'Tax exempt organizations and NQDC planning'

• Author: Marla J. Aspinwall - Michael G. Goldstein
• Pages: 251-273

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CHAPTER IX

TAX-EXEMPT ORGANIZATIONS AND NQDC PLANNING

I. INTRODUCTION

In many ways charities get all the breaks. Charities can be exempt from federal and state

income taxes, sales taxes, and property taxes. For many years, charities were exempt from

liability in many cases under the doctrine of “charitable immunity.” The rule against perpetuities

does not apply to gifts in trust to charitable organizations. Charities can even be entitled to a

reduced postage rate. However, in the area of executive compensation, charities and their

employees are at a significant disadvantage. While charities are often competing with for-profit

organizations for talented and experienced executives, typical executive compensation vehicles

such as stock options and restricted stock are not available to them. Also, tax-exempt

organization need to be concerned with being able to establish that the compensation packages

paid to their executives are “reasonable” and should take the steps necessary to establish a

presumption of reasonableness when approving any executive compensation arrangement in

order to avoid sanctions.1 However, it is the structuring of nonqualified deferred compensation

(“NQDC”) arrangements which is one of the most difficult and complicated areas of executive

compensation planning. The principal focus of this Chapter is Section 457 of the Internal

Revenue Code which is a special section applicable to NQDC arrangements sponsored by

organizations that are exempt from federal income taxes (other than churches). Section 457

imposes unique burdens on state and tax-exempt employers and their employees that do not

apply to for-profit employers and their employees.

II.

TAX-EXEMPT ORGANIZATIONS IN GENERAL

A.

Types of Tax-Exempt Organizations. We begin by considering the types of

organizations that are exempt from federal income tax.

1.

Hospitals and Other Health Care Organizations. Charitable organizations

can qualify for tax-exempt status, and the word “charitable” has been interpreted to include the

promotion of health. Thus, hospitals satisfying certain requirements are tax-exempt. Hospitals

and their employees (including administrators and employed physicians) can be interested in

NQDC plans for most of the same reasons as taxable employers and their employees.

2.

Governmental Entities. Governmental entities, including states, counties,

cities, and many of their agencies and instrumentalities are exempt from federal income taxes.

Governmental entities often have a different motive for establishing NQDC plans. Many

governmental entities are limited by the Internal Revenue Code in the use of tax-qualified plans.

As a result, these governmental entities may turn to NQDC plans.

1 IRC § 4958 imposes excise taxes on “unreasonable” payments made by tax-exempt organizations to

“disqualified individuals.” This topic is discussed in Section 12 of this Chapter.

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3.

Other Charitable Organizations. Many of the other organizations typically

considered as “charitable” are exempt from federal income tax. These organizations include

nursing homes, universities, colleges and other educational organizations, and museums.

Although church organizations are tax-exempt charitable organizations, they are exempt from

Section 457.2

4.

Other Tax-Exempt Organizations. There are a variety of other

organizations that are not “charitable” and yet they are exempt from federal income taxes (and

therefore will be subject to Section 457). These organizations include credit unions, labor

unions,3 business leagues, trade and professional associations,4 chambers of commerce,5 and

country clubs.6

III. HISTORY OF SECTION 457

A.

Pre-1978 NQDC. Prior to 1978 tax-exempt organizations were treated the same a

taxable organizations in the area of constructive receipt. One of the seminal rulings regarding

NQDC plans, Revenue Ruling 60-31,7 made it clear that an employee could be “100% vested” in

his or her NQDC plan benefits, and the employee still could avoid income tax on the NQDC

benefits until those benefits are paid. Thus, the general rule was that no “risk of forfeiture” was

required in the NQDC plan for the employee to avoid current taxation. This rule applied to tax-

exempt organizations, as well as to taxable organizations. Even if the employee retired early or

resigned and went to work for the competition, the employee still could receive the NQDC

benefits. In other words, the employee could be “100% vested” in plan benefits and still not be

taxed on such benefits until they were paid.

B.

In 1978, IRS Concludes that NQDC Is Too Good to Be True. On February 3,

1978, the IRS issued proposed regulations that would have drastically changed the tax treatment

of NQDC plans for all employers and employees.8 Proposed Treasury Regulation § 1.61-16(a)

provided that if compensation is deferred at the “taxpayer’s individual option,” the taxpayer will

be taxed on the compensation in the tax year in which the option to defer is made, regardless of

when the taxpayer actually will receive the compensation.9 For example, if a 25-year old

employee elected to defer an amount until attaining age 65, the employee would be taxed on that

full amount (undiminished by any time value of money considerations) immediately at age 25,

even though the employee will not receive any of the cash for 40 years. The requirement to pay

tax at age 25 when the payment will not be received for 40 years could create a serious “cash

crunch” for the employee. Obviously this would have greatly reduced the appeal of NQDC plans

2 IRC § 457(e)(13).

3 IRC § 501(c)(3); 71 Am. Jur. 2d. State and Local Taxation, § 480, page 781 (1973).

4 IRC § 501(c)(6).

5 Id.

6 IRC § 501(c)(7).

7 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.

8 Prop. Treas. Reg. § 1.61-16 (1978).

9 Id.