Income tax consequences of NQDC for the employee

• Author: Marla J. Aspinwall - Michael G. Goldstein
• Pages: 91-148

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CHAPTER III

INCOME TAX CONSEQUENCES

OF NQDC FOR THE EMPLOYEE

I. INTRODUCTION

Since the benefit payments under a NQDC plan are “deferred,” it will be extremely

important to the employee that his or her income tax consequences will be “deferred” as well. A

NQDC plan frequently provides that the employee must attain a specified age (e.g., 65) or not

receive the benefits until after he or she has worked a certain number of years for the employer.

If the employee will not receive the cash benefits for many years, the employee will not want to

pay income tax on the benefits until he or she actually receives the cash benefits.

It is this deferral of the income tax on the accrued NQDC benefits that often will make

NQDC so attractive to the employee.

EXAMPLE: Company already sets aside the maximum amount

possible for its senior Executive under its tax-qualified plans every

year. Nevertheless, Executive is concerned that after retirement,

she will need substantial annual income in addition to her qualified

plan benefits and Social Security benefits.

Two alternative options Executive may consider are (i) receive the

same amount of salary each year, pay income tax on that amount

(including the amount that Executive plans to save for retirement),

and separately invest the after-tax amount to save for retirement; or

(ii) enter into a NQDC plan with Company under which the part of

Executive’s salary which she plans to save for retirement will be

deferred, and have the deferred amount grow based on the

performance of certain designated investments. The amount

available to Executive at retirement can be much greater with the

NQDC plan because the amount deferred can grow without any

reduction for income taxes until the amount is actually paid to

Executive. In contrast, if Executive receives the excess salary in

cash and pays income tax immediately on that amount, only the net

amount after taxes will grow until retirement. Naturally, there will

be certain risks in connection with the NQDC plan,1 but the

1 Among the risks with a NQDC plan is the risk that the employer will go bankrupt since the employee will

have only the rights of a general unsecured creditor when enforcing his or her rights to receive payments

under the NQDC plan, according to Rev. Rul. 60-31, 1960-1 C.B. 174, modified by Rev. Rul. 64-279,

1964-2 C.B. 121, and Rev. Rul. 70-435, 1970-2 C.B. 100, which imply that if the employer becomes

bankrupt, the employee may receive pennies on the dollar or nothing in the bankruptcy proceeding. There is

also the risk of excise taxes if the NQDC plan does not comply with all of the Section 409A requirements, as

discussed later in this Chapter. In addition, under a NQDC arrangement, the employer will not be entitled to

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potential return for that risk can be significant because of the

income tax deferral.

Assume that in year 1 Executive is 55 years old and plans to save

$100,000 of her year 1 salary for retirement.2 Executive plans to

invest this excess $100,000 in growth stocks that will appreciate

10% per year for the next 10 years. For purposes of this example,

we will assume that the growth stocks pay no dividends.

If Executive receives the $100,000 in cash in 2010, and pays

federal and state income tax of $45,000 on that amount (assuming

a 45% combined federal and state income tax rate), she will have a

balance of $55,000 to invest in the growth stocks. After 10 years

at a 10% growth rate, the $55,000 will have grown to

approximately $142,654.3 Assume that in year 10, Executive sells

the growth stocks and pays capital gains tax at a combined federal

and state rate of 25% on the gain from the sale. After paying the

capital gains tax of approximately $21,914, Executive has

approximately $120,740 remaining.4

Assume instead that Executive and Company enter into a NQDC

agreement under which $100,000 will be deferred in year 1. Under

the NQDC agreement, the balance of Executive’s deferred

compensation account (which will begin with the $100,000

deferred amount) will grow as if the amount was invested in

certain growth stocks that appreciate 10% per year for 10 years.

After 10 years, the balance of this NQDC account will have grown

to approximately $259,370.5 If this amount is distributed to

Executive in year 10 as a lump sum and she pays income tax of

$116,717 on the total amount received (assuming the same 45%

combined federal and state income tax rate), Executive will have

approximately $142,653 remaining.

an income tax deduction until the amount is actually paid to the employee. IRC § 404(a)(5) (this is discussed

in detail in Chapter II, “Tax Consequences of NQDC for the Employer”).

