Unfunded Deferred Compensation

<div class="Section1"><br /> <br /> IRS guidance interpreting the Section 83(i) tax deferral option requires employers to establish an escrow arrangement if they wish to provide employees with the opportunity to defer taxes under the code section. This escrow arrangement is designed to solve potential income tax withholding issues associated with the new rules. If the employee and employer do not agree to the escrow arrangement, the employee is not a qualified employee for purposes of the Section 83(i) deferral option.<br /> <br /> All deferral stock must be deposited in the escrow account before the end of the calendar year in which the Section 83(i) election is made, and must remain in the account until the employer recovers the income tax withholding obligation from the employer. At any time between the date of income inclusion under Section 83(i)(1)(B) and March 31 of the following year, the employer is permitted to remove from escrow and retain the number of shares of deferral stock with a fair market value equal to the income tax withholding obligation that has not been otherwise received from the employee.<br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> Practically, this escrow arrangement could force corporations to repurchase their own stock in order to satisfy the employee’s income tax withholding obligations, potentially making the Section 83(i) deferral option less attractive for employers who may not wish to use their own funds to satisfy these obligations.<br /> <br /> <hr /><br /> <br /> Fair market value, for purposes of these rules, means the fair market value as determined under the Section 409A regulations, and is the fair market value of the shares at the time the corporations retains the shares held in escrow to satisfy the employee’s income tax withholding obligations.<br /> <br /> After the employee has satisfied his or her income tax withholding obligations, the shares held in escrow must be delivered to the employee as soon as reasonably practicable.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Notice 2018-97.<br /> <br /> </div>

<div class="Section1">The employer has no obligation to pay FICA or FUTA taxes, or to withhold federal income taxes, when an option is granted. Pending further guidance from the IRS, employers also are not obligated to pay or withhold FICA and FUTA taxes on the exercise of ISOs.<a href="#_ftn1" name="_ftnref1">¹</a> However, the IRS has announced that any sponsor determination to impose FICA or FUTA on the exercise of ISOs will not take effect before January 1 following the second anniversary of the announcement.</div><br /> <div class="Section1"><br /> <br /> IRC Section 6039 requires employers to provide a written statement to each employee regarding any exercise of an ISO and, beginning for transfers occurring in 2009 or later, to file a similar information return with the IRS by January 31 of the year following the transfer.<a href="#_ftn2" name="_ftnref2">²</a> Under proposed regulations, the information return must identify the parties and provide the following information:<br /> <blockquote>The date the option was granted<br /> <br /> The exercise price per share<br /> <br /> The date the option was exercised<br /> <br /> The fair market value of a share on the date of exercise<br /> <br /> The number of shares transferred pursuant to the exercise</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Notice 2002-47, 2002-28 IRB 97.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   Prop. Treas. Reg. §§ 1.6039-1, 1.6039-2.<br /> <br /> </div>

<div class="Section1">An ISO generally is not subject to ERISA’s reporting requirements since it is usually not a covered ERISA “employee benefit plan.” Therefore, a summary plan description need not be distributed to participants. An employer must furnish a statement to an employee on or before January 31 of the year following the year in which the employee exercises the ISO, stating details about the options granted.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 6039(a).<br /> <br /> </div>

<div class="Section1">The wage base for the Old Age, Survivors, and Disability Insurance (“OASDI”) portion of the FICA tax and the taxable earnings base for the OASDI portion of the SECA tax are both $176,100 (up from $168,600 in 2024, $160,200 in 2023, $147,000 in 2022, $142,800 in 2021, $137,700 in 2020, and $132,900 in 2019).</div><br /> <div class="Section1"><br /> <p style="text-align: center;"><strong>Medicare Hospital Insurance Portion and Health Care Reform Changes</strong></p><br /> There is no taxable wage base cap for the Medicare hospital insurance (“HI”) portion of the FICA tax, so all deferred compensation counted as wages for FICA purposes is subject to at least the hospital portion of the FICA tax without limit.<a href="#_ftn1" name="_ftnref1">¹</a> There also is no earnings base cap for the hospital insurance portion of the SECA tax.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Currently, the Medicare payroll tax on all wages is 2.9 percent, with the employer and employee each paying 1.45 percent. The Medicare payroll tax rate for the employee was raised to 2.35 percent beginning January 1, 2013 for individuals making more than $200,000 and couples making more than $250,000 annually. Also, a 3.8 percent Medicare tax on the lesser of “investment income” or the amount of adjusted gross income in excess of the income breakpoints became effective January 1, 2013 on individuals making more than $200,000 of specially defined adjusted gross income concerning investment and other income, and couples making $250,000 ($125,000 for married couples filing separately).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 3121(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1402(b)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.   Health Care Reform Act of 2010, PL 111-148.<br /> <br /> </div>

