Using a non-qualified deferred compensation plan to defer income.

• Author: Ellentuck, Albert B.

Facts

John Stevens is changing jobs and is currently negotiating with his new employer over the terms of his employment. Part of John's expected compensation is a bonus based on his performance each year; this is expected to be approximately $50,000. Because the employer does not have a qualified retirement plan, John intends to invest this bonus in long-term securities for his retirement.

Issue

Can payment of the bonus be structured to defer recognition of income?

Analysis

Because John intends to place the bonus in long-term investments, John's tax adviser should suggest that he consider a nonqualified deferred compensation plan. If the plan is set up properly, John will not have constructive receipt of the bonus until he actually receives it.

A cash-basis taxpayer must recognize income when it is actually or constructively received. Constructive receipt occurs when the income is credited to the taxpayer's account, set apart for him, or otherwise made available so that he can draw upon it at any time. Constructive receipt has not yet occurred if the income is subject to a substantial risk of forfeiture.

One way to be certain that John does not have constructive receipt of the bonus when it is declared is to have the employer set up a nonqualified deferred compensation plan that provides an election to defer the income. In this situation, the election should be made before the year in which the services are performed. This will ensure that there is no constructive receipt even if the plan does not contain forfeiture provisions.

The plan can contain any type of payment schedule. For example, John and his employer could agree that the annual bonus is to be paid over a four-year period or they might agree that it should not be paid until John quits or retires. (Note that the payment terms should be determined when the plan is created.) Additionally, John should have no way to change the terms once the plan is set up. Otherwise, it is likely that the IRS would argue that John does have constructive receipt because he would have control over the payment (i.e., he could withdraw the fund at any time).

The tax adviser should caution John that one disadvantage to the deferred compensation plan is that he cannot have a secured interest in the funds until they are payable. A secured interest in the funds would result in current taxation of the bonus because...