Tax and ERISA considerations associated with nonqualified severance benefit plans sponsored by professional C corporations.

• Author: Clark, Thomas P.

Employers have used nonqualified deferred compensation arrangements for decades. They have been to used to accomplish various business goals and objectives and have been given many different names depending on the purpose of the arrangement or the manner in which the deferred compensation under the arrangement is to be determined. (1) Purposes of nonqualified deferred compensation arrangements include to attract and retain employees, allow employees to defer future salary or bonuses, create incentives for employees, pay supplemental compensation, protect employees from hostile takeovers, or pay the shareholders of a professional service corporation the unrealized receivables they have generated after retirement.

Most nonqualified deferred compensation arrangements are "unfunded"; that is, the employer's promise to pay the deferred compensation is unfunded and unsecured. An employer may set aside assets to fund its promise to pay, but the assets typically remain part of the employer's general assets and are subject to the claims of the employer's creditors. The employee's right to receive the deferred compensation under an unfunded, nonqualified deferred compensation arrangement is no greater than that of any other unsecured creditor of the employer, and is subject to the employer's credit and business risks, risk of nonpayment, and risk of the employer's unwillingness to pay. These fears have prompted many employers and highly compensated employees to look for ways to secure the employer's promise to pay deferred compensation.

Unfortunately, there is no completely satisfactory way to secure the employer's promise to pay under a nonqualified deferred compensation arrangement. Securing the employer's obligation to pay deferred compensation will cause the employee to be taxed immediately on the amounts set aside for the employee unless the employee's right to receive the deferred compensation is subject to a substantial risk of forfeiture. Furthermore, a funded, nonqualified deferred compensation arrangement normally is subject to the participation, vesting, funding, and fiduciary requirements imposed by the Employee Retirement Income Security Act of 1974 (ERISA).

The purpose of this article is to consider the federal income tax consequences of a severance benefit plan adopted by a Florida professional service corporation (PSC) taxed as a "C corporation" which uses the cash receipts and disbursements method of accounting for federal income tax purposes as a way to pay the uncollected receivables generated by a shareholder of the PSC after retirement in the form of deductible compensation. This article will consider possible methods of securing the employer's promise to pay the deferred compensation, and the tax and ERISA implications associated with this arrangement. This article also will briefly discuss the exemptions from attachment, garnishment, or legal process that may be available; however, a detailed discussion of these issues are beyond the scope of this article. A discussion about the securities law issues and accounting treatment applicable to nonqualified severance benefit plans also is beyond the scope of this article.

Severance Benefit Plan

Most, if not all, PSCs conduct business and keep their books and records on a cash basis method of accounting for both financial and tax purposes; and most, if not all, PSCs pay their shareholders/employees compensation for services performed based on the amount of cash collected and remaining after all other expenses have been paid. When a shareholder withdraws from a PSC, however, the PSC usually will have uncollected receivables that were generated by the withdrawing shareholder before his or her withdrawal. The withdrawing shareholder usually expects to be paid for those receivables since they are directly related to services previously performed for which the withdrawing shareholder has not yet been paid.

The PSC and its shareholders generally address these compensation issues as part of an employment agreement or separate compensation arrangement in order to avoid misunderstandings about their respective contractual rights and obligations and to substantiate that payments made by the PSC to its shareholders for services provided are intended as compensation, and thus deductible by the PSC, and not as dividends or payments for the withdrawing shareholders shares of capital stock. The shareholders of PSC understand that the PSC's ability to pay compensation in the future depends on its ability to collect its uncollected receivables. If a PSC is sued for malpractice committed by one of its shareholders, and if a judgment is rendered against the PSC, the PSC's uncollected receivables are subject to attachment to the extent that the PSC is unable to satisfy the judgment from some other source of funds such as malpractice insurance.

Income Tax Treatment

* Income Tax Consequences to Employee. For purposes of federal income taxation, gross income includes all income from whatever source derived, including compensation for services, whether in the form of cash or property. (2) The receipt of gross income may be actual or constructive. (3) An unfunded, unsecured promise by an employer to pay an amount in cash to an employee at some time in the future is generally not taxable to the employee until payment is actually made by the employer, provided the employee is a cash-basis taxpayer. (4) However, if an employer secures its promise to pay by irrevocably setting aside property to fund its promise, the employee must include the value of the property in his income in the first year in which the property is transferable by the employee or the employee's right to receive the property is not subject to a substantial risk of forfeiture. (5)

If the PSC's contractual obligation to pay compensation to a shareholder both during and after employment is nothing more than an unfunded, unsecured promise to pay in the future, the PSC's promise to pay should not constitute property or the equivalent of cash, and, thus, the shareholder should not be in actual or constructive receipt of income even if the PSC's promise is not subject to substantial limitations or restrictions. (6)

If the PSC funds and secures its promise to pay future compensation to a shareholder by acquiring a life insurance policy or annuity in the name of the shareholder, the shareholder must include the value of the life insurance policy or annuity in his income in the first year in which the life insurance policy or annuity is transferable by the shareholder or the shareholder's right to receive the insurance policy or annuity is not subject to a substantial risk of forfeiture. (7) If the PSC retains complete ownership and control of the insurance policy or annuity and the shareholder does not obtain any rights or interests in the policy or annuity, the PSC's promise to pay should retain its character as nothing more than an unfunded, unsecured promise to pay in the future, and the shareholder should not recognize any income until he receives payment. (8)

* Income Tax Consequences to Employer. A taxpayer who uses the cash receipts and disbursements method of accounting usually takes deductions into account "when paid." (9) Taxpayers using an accrual method of accounting, however, usually take deductions when "all the events have occurred which...