Under the constructive receipt doctrine, an amount becomes currently taxable to a cash basis taxpayer, even before it is actually received, if it is credited to the employee’s account, set aside, or otherwise made available to the employee.
Once income is unconditionally subject to the taxpayer’s demand, that income must be reported, even if the taxpayer has not chosen to reduce that income to his possession.
Amounts due from the employer will be includable in the income of an employee who is a cash basis taxpayer as soon as:
- the money is available to him;
- the employer is able and ready to pay;
- the employee’s right to payment is unrestricted; and
- the failure to receive the money results from the exercise of the employee’s own choice.
Since the major advantage of a nonqualified deferred compensation plan to an employee is the deferral of tax (which deferral is analogous to an interest free loan from the government), it is essential that the plan avoid constructive receipt.
There is no constructive receipt if the employee’s control over receipt is subject to a substantial limitation or restriction. Perhaps the easiest way to avoid constructive receipt is to design the plan so that:
- the compensation is deferred before it is earned;
- the employer’s promise to pay benefits is completely unsecured; and
- ultimate payment of the benefits is conditioned upon the passage of time or the occurrence of an event beyond the employee’s control.
Such actions will avoid constructive receipt even though the benefits are completely nonforfeitable.
The problem of constructive receipt (keeping the time and manner of payment outside the employee’s control) extends beyond the asset buildup period. Plan provisions must also assure that the employee is not taxed on more than is actually received during the distribution period.
Example. Assume that a plan provides for a distribution of benefits over ten years in equal annual installments, starting at age sixty-five. If the employee could elect, at any time during the distribution period, to accelerate the balance of payments, then the constructive receipt doctrine would require an immediate inclusion in income of the entire amount that the employee could elect to receive. Alternatively, assume that a plan provides for a ten-year distribution period, but allows the employee to elect, during the distribution period, to spread the ten annual payments over fifteen years. Even if the employee chose the fifteen-year option, he would still be taxed as if plan assets were received over the original ten-year period.
If the covered employee’s election to reduce his salary is made before rendering services for which compensation is deferred then—in order to avoid constructive receipt—all that is necessary is that there be a substantial limitation or restriction on the employee’s ability to reach plan assets. But, according to the IRS, in order to defer compensation after services have been performed, the plan must provide substantial risk of forfeiture provisions, a much more severe standard than a mere substantial limitation or restriction.
Many attorneys believe that an election regarding the mode of payment can safely be made without constructive receipt as long as it is made before any amount is actually payable. However, the IRS refuses to rule favorably on a nonqualified plan that allows elections after the beginning of the period of service in which the compensation is earned–unless substantial forfeiture provisions are in effect. Therefore, most plans require that participants must choose the time and manner in which benefits will be paid before the deferred amount is earned.
It is possible to build a great deal of flexibility into a salary reduction arrangement without triggering the constructive receipt doctrine, by permitting prospective adjustments to be made to the percentage of compensation to be deferred in future years on an annual basis.
Substantial Risk of Forfeiture
A substantial risk of forfeiture exists where rights in transferred property are conditioned directly or indirectly upon the performance (or nonperformance) of substantial services. For instance, if property must be returned to the employer should total earnings not increase in a given period of time, the property is subject to a substantial risk of forfeiture.
A common misperception is that a nonqualified deferred compensation plan requires a substantial risk of forfeiture. As discussed above, this is not generally true. What is required is a substantial limitation on the employee’s ability to reach the plan assets. A substantial risk of forfeiture is generally only required for 457(f) plans for tax-exempt employers. A substantial risk of forfeiture, however, is frequently included in plans for taxable employers that involve employer contributions as a way of tying the participant to the employer (i.e., golden handcuffs).
When is a risk substantial? The answer will always depend upon the facts and circumstances of each case. Planners must be sure that there is a clear line of demarcation between a mere contractual right to receive compensation in the future–which is safe from the application of the economic benefit theory–and a right that is secured and is not subject to a substantial risk of forfeiture.
Controlling Shareholders and Constructive Receipt
The IRS will not issue a private ruling with respect to the tax treatment of a controlling shareholder-employee’s participation in a nonqualified deferred compensation plan. The IRS seems to be concerned, in part, that a controlling shareholder, by virtue of his control, has the power to modify the terms of a deferral agreement at any time, and to access deferred amounts at will, and is therefore necessarily in constructive receipt of deferred amounts (i.e., there is no substantial limitation on the ability of the controlling shareholder to access plan assets).
It is the authors’ opinion that if the plan is properly drafted and designed, a controlling shareholder-employee should be able to participate and be taxed (or escape current taxation) in the same manner as a non-shareholder employee.
Steps to thwart an attack on a plan in which a controlling shareholder is a participant include the following:
- Separate the financing of the employer’s obligation from the plan itself. For example, if a life insurance policy is to be used, do not match the policy benefit with the promises made. When the vehicle used to finance benefits is identical to and directly keyed into the benefits promised under the plan, the IRS may deny favorable tax treatment. If the life insurance is maintained by the employer as key employee coverage and is kept totally separate from the agreement, there should be no constructive receipt or economic benefit issues.
- If possible, include at least one highly compensated person who is not a shareholder-employee in the plan. The participation of a nonshareholder-employee greatly enhances the argument that the plan is for corporate, rather than shareholder, purposes, and will serve to justify a corporate income tax deduction when benefits are to be paid. Do not create a plan for the sole benefit of a controlling shareholder.
- Create a full documentation of the corporate advantage to be gained and the business purpose to be served by the plan in corporate minutes and in the agreement itself. Use wording that indicates that other successful competitive companies are providing similar supplemental compensation in their benefit programs. Incorporate wording from trade journals evidencing that such plans are commonly used in the employer’s industry or profession as a form of compensation for the recruitment, retention, retirement, and reward of key employees.
- Consider using a rabbi trust. A rabbi trust can serve as a device that creates a substantial restriction or limitation upon the ability of even a controlling (however defined) shareholder to reach deferred amounts until the occurrence of specific events. Under state law, the independent trustee has the fiduciary responsibility to deny access to anyone until the covered person has satisfied the plan’s triggering criterion (for example, disability, death, or attainment of a specified retirement age). Thus, the rabbi trust should negate any raw power that a controlling shareholder may have to reach benefits.
- Establish an independent compensation review committee with the power to deny benefits to participants who do not meet plan criteria. Have the committee actually meet and review the operation of the plan and police its provisions.
- Do not provide a plan for shareholder-employees with terms and benefits more generous than would be provided to nonshareholder-employees. Provide that contributions or benefits on behalf of shareholder-employees cannot be proportionately greater than those provided to key employees who are not shareholders. In other words, base the plan benefit formula upon a reasonable and uniform percentage of salary.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM