Executive compensation, fringe benefits and employee business expense reimbursements.

• Author: Walker, Deborah

Executive Compensation, Fringe Benefits and Employee Business Expense Reimbursements

This two-part article will provide an overview of recent developments in employee benefits, including qualified retirement plans, executive compensation and welfare benefit plans. Part I, below, will focus on executive compensation and welfare benefit plans, including the special rules that apply to tax-exempt organizations and employee business expense reimbursement arrangements. The past year has seen a number of particularly favorable judicial decisions for taxpayers, regarding nonqualified deferred compensation and the receipt of property for services. On the other hand, employers are experiencing increased enforcement of income tax withholding requirements, particularly for expense allowance arrangements. For the first time since the passage of the Employee Retirement Income Security Act of 1974 (ERISA), the Department of Labor (DOL) is monitoring compliance with reporting requirements for benefit plans and many employers are receiving penalty notices.

Part II, to be published in December, will focus on recent qualified plan developments, specifically recently released final regulations under Secs. 401(a)(4), 401(k), 401(m) and 410(b). These regulations will guide plan sponsors in determining whether their qualified retirement plans are nondiscriminatory. Proposed regulations under Sec. 414(r) describe how the employer can apply discrimination testing rules on a separate line of business basis. In addition, the IRS has started two programs to restore the qualified status to plans that inadvertently become disqualified. Finally, the DOL is releasing new rules on plan investments and the courts have addressed prohibited transactions between qualified plans and the employer.

Nonqualified Deferred Compensation

* Constructive receipt In this uncertain economy with its many business failures, employees who participate in nonqualified deferred compensation plans may want to withdraw their balances from those plans. This is because participants in nonqualified plans are unsecured creditors of the employer, which means they might not realize their expected benefit if the employer were to become insolvent. The question is whether giving these employees the option to withdraw these funds will trigger current tax under the constructive receipt doctrine. It is also important to be careful that amounts are not withdrawn in violation of regulatory or legal considerations.

Generally, individuals recognize income in the year of receipt. Under the constructive receipt doctrine, income is taxable to the individual in the year it is set apart or otherwise made available to him to draw on at any time or with the giving of notice of intention to draw on the income. However, an individual will not be in constructive receipt of income if receipt is subject to substantial limitations or restrictions.(1) Neither the Code nor the regulations define the term "substantial limitations or restrictions."

Whether a penalty is substantial depends on the facts and circumstances. It seems reasonable that a discount of some amount on a lump-sum payment would result in a substantial limitation or restriction. How large this discount must be will depend on many factors, including the investment alternatives available to the individual and the financial security of the payor. If the payor's financial security is questionable, the discount will have to be greater than if the payor is financially secure and the likelihood of payment is great. Similarly, if the employee has investment alternatives with significantly greater return potential than that earned by the deferred compensation held by the employer, a relatively large discount might not be a substantial restriction or limitation. While the particular facts and circumstances will control, the IRS has issued some guidelines as to what is a substantial penalty.

An employee is not required to recognize income on a stock appreciation right (SAR) until the year he exercises the right.(2) The employee's right to benefit from further appreciation in the stock without risking capital is a valuable right--and the forfeiture of a valuable right by its exercise is a substantial limitation that precludes constructive receipt.

Similarly, a taxpayer with the immediate right to cash out certain amounts from a Sec. 403(b) annuity contract was not in constructive receipt of the amounts.(3) The IRS based its reasoning on Rev. Rul. 68-482, in which, due to reincurred loading charges, an employee could not normally buy a new annuity contract of comparable or greater value.(4) These reincurred loading charges were enough to prevent constructive receipt. In the letter ruling, the employee had to pay a $10 minimum withdrawal charge plus an amount equal to 6% of the portion of the amount withdrawn that exceeded 20% of the value of the account. The IRS concluded that the employee was not in constructive receipt of the contract.

This year, in a significant taxpayer victory (Martin(5)), the Tax Court held that employees, whose election as to the form of their benefits was extremely close in time to their eligibility for those benefits, were not in constructive receipt of the amounts. The question before the Tax Court was whether the employees were in constructive receipt of the amounts either at the time a lump-sum option first became available or at the time the participants elected to receive installments.

The court considered five factors in applying the criteria of the regulations and legal precedent to the facts in this case.

1. Whether the plan was funded; 2. whether the participant's right under, and interest in, the plan was secured; 3. whether the election could be made only before the amounts became due and/or ascertainable; 4. whether the participant's right to receive income was subject to substantial limitations or restrictions; and 5. whether interest was payable on installment payments and

when interest, if any, accrued.

According to the court, these factors are neither exclusive nor necessarily individually determinative. The plan was unfunded, and the participants had only an unsecured right under the plan to receive benefits. The election to receive installment payments could be made only before the amounts became due and fully ascertainable. Further, once a payment method was elected, a change in the form of payment would not be effective until the year after the requested change. Because participants had to make their elections before the surrender date, they did not acquire an unconditional right to receive payment before the surrender date. Although the participants had the right to receive a lump-sum distribution before electing to receive installment payments, the lump-sum was not due. Because the value of the benefit fluctuated on a monthly basis, it was not ascertainable on the election day. The participants would have had to forfeit certain rights and future benefits in exchange for current or installment benefits, such as the right to benefit from future equity growth without risking actual capital. The court held this to be a substantial limitation or restriction on the right to receive income. Finally, the fact that interest accrued only after the first installment payment supported the taxpayers' argument for no constructive receipt.

Based on the application of the five factors to the facts in Martin, the court concluded that the choice to receive lump-sum or installment benefits was not sufficiently unfettered to cause constructive receipt of the lump-sum amount. While the determination of constructive receipt is a factual determination, the five factors the Tax Court used in reaching its decision can help in determining whether constructive receipt applies when participants in a deferred compensation plan can choose a payout option.

The facts in Martin were considered in IRS Letter Ruling (TAM) 8632003(6) five years before the Tax Court's decision. The IRS distinguished the facts in the letter ruling from situations in which an election to defer income after it was earned was allowed. When the employee was required to perform additional services for the employer in order to achieve the deferral of earned fees, and the employer wanted to delay payment of the fees, and when further deferral of income was the result of a bilateral negotiation between the employee and the employer, constructive receipt did not apply.(7)

* Employment taxes The rules governing the application of social security (FICA) taxes to payments made under non-qualified deferred compensation arrangements are complex. IRS Letter Ruling 9107014(8) outlines the rules when an employee receives amounts for services performed both before 1984 and after 1983.

In general, wages subject to FICA include all remuneration for employment, unless specifically excepted.(9) Any amount deferred under a nonqualified deferred compensation agreement is taken into account for FICA purposes as of the later of

--when the services are performed; or --when there is no substantial risk of forfeiture of the right to such amounts.(10)

Once a deferred compensation amount becomes subject to FICA, it (and the income attributed to it) will not be treated as FICA wages again when actually paid.(11) This rule is effective for remuneration paid after 1983, except for that paid under an arrangement in existence on Mar. 24, 1983. For these arrangements, the rule applies only for services performed after 1983. Amounts for services performed before 1984 are subject to the rules in effect before the enactment of Sec. 3121(v).(12)

Before Sec. 3121(v) was enacted by the Social Security Amendments of 1983, Sec. 3121 contained several exceptions for retirement payments. The following were not subject to tax.

* Payments made to, or on behalf of, an employee under an employer plan that provides for employees generally or for a class or classes of employees on...