Unfunded deferred compensation plans.

• Author: Tonyan, Peter D.

Many country clubs and other exempt organizations provide unfunded deferred compensation plan benefits to key employees from the employer's general assets,

which are accessible by the employer's general creditors. Generally, these plans allow employees to defer part of their current compensation until retirement or termination.

History

Before 1978, the IRS ruled that an employer's obligation to make future payments to an employee under an unfunded deferred compensation arrangement would not be taxable to the employee or deductible by the employer until the employee had the unrestricted right to payment. In 1978, the Service issued Prop. Regs. Sec. 1.61-16, which states that compensation is includible in taxable income in the year it is earned if the employee has the right to elect to received it in that year. In 1978, in response to public protests, Congress nullifield the regulation's application for taxable entities (Revenue Act of 1978, Section 132).

In addition, Sec. 457 was enacted to allow states and their political subdivisions to offer deferred compensation arrangements--but with sharply limited deferral opportunities for their employees. The Tax Reform Act of 1986 (TRA) extended Sec. 457 to tax-exempt organizations.

Overview

Under Sec. 457, amounts deferred in an "eligible" deferred compensation plan are not includible in income until paid or otherwise made available to the employee. As long as the plan in eligible, the proposed regulation is suspended for tax-exempt organizations and states and their political subdivisions. If the plan is not an eligible plan, the amounts deferred are subject to immediate inclusion in the affected employee's gross income in the year of deferral--unless they are subject to a substantial risk of forfeiture.

Substantial risk

of forfeiture

Compensation is subject to a substantial risk of forfeiture if the individual's right to receive it is conditioned on the future performance of substantial services (Sec. 457(f)(3)(B)). The fact that an employer's promise to pay is unfunded and unsecured does not constitute a substantial risk of forfeiture. Generally, exempt organizations provide elective deferred compensation arrangements for certain key employees who are not required to perform future services. Thus, for the amounts to be tax-deferred, the plan must be an "eligible plan."

Eligible plans

An eligible plan must meet the following requirements.

* The plan allows participation only by individuals who...