Using nonqualified deferred compensation to attract and keep employees.

• Author: Stara, Nancy J.

A need exists for flexible compensation arrangements that can (1) provide performance incentives and aid in the retention of personnel without straining cash flow, (2) maximize retirement savings by using favorable tax rates to increase investment returns and (3) minimize the need for regulatory compliance. Nonqualified deferred compensation arrangements (DCAs) can meet these needs. Other reasons favoring their use include the following:

* The Sec. 401(a)(17) compensation limit for qualified plans has decreased from $235,840 to $150,000, lessening potential retirement savings. Under Section 13212 of the Revenue Reconciliation Act of 1993 (RRA '93), indexing of the $150,000 limit will not occur until 1996 and cannot exceed $10,000 per year. In contrast, DCAs are not subject to a stated compensation limit, and must meet only a standard of reasonable compensation.

* The marginal individual income tax rate is 39.6%, while the marginal corporate tax rate is 35%. Thus, while the corporation will be denied an immediate tax deduction for the deferred compensation, the individual tax savings from deferring the compensation will exceed the delayed corporate tax benefit. The marginal individual rate increases when adjusted to consider the phaseout of personal exemptions, limit on itemized deductions and RRA '93 Section 13207's repeal of the compensation cap for the medicare portion of FICA, resulting in an even greater tax benefit from the deferral.(1)

* DCAs are relatively free from regulation. Sections 3(36) and 4(b)(5) of the Employee Retirement Income Security Act of 1974 (ERISA) provide that unfunded excess benefit plans existing solely to provide benefits in excess of the Sec. 415 limits are exempt from ERISA requirements. Unfunded "top-hat" plans maintained for a select group of management or highly compensated employees are subject only to limited reporting and disclosure requirements and to ERISA enforcement.(2)

* The flexibility of DCAs provides unique planning opportunities. For instance, initial elections of method and time of payment can be modified later to meet changing needs and to provide for unforeseeable emergencies; investment vehicles can be chosen to provide performance incentives; participation can be restricted or canceled; and vesting schedules can be designed to encourage retention.

Nonqualified plans may be used with corporate directors as well as employees. DCAs may be particularly beneficial for closely held corporations in which family members are both directors and employees. In Jacobs,(3) a corporate director and president was denied a Keogh plan deferral for his director's fees because of the employment relationship. Except in partnerships, use of a DCA avoids this issue.(4)

An understanding of the deferral rules is critical to using DCAs effectively. This article provides a practical analysis of these rules, including recent rulings and court decisions, and discusses planning opportunities.

DCA Requirements

To maintain relative freedom from ERISA requirements, DCAs providing excess benefits or limiting coverage to a select group of management or highly compensated employees must be "unfunded," a term that is not defined. The ERISA Conference Report cited a phantom or shadow stock plan as an example of an unfunded plan.(5) The DOL has noted that because of the absence of regulations, it will give significant weight to positions adopted by the Service for Federal income tax purposes.(6) The IRS position, under Regs. Secs. 1.446-1(c)(1)(i) and 1.451-1(a), is that compensation for a cash-basis taxpayer becomes funded, and hence, taxable, when cash, property or services are actually or constructively received. Conversely, if compensation is not received, it is unfunded.

Actual and Constructive Receipt Doctrines

Actual receipt

"Receipt" occurs when a taxpayer gains unqualified control of cash, property or services.(7) According to Rev. Rul. 60-31,(8) "a mere promise to pay, not represented by notes or secured in any way," does not constitute receipt. However, according to the Fifth Circuit in Cowden,(9) if the promise to pay the taxpayer is unconditional and assignable, is not subject to set-offs and is of a kind frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, it is the equivalent of cash. This cash equivalent provides an economic benefit if the taxpayer actually receives property or a valuable future right, even if such property is not subject to the taxpayer's immediate control.(10) As shown in Sproull,(11) the greatest concern is the application of the economic benefit doctrine when a taxpayer receives a future right capable of current valuation.

In Sproull, an employer created a trust for the sole benefit of an employee or his beneficiary. The employee had no part in establishing the trust. The employer transferred a sum to the trust to be paid over the following two years in consideration for the employee's past services. Although the terms of the trust limited the employee's immediate access, the Tax Court held the employee was immediately taxable, because

--he was fully vested and had to do nothing further to earn the amount transferred;

--the only duties of the trustee were to invest, accumulate and pay over the trust income and principal to the employee or his beneficiary;

--no one, other than the employee, had an interest in or control over the trust assets; and

--the trust agreement contained no restriction on the employee's right to assign or dispose of his trust interest.

Sproull shows that the economic benefit doctrine extends to a DCA when there is a current beneficial interest in a future right to receive property. This interest may be valued if it is fully vested in the employee and secured against the employer's creditors.(12)

Constructive receipt

Alternatively, under Regs. Sec. 1.451-2(a), constructive receipt occurs when cash, property or services are "made available" without "substantial limitations or restrictions." According to Martin,(13) to be made available, an amount must be set apart, due and fully ascertainable. An amount is made available, for example, if a taxpayer may unilaterally demand payment of the amount in cash, property or services.(14) Under Regs. Sec. 1.451-2(a), however, if an employer merely credits funds to an employee on its books so that they are not available until a future date, the amount is neither set aside nor due. Under Martin, if the amount is based on profits and cannot be precisely determined until year-end, it is not fully ascertainable; further, under Rev. Rul. 60-31, a mere promise to pay that is not secured is not set apart...