Deducting interest in deferred compensation arrangements.

• Author: Wilson, Bill (American executive)

Most employers provide deferred compensation arrangements to certain executives and directors. Some of these arrangements also provide for "interest" to accrue on the amounts deferred until the benefits are paid to the participants. An ongoing issue concerns when that interest can be deducted.

In a recent Ninth Circuit case (Albertson's, Inc., 12/30/93, rev'g 95 TC 415 (1990)), the court held that interest accrued on deferred compensation was deductible in the year incurred. The Ninth Circuit reversed the Tax Court, which had held that the interest was additional deferred compensation and therefore not deductible until the year paid to the participant under Sec. 404.

The Albertson's case

Albertson's Inc. had deferred compensation arrangements for eight executives and an outside director. The agreements provided deferred compensation for the participants plus an "additional amount" calculated by a predetermined formula. The deferred compensation and the additional amount vested immediately and were payable on retirement or termination of employment. The executives' agreements equated the additional amount to interest accrued at a rate approximating the company's borrowing rate. Similarly, the additional amount in the outside director's contract was directly related to interest rates on certificates of deposit as published in The Wall Street Journal. If elected by the participant, payment of the total amount due could be deferred an additional 15 years beyond the date of retirement or termination, and the additional amount would continue to accrue until payout.

In response to a request for a change in accounting method, the IRS initially permitted Albertson's to deduct the additional amount in the year accrued. Subsequently, the Service changed its position, determining that the additional amount was compensation and, therefore, not deductible under Sec. 404 until paid to the participants. The IRS assessed Albertson's for the amount due, and the Tax Court ruled in favor of the Service. The Ninth Circuit, however, held for Albertson's, stating that the additional amount in these deferred compensation agreements constituted interest and, as such, was deductible under Sec. 163, not Sec. 404.

Additional issues

Vested plans: In Albertson's the deferred compensation was fully vested. When the deferred compensation is not fully vested, the interest element may be considered to be compensation. This is analogous to the treatment of dividends paid on...