<div class="Section1">Under “eligible” plans, only individuals may participate, but they may be either employees or independent contractors. Partnerships and corporations cannot be participants.<a href="#_ftn1" name="_ftnref1">¹</a> Where local government employees were hired by a for-profit water company as part of privatization, they could no longer continue to participate in the local government’s Section 457 plan.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> It should be noted that plans for nongovernmental private tax-exempt employers are subject to ERISA (unlike a governmental plan), except for church plans. Therefore, private tax-exempts must structure their 457 plans to take advantage of a top hat ERISA exemption (e.g., by allowing only a select group of management or highly compensated employees to participate). Otherwise, the plan would be subject to the exclusive purpose and funding requirements of Title I of ERISA, and a nongovernmental tax-exempt Section 457 plan cannot, by definition, meet those requirements.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Sen. Rep. 95-1263 (Revenue Act of 1978), <em>reprinted in</em> 1978-3 CB (vol. 1) 364.)<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   IRS Information Letter 2000-0300.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.   Let. Rul. 8950056.<br /> <br /> </div>

<div class="Section1">The Qualified Domestic Relations Order (QDRO) rules applicable to qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3915">3915</a>) also apply to eligible Section&nbsp;457 plans, so that the IRC Section&nbsp;457(d) distribution rules are not violated if an eligible Section&nbsp;457 plan makes a distribution to an alternate payee pursuant to a valid QDRO.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> Contrast this with a 457(f) &ldquo;ineligible&rdquo; plan where a DRO outlined by Section&nbsp;409A regulations applies ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>). Although there are parallels, the DRO has significant differences from the QDRO that a QDRO is designed to act on escrowed &ldquo;plan assets&rdquo; of a qualified plan that do not and must not exist in the case of a 457(f) &ldquo;ineligible&rdquo; plan that is and must be unfunded and unsecured (even if placed in a Rabbi Trust).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&sect;&nbsp;414(p)(10), 414(p)(11).<br /> <br /> </div></div><br />

<div class="Section1">Where an employee receives a basic vested right in cash values of a policy, or basic life insurance protection and a vested right in the cash surrender values of a policy, the policy becomes a split dollar life insurance arrangement. A split dollar arrangement is also subject to Section 409A, unless it is structured as one of the two excepted variations under IRS Notice 2007-34.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> Premiums for a split dollar policy should be taxable to the employee under both split dollar and Section 409A rules (making it subject to the Section 409A penalty taxes and interest if the arrangement does not comply with Section 409A requirements in both form and operation). The Tax Court has held that employer-paid life insurance premiums on an employee’s life, where the annual increase in the cash surrender value benefits the employee and the employee also receives annual insurance protection for both the employee and family, will be includable in the employee’s gross income.<a href="#_ftn2" name="_ftnref2">²</a> Only an endorsement split dollar (where the participant receives only an interest in a portion of the policy death benefits and pays only an economic benefit tax cost) seems to escape additional taxation under both split dollar and Section 409A tax rules.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRS Notice 2007-34 was issued as the same time as the final Section 409A regulations in April of 2007 and were intended to specifically discuss the application of Section 409A to split dollar life insurance plans in more detail.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   <em>Frost v. Comm.</em>, 52 TC 89 (1969).<br /> <br /> </div>

