5.7 Nonqualified Plans

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5.7 NONQUALIFIED PLANS

A number of compensation plans are not exempt from taxation, because they do not satisfy one or more of the requirements for qualification under I.R.C. § 401(a). Those plans, which are often referred to as "nonqualified plans," do not offer the same tax advantages as do qualified plans but, nevertheless, may provide certain compensation advantages or incentives for employees. The tax consequences vary depending on whether the plan is characterized as a funded or unfunded plan.

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5.701 Funded Plan. Employer contributions to an "employee's trust" pursuant to a nonqualified plan are includible in the employee's gross income in the first taxable year in which the rights of the beneficiary under the plan are "transferable" or "are not subject to a substantial risk of forfeiture." ⁴⁴² These phrases, which are significant in determining the timing of the tax consequences, are specifically defined. A "substantial risk of forfeiture" exists when the right to full enjoyment of the plan's benefits is conditioned upon the future performance of substantial services by the employee. ⁴⁴³ The rights of a plan beneficiary are "transferable" only if the rights transferred are not subject to a substantial risk of forfeiture. ⁴⁴⁴ Thus, in funded plans, the employee will be deemed to have realized income in the amount and at the time contributions to the nonqualified plan are no longer subject to a substantial risk of forfeiture. This tax treatment applies not only to the contributions by an employer, but also to compulsory contributions made by the employee. Voluntary employee contributions, whether or not subject to a substantial risk of forfeiture, are includible in the employee's gross income. ⁴⁴⁵

A funded plan, for tax purposes, is one in which the employer sets aside plan assets for the sole benefit of the plan's beneficiaries, usually in such a manner that general creditors of the employer cannot displace the interests of the beneficiaries. In a funded plan, the plan assets are typically held in a separate trust or escrow account or the plan is funded through the employer's purchase of an annuity-type contract in which the employees or the plan's beneficiaries have rights in preference to the general creditors of the employer.

The employee's interests in funded plans are taxable to the employee, in accordance with the foregoing rules, at the time the employee's rights (or the beneficiary's rights) under the plan are transferable or are no longer subject to a substantial risk of forfeiture. However, the time of distribution of benefits to the employee or beneficiary may occur subsequently to the time they become taxable. When benefits are actually distributed from a funded plan, the employee is taxed under general annuity rules described in I.R.C. § 72 that permit the employee at the time of distribution to receive tax free the portion of the distribution that represents the employee's "investment in the contract" under the annuity rules.

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The IRS has published at least two private letter rulings that discuss the taxation of the trusts used to fund nonqualified deferred compensation. ⁴⁴⁶ The private letter rulings indicate that an employer must meet specific requirements to avoid denial of the employer's deduction for contributions to the trust and to avoid double taxation on the trust earnings. The rulings appear to severely limit the usefulness of the trust.

5.702 Unfunded Plan. For tax purposes, an unfunded plan is one in which the employee has no rights to a separate trust or escrow account, nor any interest in an annuity-type contract from which the plan's benefits are to be paid, superior to or in preference to the rights of general creditors of the employer. That is to say, unfunded plans are those in which the employee has a mere contractual right against the employer for the payment of a compensation benefit at some described time in the future. It makes no difference that the employer may nevertheless be setting aside funds with which to meet the future obligation to the employee (or the employee's beneficiary), as long as the employee has no legal claim against such funds in preference to general creditors.

Until benefits are actually paid or made available to the employee, there are no tax consequences associated with the arrangement. The employee does not realize income until benefits are actually paid or made available, and the employer is not entitled to a deduction until that time. A different rule applies, however, when the employee has either constructive receipt of the funds or benefits or derives an economic benefit therefrom. In either case, the employee will be deemed to have realized taxable income before actual receipt of the unfunded plan's benefits. It is essential, therefore, in unfunded arrangements to avoid the possibility of constructive receipt by the employee or the employee's realizing an economic benefit from the arrangement before distribution. There is a complete discussion of the constructive receipt rules in Martin v. Commissioner. ⁴⁴⁷ The IRS disagrees with the holding of Martin; nevertheless, the discussion is instructive.

At the time distributions are made, the employee will realize ordinary income in the amount of benefits received, and the employer will be entitled to a concomitant deduction.

5.703 Deferred Compensation Agreements. In the simplest case, the employer may agree to pay the employee, upon termination of

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service or upon retirement, either a fixed amount or some amount based on the employee's years of service and the compensation level. The employee may be required to remain in continued service with the employer for a fixed number of years in order to become entitled to the benefits. Payments under deferred compensation arrangements generally begin on the employee's retirement or termination of service and are frequently made in installments over a relatively short period.

The deferred compensation arrangement can be either funded or unfunded, in a tax sense. This will depend on whether the employee has merely a creditor's claim against the employer (unfunded arrangement) or whether the employer has set aside, in a specific trust or other arrangement (funded plan), amounts to satisfy the employee's future claim in preference to general creditors of the employer. Where an unfunded arrangement is desired, it is not necessary to provide "forfeiture" provisions in order to avoid the risk of current taxation to the employee, since that consequence results by virtue of the unfunded arrangement. Nevertheless, employers may have nontax reasons for including forfeiture provisions as an inducement to the continued services of the employee.

Under some arrangements, the employer guarantees the employee a fixed number of payments and, if the employee dies before receiving all the payments, the remaining balance will be paid to the employee's designated beneficiary. In those cases, where the receipt of all of the benefits under the plan may be accelerated by the employee's early death, employers may find it advantageous to take out an insurance policy on the life of the employee. Such an arrangement will not necessarily become a funded arrangement if the employee has no specific rights to the insurance policy proceeds and the proceeds are payable to the employer and subject to the claims of any general creditor.

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