2 In this example, the $100,000 is in excess of the amounts contributed under the company’s qualified plans.

3 The compound sum of $1 invested for 10 years at a 10% growth rate is 2.5937. See Weston & Brigham,

Essentials of Managerial Finance, A-1 (5th ed. 1979). Thus, $55,000 contributed in year 1 and invested for

10 years at a 10% growth rate will grow to $142,654 [$55,000 x 2.5937].

4 The stock is assumed to have a value of $142,654, before the sale of the stock and Executive’s basis in the

stock is assumed to be $55,000. Thus, the gain on the sale would be $87,654 (under IRC § 1001, the gain

is the amount realized — in this case, the sales price of $142,654 — in excess of the basis of the property

sold — in this case, $55,000). If the combined federal and state capital gains tax is $21,914 (gain of $87,654

at an assumed 25% tax rate), Executive’s remaining amount would be $120,740.

5 The compound sum of $1 invested for 10 years at a 10% growth rate is 2.5937. See Weston & Brigham, supra

note 3, at A-1. Thus, $100,000 contributed in year 1 and invested for 10 years at a 10% growth rate will

grow to approximately $259,370 [$100,000 x 2.5937 = $259,370].

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Thus, Executive accumulates more for her retirement by entering

into the NQDC agreement with Company compared to receiving

the money as part of her salary and separately investing the after-

tax amount.

In considering the income tax consequences for the employee, it is important to

remember that NQDC plans can be structured as “salary-reduction” plans or as “supplemental”

compensation plans. In a salary-reduction plan, the employee elects to defer a fixed percentage

or amount of compensation which he or she otherwise would receive in cash (in effect, there is a

payroll deduction for the NQDC, and the employee’s take-home pay is reduced by the amount

deferred under the NQDC plan). In a supplemental compensation plan, the employee’s take-

home pay is not reduced, but instead the employer uses extra compensation (in excess of the

employee’s take-home pay) to provide the benefits. The employer may provide a plan whereby

the employer credits an annual contribution to a notional account each year which will generally

also be credited with earnings based on some specified rate or hypothetical investment and the

plan will pay the employee the cumulative balance of the amounts credited to such account at

some point in the future (a “defined contribution plan”). Alternatively, the employer may

provide a plan that specifies a target benefit amount that the plan will provide to the employee in

the future based, for example, on a percentage of the employee’s final average earnings rate

payable for a specified period of time (a “defined benefit plan”).

II.

HISTORICAL HURDLES TO DEFERRING INCOME TAX

ON NQDC BENEFITS UNTIL PAYMENT

Historically, in order for a NQDC arrangement to successfully defer immediate taxation

of benefits, the plan needed to clear four hurdles: (i) Section 83; (ii) the “constructive receipt”

doctrine; (iii) the “economic benefit” doctrine; and (iv) the “vested accrued benefit” tax of

Section 402(b). However, Section 409A has added an additional rigorous and dangerous hurdle.

If any of these hurdles is not cleared, the tax consequences can be very painful for the employee.

The employee may be taxed immediately or even retroactively on the benefits as they accrue and

vest under the NQDC plan, even though the employee may not receive the cash benefits for

many years, the benefits may also be subject to a 20% federal excise tax under Section 409A,

and in some states, additional excise taxes may apply.6 Before delving into the most significant

of the hurdles, Section 409A, it is helpful to review the others to understand Section 409A’s

extension of these other historical concepts.

A.

Section 83. Section 83 generally provides that, if an employer transfers

“property” to a person in connection with the performance of services, the service provider must

include the fair market value of the property in gross income for the first taxable year in which

the service provider’s rights to such property are either (i) transferable or (ii) not subject to a

substantial risk of forfeiture, whichever occurs earlier.7

6 See e.g., California Revenue and Taxation Code Sections 17501 and 24601, which incorporate the Section

409A rules in California and tack-on an additional 20% California excise tax on top of the 20% federal excise

tax.

7 IRC § 83(a).