Current developments in employee benefits.

• Author: Walker, Deborah
• Position: Part 1

As the provision of executive compensation and employee welfare benefits becomes more important to employees, the need to monitor the tax treatment of such amounts also increases. Now more than ever practitioners face increased IRS scrutiny of plans. It is important to understand not only the tax rules regarding these plans, but also financial accounting, securities rules and labor law.

The past 12 months have brought significant changes in the taxation of compensation and employee benefits. Not only have there been significant developments in the taxation of certain forms of executive compensation, most notably deferred compensation secured in a secular trust, but new positions can be taken in the taxation of employee fringe benefits.

This three-part article will discuss the recent changes in compensation and employee benefits. Part I, below, will discuss executive compensation and employee benefits, Part II, to be published in December, and Part III, in January, will focus on changes affecting qualified retirement plans.

Nonqualified Deferred Compensation

* Secular trusts

Secular trusts are a means of funding and securing nonqualified deferred compensation agreements. While the employee for whom the benefit is being provided is currently taxed on the vested amounts set aside in the trust for his benefit, the current low tax rates and added certainty of future payments make this type of arrangement acceptable in the current economic environment. Since the Tax Reform Act of 1986, many practitioners have questioned how Sec. 402(b)(1)and (2) apply to secular trusts and whether secular trusts are grantor trusts. Recent letter rulings provide some answers.

In IRS Letter Ruling 9206009,(1) X Corporation established a plan to provide nonqualified deferred compensation for nonemployee members of its board of directors. To secure its obligations under the plan, X proposed to contribute funds to a trust for any plan participant whose benefits were vested. A participant would have the right to receive his trust account balance at a future date in accordance with payment terms under the plan. The participant would not have a vested right to the income allocable to the participant's account balance until the participant's benefit was payable. Income earned by the trust would be allocated to the participants' accounts once benefit payments began. Before benefit payments began, the trust income would be distributed to X. Each year, the participants would receive a payment from the trust to cover their Federal income tax liability.

Sec. 402(b)(1) provides that employer contributions to a nonqualified employees' trust are included in the employees' gross income in accordance with Sec. 83. To apply Sec. 83 to a trust, the value of the employee's interest in the trust is substituted for the Sec. 83 taxable value--the property's fair market value (FMV).

Old Sec. 402(b)(2)(A)(now Sec. 402(b)(4)(A))provides that if one of the reasons a trust is not a qualified trust is the plan's failure to meet the requirements of Sec. 401(a)(26)or Sec. 410(b), highly compensated employees (defined under Sec. 414(q))must include in gross income their vested accrued benefit in the trust in lieu of the amount determined under Sec. 402(b)(i)(now (b)(1) or (2)).

For purposes of the Sec. 402 rules, "employee" includes a self-employed individual(2) The employer of such an individual is the person treated as his employer under Sec. 401(c)(4), which includes an individual who owns the entire interest in an unincorporated trade or business. Because a corporate director is a self-employed individual, he is treated as his own employer.

The IRS ruled that the plan met the requirements of Secs. 401(a)(26) and 410(b) with respect to each participant because each employer (i.e., each participant) had only one employee. Therefore, Sec. 402(b)(1), instead of Sec. 402(b)(2)(now (b)(4)), applied to the trust. Thus, each participant would be taxed on the portion of the contribution to the trust equal to the present value of the contribution payable in accordance with the terms of the plan, but not greater than the present value of the accrued benefit under the plan.

The facts in IRS Letter Ruling 9207010(3) are similar to Letter Ruling 9206009, except that the plan participants were employees rather than independent contractors. Because the plan covered only a select group of officers, it failed both Sec. 401(a)(26) and Sec. 410(b). The taxation of contributions for the highly compensated employees would be dictated by Sec. 402(b)(2)(now (4)), while taxation of the nonhighly compensated employees would be similar to that described in Letter Ruling 9206009. A highly compensated employee must include in income an amount equal to his vested accrued benefit (other than his investment in the contract) as of the close of the tax year of the trust that ends with or within his tax year. Under these rules, accumulated earnings, whether or not realized for tax purposes, are taxed to the highly compensated employee. For years in which the company retains the right to allocate trust income among participants, the taxable amount will be the lesser of the present value of the participant's trust account balance payable at the time provided under the plan, or the present value of the participant's benefit under the plan. For years in which the company can allocate income only to the participant's account, the participant's vested accrued benefit will be the lesser of his account balance or the present value of his benefits under the plan. IRS Letter Rulings 9212019(4) and 9212024(5) detailed similar tax consequences for participants accruing benefits in an employee's trust.

Contributions paid by an employer to a nonqualified deferred compensation plan are deductible in the employer's tax year in which ends the employee's tax year in which an amount attributable to such contribution is included in the employee's gross income.(6) For example, if an employer contributes $1,000 to an employee's account for the employer's 1977 calendar tax year, but the amount is not included in the employee's gross income until 1980 (at which time the includible amount is $1,150), the employer's deduction is $1,000 in 1980. When a funded plan has more than one employee participant, the employer is not allowed a deduction unless separate accounts are maintained for each employee to which employer contributions are allocated, along with any income earned thereon. Such accounts must be sufficiently separate and independent to qualify as separate shares under Sec. 663(c). The deduction timing rules under Sec. 404 also apply to plans covering independent contractors.(7)

In Letter Ruling 9206009, the IRS ruled that the trust established by X did not satisfy the separate share rule until the participants had the right to the trust income. Thus, X could not deduct currently or in the future contributions allocated to such trust accounts. This interpretation of the separate share rule can result in a significant detriment to some existing arrangements. X would receive a deduction for contributions allocated to trust accounts when X no longer retained the power to reallocate trust income.

A similar result regarding deductibility was reached in Letter Ruling 9207010. Under the terms of the plan in this ruling, the employer retained the power to allocate the trust income on shares of participants not yet in pay status among any of the other participants not in pay status. As soon as benefits became payable under the plan, the income allocable to a participant's share could not be allocated to any other participant. Again, no deduction was allowed to the employer for contributions to accounts of participants not in pay status because the separate share rule had not been met.

This result can be corrected, if consistent with plan design, by providing that the income allocable to each participant's share is allocable solely to his account, removing any right of payment of trust income to the employer or right to allocate income among participants' accounts. Letter Rulings 9212019 and 9212024 provide that language to this effect in a plan will meet the separate share rule, and that a deduction will be allowed under Sec. 404(a)(5) in the tax year in which amounts attributable to those contributions are includible in the participant's gross income, to the extent the ordinary, necessary and reasonable test of Sec. 169. is met. Alternatively, a separate trust for each plan participant could be used, providing that all income is allocated to trust beneficiaries in accordance with their account balances.

The IRS next addressed the grantor trust issue. Sec. 677(a)(1) provides that the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be distributed to the grantor. Sec. 677(a)(2) provides that the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be held or accumulated for future distribution to the grantor.

The IRS, however, ruled that the rules that apply to employee trusts under Secs. 402(b) and 404(a)(5) preclude such a trust from being a grantor trust. Thus, X is not treated as the owner of any portion of the trust and the income is taxed to the trust under Sec. 641. When the trust is taxed as other than a grantor trust, the income is effectively taxed twice--once at the trust level and once when amounts are distributed from the trust or, under Sec. 402(b)(2), when the highly compensated employee has an increased accrued benefit. To avoid this result, the employer could design the trust as a grantor trust of the employee. In this case, many employees would prefer to receive cash currently.

* Rabbi trusts

While secular trusts may not be as tax beneficial as they formerly were considered to be, the IRS has made the use of rabbi trusts...