Tax consequences of NQDC for the employer

• Author: Marla J. Aspinwall - Michael G. Goldstein
• Pages: 47-84

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CHAPTER II

TAX CONSEQUENCES OF NQDC FOR THE EMPLOYER

I. INTRODUCTION

As discussed in Chapter III, “Income Tax Consequences for the Employee,” the deferral

of the income tax liability on the benefits accrued under a NQDC plan is a great benefit for the

employee. The tax consequences of NQDC are deferred for the employer as well. However,

deferral for the employer means that the employer cannot claim an income tax deduction until

the employee includes the deferred amount in his or her taxable income. A great deal of tax

planning is aimed at deferring income and accelerating deductions. NQDC allows the employee

to defer including the NQDC benefit in his or her taxable income, but also defers the tax

deduction for the employer.1

II.

THE EMPLOYER’S DEDUCTION OF

THE AMOUNTS PAID UNDER A NQDC PLAN

A.

The Matching Rule of Section 404(a)(5). Prior to 1942, an accrual basis

employer could deduct the value of the benefits promised under a NQDC plan each year as the

benefits accrued.2 This was a tremendous advantage as the employer could claim a current

income tax deduction, but the employee would not be required to include the NQDC benefits in

his or her taxable income until the benefit was received by the employee. In the Revenue Act of

1942 (the “1942 Act”), Congress amended the Internal Revenue Code of 1939 to provide that no

deduction for compensation under a NQDC plan is permitted until the benefit is taxable to the

employee, regardless of whether the employer is a cash basis or accrual basis taxpayer.3

This timing rule is now set forth in Section 404(a)(5) which provides:

[I]f compensation is paid or accrued on account of any employee under a plan

deferring the receipt of such compensation, such . . . compensation shall not be

deductible under this chapter; but if they would otherwise be deductible, they

shall be deductible under this section . . . [I]n the taxable year in which an amount

attributable to the contribution is includible in the gross income of employees

participating in the plan, but in the case of a plan in which more than one

employee participates only if separate accounts are maintained for each

employee . . . .

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1 Based in part on the deferral of the employer’s tax deduction, a New York Times editorial referred to NQDC

as “a stealth tax on shareholders.” Tax-Deferred Pay for Executives, N.Y. Times, Oct. 18, 1996, at 36. See

also Albertson’s, Inc. v. Commissioner, 95 T.C. 415, 432 (1990) (concurring opinion) (“It can be said that . . .

the employer is being taxed in substitution for not currently taxing the employee.”).

2 Albertson’s, Inc. v. Commissioner, 42 F.3d 537, 542 (9th Cir. 1994); Oxford Inst. v. Commissioner, 33

B.T.A. 1136 (1936) (relying on Section 23 of the Revenue Act of 1932, which was later incorporated into the

Internal Revenue Code of 1939).

3 Id.

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A similar rule applies to NQDC plans for independent contractors.4 Thus, the employer’s

deduction “matches” the employee’s inclusion of the deferred amount in his or her taxable

income, i.e., they both must occur in the same taxable year.

This “matching” rule is in sharp contrast to the rule for qualified plans (for these

purposes, the term “qualified plan” means a plan meeting the requirements of Section 401). With a

qualified plan, the employer is entitled to deduct its contributions to a separate trust which funds

the future benefit payments under the qualified plan each year,5 even though the employee may not

receive the benefit payments for many years — usually at termination of employment.

The legislative history of the 1942 Act does not discuss the purpose of the matching rule,6

but one court has considered the purpose of the matching rule in detail, and has concluded that

the purpose is to provide an incentive for employers to establish qualified plans.7 With a

qualified plan, the employer must satisfy many burdensome requirements, including the eligibility

and participation rules which will require that some number or percentage of the lower paid

employees are covered by the plan.8 In contrast, “Congress has imposed few restrictions upon

nonqualified deferred compensation plans. An employer may limit participation in a

nonqualified plan to highly paid executives, and it need not guarantee equal benefits for all

participants.”9

As further support, the court points out that in a qualified plan, the employer is required

to fund the benefits provided on a current basis10 by contributing funds to a trust or insurance

company each year as benefits accrue under the plan.11 These funds (set aside in the trust or with

the insurance company) can be used only to pay the benefits under the plan, i.e., the employer

cannot use those funds for other purposes, and the corporation’s creditors cannot reach those

amounts.12 Thus, with a qualified plan, the funds intended to be used to provide the benefits are

out of the company’s control and cannot be reached by the company’s creditors (so long as the

plan is not terminated and excess funds recaptured). As a result, the court concludes that with a

qualified plan “the employer, in effect, is required to make the deferred payments at the time the

employee is earning the compensation.”13

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4 See IRC § 404(d).