<div class="Section1">Since the enactment of IRC Section&nbsp;409A, the IRS has refused to issue advance rulings on the tax consequences of nonqualified deferred compensation plans of for-profit companies as it once did prior to Section&nbsp;409A ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>). The availability and requirements for favorable letter rulings for plans under Section&nbsp;457(b) were not clear even before the enactment of Section&nbsp;409A (and even before the IRS&rsquo; release of guidance refusing to issue letter rulings on all plans in for-profit entities).<div class="Section1"><br /> <br /> It was clear though, prior to the enactment of Section&nbsp;409A, that the IRS would not issue an advance ruling on the tax consequences of a Section&nbsp;457(b) plan covering independent contractors, unless all such independent contractors were identified.<a href="#_ftn1" name="_ftnref1">¹</a> Now that&nbsp;457(b) &ldquo;eligible&rdquo; plans are specifically exempted from, and 457(f) &ldquo;ineligible&rdquo; plans are specifically covered by, Section&nbsp;409A statutorily, perhaps the IRS will begin to provide letter rulings on 457(b) &ldquo;eligible&rdquo; plans. However, the IRS has indicated its direction will be to issue fewer letter rulings on qualified plans, so it is currently not likely that&nbsp;457(b) plan can obtain a letter ruling either. As noted, the IRS specifically will not issue letter rulings on the income tax consequences of plans that are covered by Section&nbsp;409A, which would include 457(f) &ldquo;ineligible&rdquo; plans (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Rev. Proc. 2003-3, &sect;&nbsp;3.01(36), 2003-1 CB 113, as modified by Rev. Proc. 2011-56.<br /> <br /> </div></div><br />

<div class="Section1">If a death benefit is provided by a nongovernmental Section&nbsp;457 plan, whether a 457(b) &ldquo;eligible&rdquo; or 457(f) &ldquo;ineligible&rdquo; plan, any such death benefit will not qualify for exclusion from gross income as the proceeds of life insurance under IRC Section&nbsp;101(a). The life insurance proceeds must first be paid to the employer as sole beneficiary; hence, are &ldquo;washed&rdquo; through the employing entity and lose their tax-free character.<a href="#_ftn1" name="_ftnref1">¹</a> Prior to the enactment of Section&nbsp;409A, both 457 &ldquo;eligible&rdquo; and &ldquo;ineligible&rdquo; plans would have to be treated under the deferred compensation rules of Section&nbsp;457.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> Since the enactment of Section&nbsp;409A, however, an &ldquo;eligible&rdquo; plan would be subject only to Section&nbsp;457 treatment on the deferred compensation death benefit, while a Section&nbsp;457(f) ineligible plan would have to comply with both Sections 457 and 409A. However, the outcome is still the same because a death benefit paid from the employer rather than directly from the life insurance carrier (e.g., as in the case of endorsement split dollar) will still be treated as deferred compensation and thereby as income-in-respect of a decedent, etc. rather than the proceeds of life insurance ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3602">3602</a>). The proposed 457/409A integration regulations have not changed this result.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> As a practical matter, what this means is that tax-exempt organizations cannot create the combination of an endorsement split dollar life insurance arrangement on a single organization-owned policy acquired to help support a 457 supplemental deferred compensation plan. It will only be able to support a DBO plan and the payment will produce IRD.<br /> <br /> <hr><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.457-10(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Let. Rul. 9008043.<br /> <br /> </div></div><br />

<div class="Section1">The participants in a governmental nonqualified deferred compensation plan covering state judges are taxed under the rules applicable to funded or unfunded nonqualified deferred compensation plans [but a plan is not subject to the requirements of 457 as deferred compensation, especially 457(f)] if:<div class="Section1"><br /> <blockquote>(1)&nbsp;&nbsp; the plan has been continuously in existence since December&nbsp;31, 1978;<br /> <br /> (2)&nbsp;&nbsp; the plan requires all eligible judges to participate and contribute the same fixed percentage of their basic or regular compensation;<br /> <br /> (3)&nbsp;&nbsp; the plan provides no judge with an option as to contributions or benefits, which, if exercised, would affect the amount of his or her includable compensation;<br /> <br /> (4)&nbsp;&nbsp; retirement benefits under the plan are a percentage of the compensation of judges holding similar positions in the state; and<br /> <br /> (5)&nbsp;&nbsp; benefits paid to any participant in any year do not exceed the limitation of IRC Section&nbsp;415(b) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3868">3868</a>).<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> However, plans for judges that do not meet these conditions must comply with requirements of a Section&nbsp;457(b) eligible or 457(f) ineligible plan, as applicable.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Rev. Act of 1978 &sect;&nbsp;131 (as amended by TEFRA 1982 &sect;&nbsp;252); TRA 1986 &sect;&nbsp;1107(c)(4); PL 97-514 (TEFRA), Section&nbsp;252, and reaffirmed in Prop. Treas. Reg. Section&nbsp;1.457-11(b)(1), REG 1147197, June&nbsp;22, 2016. See also <em>Foil v. Comm.</em>, 91-1 USTC &para;&nbsp;50,016 (5th Cir. 1990); <em>Yegan&nbsp;v. Comm.</em>, TC Memo 1989-291.<br /> <br /> </div></div><br />