In a properly drafted plan (one which avoids constructive receipt, the economic benefit doctrine, and Code section 83, and is compliant with Code section 409A—see below), the employee will not be taxed until benefits are actually received, at which time he reports the benefits as ordinary income.
Amounts received from the plan by beneficiaries are taxable as received at ordinary rates, with one exception: to the extent that the inclusion of the benefit results in federal estate tax upon the covered employee’s estate, an income tax deduction may be allowed to recipients under Code section 691 (for income in respect of a decedent). No income averaging is available to either the employee or the employee’s survivors.
Payments made to the employee (or his beneficiary) from a nonqualified plan–either directly by the employer or through a trust established to hold the financing vehicles for the plan–are deductible by the employer in the year that benefits are includable in the employee’s (or beneficiary’s) income, to the extent that they meet the ordinary, necessary, and reasonable tests applied to all compensation.
Contributions to a plan that is primarily for the benefit of shareholders are not deductible (and may be treated as dividends). This emphasizes the importance of documenting the business purpose for the plan in a corporate resolution.
Funding the Plan
The internal buildup of value inside a life insurance contract is currently income tax deferred. By contrast, to the extent that the employer finances its obligation under the contract with mutual funds, stocks, bonds, or other assets producing taxable income, that taxable income is reportable—as earned—by the employer, at the employer’s tax rate. This is another reason why life insurance is so often the principal (or an important auxiliary) financing vehicle.
When assets are held inside a rabbi trust designed to hold the financing mechanism, the tax consequences are essentially the same as when the assets are held directly by the employer. If properly drafted, the trust will be considered an employer grantor trust for income tax purposes. This means all trust income, deductions, and tax credits are treated as if earned by or allowable to the employer for tax purposes.
FICA and FUTA
Amounts deferred under a nonqualified plan are considered to be wages for Federal Unemployment Tax (FUTA) purposes and subject to Social Security tax when:
- the services are performed; or
- when the employee no longer has a substantial risk of forfeiture, whichever is later.
However, because federal unemployment tax is imposed only on the first $7,000 of wages for the calendar year, an employee’s nonforfeitable interest in a nonqualified plan should not create any FUTA tax liability.
It appears that outside directors who defer receipt of their fees for services performed must include their fees in net earnings for self-employment for Social Security tax purposes when the deferred fees are actually or constructively received.
Where an employee is fully vested in his benefit under a nonqualified deferred compensation plan, Social Security taxes apply immediately to deferred amounts—up to the applicable wage base ceilings. However, because most participants in nonqualified plans will earn more than the Social Security taxable wage base ($118,500 as indexed in 2015), a participant would pay little or no Social Security tax on such deferred benefits.
Estate Tax Consequences
The present value of any death benefit (or, if the payment is made in a lump sum, that lump sum amount) payable to a beneficiary is includable in a deceased employee’s estate. The discount rate for computing the present value of the stream of income payments is the Section 7520 interest rate (basically 120 percent of Applicable Federal Midterm Rate or AFMR) and varies monthly.
Keep in mind that inclusion of this asset in the gross estate is moot if the annuity is payable solely to the surviving spouse, since it will qualify for the federal estate tax marital deduction. But planners should remember that if payments are contingent, or if they continue beyond the surviving spouse’s death (as is usual in the case of payments for a fixed number of years), then, absent a timely and proper Qualified Terminable Interest Property (QTIP) election by the deceased employee’s executor, there will be no marital deduction.
Subject to the annual exclusion deduction15 and the $11,400,000 Generation Skipping Transfer Tax (GSTT) exemption (as indexed for inflation in 2019),16 if nonqualified deferred compensation payments are made by a corporation to someone classified as being two or more generations below the employee (for example, the client’s grandchild), GSTT will be imposed. Gift tax implications depend upon whether the employee retains the right to change the designation of the beneficiary. Assuming that the employee retains the right to change the beneficiary designation (typically by notifying the employer in writing), and that the prior beneficiary’s consent is not required to make such a change, there is no completed gift to the new beneficiary for gift tax purposes. So most nonqualified deferred compensation plans will not have any gift tax implications.
But, at the time when the employee makes an irrevocable assignment of the right to receive payments from the plan, the gift of the employee’s property interest in the plan will be complete and gift tax will be imposed. No annual gift tax exclusion would be allowed, because such a gift would be of a future interest as the beneficiary does not have the immediate, unfettered, and ascertainable right to use, possess, and enjoy the payments.