5 Id.; IRC § 404(a)(1)-(4).

6 See Albertson’s, 42 F.3d at 543.

7 Id.

8 See IRC §§ 401(a)(3), 401(a)(26), (participation requirements) and 410 (minimum participation standards).

9 Albertson’s, 42 F.3d at 541.

10 Id. at 542 (“The most significant difference between the two types of plans, for purposes of tax deductibility,

is that under a qualified plan the employer must turn over annually to a third party the basic amounts that are

deferred and may not use those amounts for the employer’s own benefit.”).

11 Id.; Albertson’s v. Commissioner, 95 T.C. at 425 (“An employer that contributes to a qualified plan must pay

the contributions to a trustee under a trust arrangement or to an insurance company that issues an annuity

contract with respect to the plan.”).

12 Id. at 426.

13 Albertson’s, 42 F.3d at 542.

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In contrast, with a NQDC plan, in many cases the employer merely adopts a “pay as we

go” approach, i.e., no funds are specifically set aside to fund the future benefit payments that will

be required under the NQDC plan.14 In that case, the employer enjoys complete flexibility to use

its assets as it deems appropriate. For example, if the company’s officers and directors decide

that the company needs to expand or to reduce its other debts, the company can use the funds

previously intended to provide the NQDC benefits for those purposes. Even if the employer

establishes a rabbi trust or other similar device15 to “informally fund” the benefits under a NQDC

plan, the funds still can be reached by the employer’s general creditors.16 Thus, in the case of a

NQDC plan, “the employer’s obligation to part with the funds is deferred.”17 The court

concludes that “[I]f one could simply retain the funds and receive tax benefits similar to those

one would receive if those amounts were paid out, there would clearly be little incentive to

establish a qualified plan.”18

By exempting contributions to qualified plans from the matching principle of Section

404(a)(5), Congress compensates employers for meeting the burdensome requirements

associated with qualified plans by granting them favorable tax treatment.19

B.

The “Reasonable Compensation” Restriction of Section 162. Prior to the Tax

Reform Act of 1986, Section 404(a)(5) specifically referred to Section 162, clearly indicating

that a payment under a NQDC plan would only be deductible if it satisfies the requirements of

Section 162.20 The Tax Reform Act of 1986 removed the reference to Section 162 (and Section

212) from Section 404(a)(5), but the legislative history indicates that the amendments were

intended to broaden the scope of Section 404(a)(5) to apply to all forms of compensation.21

Thus, it appears that NQDC payments still must meet the requirements of Section 162 (or 212) to

be deductible.22

Compensation will be deductible under Section 162 if it constitutes an ordinary and

necessary expense paid in carrying on the taxpayer’s trade or business.23 The expenses that can

be deducted under Section 162 include “a reasonable allowance for salaries or other

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14 The Wyatt Company, From Pitfalls to Possibilities: Survey Report on Deferred Compensation, 1 (1994)

(“over 60% of companies in our survey simply pay benefits out of current operating income as they come

due.”).

15 Rabbi trusts are discussed in detail in Chapter VII “Rabbi Trusts and Other Risk Reduction Devices.”

16 One exception is the secular trust arrangement, discussed in detail in Chapter VII, “in which the employee is

taxed currently on the amounts contributed to the trust to fund the accrued NQDC benefits. The funds in the

secular trust cannot be reached by the employer’s creditors.”

17 Albertson’s, 42 F.3d at 542.

18 Id. at 542.

19 Id. at 543.

20 See Andrews Distributing Co. v. Commissioner, 31 T.C.M. (CCH) 732, 734-5 (1972).

21 See Albertson’s, Inc. v. Commissioner, 38 F.3d 1046, 1055 (9th Cir. 1993).

22 See Treas. Reg. § 1.404(a)-1(b) (“In order to be deductible under Section 404(a), contributions must be

expenses which would be deductible under section 162 . . . or 212. . . .”); Treas. Reg. § 1.404(a)-12(b)(2).

23 IRC § 162.