" name="_ftn6">6</a>. See IRS website at https://www.irs.gov/retirement-plans/tax-consequences-of-plan-disqualification, last reviewed by the IRS September 6, 2022. <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.402(b)-1(c)(1). </div></div>