Section 409A Requirements
Added by the American Jobs Creation Act of 2004, Code Section 409A imposes special requirements for participants making elections to defer compensation. Participants now must generally make deferral elections prior to the end of the preceding taxable year. In the first year in which a participant becomes eligible to participate in a plan, however, the participant may make an election within thirty days after the date of eligibility, but only with respect to services to be performed subsequent to the election. In the case of any performance-based compensation covering a period of at least twelve months, a participant must make an election no later than six months before the end of the covered period.
Distribution provisions must also comply with the rules of Code section 409A. Under these rules, plan distributions may not be made (without penalty) earlier than one of the following events:
Separation from service – If the employee is a key employee of a publicly-traded company, as defined under the top-heavy rules of Code section 416(i), a distribution upon separation from service may not begin until six months after separation.
Disability – Disability is defined as either the strict Social Security definition of total and permanent disability, or, under certain conditions, disability under an accident and health plan covering employees of the employer.
Death of the employee
A time specified under the plan – Payment upon occurrence of an event, such as the employee’s son’s graduation from high school, is not considered payment at a specified time.
A change in ownership or control, as defined in regulations.
Occurrence of an unforeseeable emergency – The distribution may not exceed the amount necessary for the emergency plus taxes on the distribution. Section 409A(a)(2)(B)(I) spells out the definition of “unforeseeable emergency”:
- a severe financial hardship to the participant resulting from an illness or accident of the participant, spouse, or dependent;
- loss of the participant’s property due to casualty; or
- other similar extraordinary and unforeseeable circumstances beyond the participant’s control.
This change resulted from a view in the Congress and the Treasury Department that prior restrictions on distributions for nonqualified plans were not stringent enough to justify the deferral of taxes on the amounts in question. For example, under prior law, many plans allowed employees to withdraw amounts without restriction except for a haircut provision, under which a small penalty (such as 6 percent) was imposed on the amount withdrawn, or the participant was restricted from deferring subsequent compensation for a period such as six months. These haircut provisions will no longer be allowed.
Loss of the Haircut Provision
The loss of haircut provisions is arguably the most negative feature of section 409A from the employee’s standpoint. A haircut provision was an important safeguard: if the employee felt that financial or other conditions within the company might threaten the deferred compensation benefit within the near future, the employee could get his money out under the plan’s haircut withdrawal provision. In effect, Congress views the use of this type of safeguard as an abuse, regardless of whether the employee is a high-level executive capable of actually manipulating the situation or just a mid-level executive trying to preserve his retirement funds in a failing or hostile corporate environment.
Section 409A(a)(3) also penalizes “acceleration of the time or schedule of any payment under the plan.” The rule is generally not violated if the benefit acceleration doesn’t change the timing of income inclusion. For example, the plan could provide a choice between a lump sum and a fully (immediately) taxable annuity contract. Regulations define certain other circumstances under which a plan may permit the acceleration of payments:
An accelerated distribution may be permitted if it is not elective and is beyond the control of the employee, such as a distribution to comply with a court-ordered divorce settlement or a Federal conflict-of-interest requirement.28 For example, if federal authorities required a government official to cash out his deferred compensation contract with a company currently doing business with the government rather than allowing it to continue in effect throughout his term of office, creating a scandalous impression of bias and corruption, this would not violate section 409A(a)(3).
A Section 457(f) plan (a plan for executives of governmental or nonprofit organizations) may allow a payout to provide for taxes due on a vesting event.
Payments may be accelerated in order to pay employment taxes (FICA and FUTA) and the income tax withholding resulting from this acceleration. This relief provision is required because in an unfunded plan, FICA and FUTA taxes are payable upon vesting of the amounts involved, while income taxes may not be due until a much later year (the year of receipt or constructive receipt).
- Payments may be accelerated to terminate a participant’s interest in a plan under certain circumstances:
- after separation from service where the payment is not greater than $10,000;
- where all arrangements of the same type are terminated;
- in the twelve months following a change in control event; or
- upon a corporate dissolution or bankruptcy.
Payments may be accelerated to terminate a deferral election following an unforeseeable emergency (see definition above).
The purpose of the nonacceleration rule is to prevent executives from taking money out of a failing corporation when they see financial trouble approaching for the corporation. This is the type of practice involved in the Enron and similar corporate scandals of the last several years, and Congress has decided to try to prevent such practices with IRC Section 409A. The rules, however, limit design flexibility in many situations where abusive practices are not likely.
Code section 409A includes substantial penalties for failing to meet its requirements when deferring compensation. Any violation of the deferral or distribution requirements results in retroactive constructive receipt, with the deferred compensation being taxable to the participant as of the time of the intended deferral. In addition to the normal income tax on the compensation, the participant must pay an additional 20 percent tax, as well as interest at a rate 1 percent higher than the normal underpayment rate.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM