Excerpts from Joint Committee on Taxation staff's discussion of the nonqualified deferred compensation provision included in Chairman Charles Grassley's (R-IA) mark of the tax bill now being considered by the Senate Finance Committee.
K. Inclusion in Gross Income of Certain Deferred Compensation Present Law
The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the individual earning the compensation depends on the facts and circumstances of the arrangement. A variety of tax principles and Code provisions may be relevant in making this determination, including the doctrine of constructive receipt, the economic benefit doctrine,193 the provisions of section 83 relating generally to transfers of property in connection with the performance of services, and provisions relating specifically to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)). In general, the time for income inclusion of nonqualified deferred compensation depends on whether the arrangement is unfunded or funded. If the arrangement is unfunded, then the compensation is generally includible in income when it is actually or constructively received. If the arrangement is funded, then income is includible for the year in which the individual's rights are transferable or not subject to a substantial risk of forfeiture.
Nonqualified deferred compensation is generally subject to social security and Medicare tax when it is earned (i.e., when services are performed), unless the nonqualified deferred compensation is subject to a substantial risk of forfeiture. If nonqualified deferred compensation is subject to a substantial risk of forfeiture, it is subject to social security and Medicare tax when the risk of forfeiture is removed (i.e., when the right to the nonqualified deferred compensation vests). This treatment is not affected by whether the arrangement is funded or unfunded, which is relevant in determining when amounts are includible in income (and subject to income tax withholding).
In general, an arrangement is considered funded if there has been a transfer of property under section 83. Under that section, a transfer of property occurs when a person acquires a beneficial ownership interest in such property. The term "property" is defined very broadly for purposes of section 83.194 Property includes real and personal property other than money or an unfunded and unsecured promise to pay money in the future. Property also includes a beneficial interest in assets (including money) that are transferred or set aside from claims of the creditors of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with the performance of services, vested contributions are made to a trust on an individual's behalf and the trust assets may be used solely to provide future payments to the individual, the payment of the contributions to the trust constitutes a transfer of property to the individual that is taxable under section 83. On the other hand, deferred amounts are generally not includible in income in situations where nonqualified deferred compensation is payable from general corporate funds that are subject to the claims of general creditors, as such amounts are treated as unfunded and unsecured promises to pay money or property in the future.
As discussed above, if the arrangement is unfunded, then the compensation is generally includible in income when it is actually or constructively received under section 451. Income is constructively received when it is credited to an individual's account, set apart, or otherwise made available so that it can be drawn on at any time. Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. A requirement to relinquish a valuable right in order to make withdrawals is generally treated as a substantial limitation or restriction.
Special statutory provisions govern the timing of the deduction for nonqualified deferred compensation, regardless of whether the arrangement covers employees or nonemployees and regardless of whether the arrangement is funded or unfunded.195 Under these provisions, the amount of nonqualified deferred compensation that is includible in the income of the individual performing services is deductible by the service recipient for the taxable year in which the amount is includible in the individual's income.
Arrangements have developed in an effort to provide employees with security for nonqualified deferred compensation, while still allowing deferral of income inclusion. A "rabbi trust" is a trust or other fund established by the employer to hold assets from which nonqualified deferred compensation payments will be made. The trust or fund is generally irrevocable and does not permit the employer to use the assets for purposes other than to provide nonqualified deferred compensation, except that the terms of the trust or fund provide that the assets are subject to the claims of the employer's creditors in the case of insolvency or bankruptcy. As discussed above, for purposes of section 83, property includes a beneficial interest in assets set aside from the claims of creditors, such as in a trust or fund, but does not include an unfunded and unsecured promise to pay money in the future. In the case of a rabbi trust, terms providing that the assets are subject to the claims of creditors of the employer in the case of insolvency or bankruptcy have been the basis for the conclusion that the creation of a rabbi trust does not cause the related nonqualified deferred compensation arrangement to be funded for income tax purposes.196 As a result, no amount is included in income by reason of the rabbi trust; generally income inclusion occurs as payments are made from the trust.
IRS has issued guidance setting forth model rabbi trust provisions.
Description of Proposal
Under the proposal, amounts deferred under a nonqualified deferred compensation plan198 are currently includible in income unless certain requirements are satisfied. Distributions from nonqualified deferred compensation arrangements can only be distributed upon separation from service, disability, death, a specified time, change in control, or financial hardship. The deferred compensation plan cannot permit the acceleration of the time of such payment by reason of any event. Separation from service distributions to disqualified individuals (as defined in section 280G) cannot be made earlier than six months after the date of separation from service. Amounts payable upon the occurrence of an event are not treated as amounts payable at a specified time. For example, amounts payable when an individual attains age 65 are payable at a specified time, while amounts payable when an individual's child begins college are payable upon the occurrence of an event.
Disability is defined as under the Social Security Act. Under such definition, an individual is considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than twelve months.
Financial hardship is defined as severe financial hardship of the participant or beneficiary resulting from an illness or accident of the participant or beneficiary, the participant's or beneficiary's spouse or the participant's or beneficiary's dependent (as defined in 152(a)); loss of the participant's or beneficiary's property due to casualty; or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or beneficiary. The amount of the distribution must be limited to the amount needed to satisfy the hardship plus taxes. Distributions can not be allowed to the extent that the hardship may be relieved through reimbursement or compensation by insurance or otherwise, or by liquidation of the participant's assets (to the extent such liquidation would not itself cause financial hardship). Under the proposal, change in control will be defined by the Secretary.
Initial deferrals must be required to be made no later than prior to the beginning of the taxable year that the compensation is earned. In the first year that an employee becomes eligible for participation in the plan, the election can be made within 30 days after the date that the employee is initially eligible. Subsequent elections to delay the timing or form of payment can be permitted only if the subsequent election is made more than 12 months prior to the date of the scheduled distribution and provides additional deferral for a period of not less than 5 years. A participant cannot be allowed to make more than one subsequent election. No accelerations can be allowed.
If impermissible distributions or elections are made, or if the plan or arrangement is amended to allow for impermissible distributions or elections, amounts deferred are currently includible in income. If the requirements of the proposal are not satisfied, in addition to current income inclusion, interest at the underpayment rate plus one percentage point is imposed on the underpayments that would have occurred had the compensation been includible in income when first deferred. Interest imposed under the proposal is treated as interest on an underpayment of tax. Earnings on amounts deferred are also subject to the proposal.
Under the proposal, amounts deferred through an offshore trust are currently includible in income. In addition, amounts deferred under a nonqualified deferred compensation arrangement that provides that upon a change in the employer's financial health, assets will be restricted to the payment of deferred compensation would also be currently includible in income. The rule is violated upon the earlier of when the assets are so restricted or when the plan provides that assets will be restricted. Interest at the underpayment rate plus one percentage point is also imposed on the underpayments that would have occurred had the amounts deferred in an offshore trust or arrangement with financial trigger been includible in income for the taxable year such amounts were first set aside.
A nonqualified deferred compensation plan is any plan that provides for the deferral of compensation other than a qualified retirement plan.
Annual reporting to the IRS of amounts deferred is required under the proposal. Amounts deferred are required to be reported on an individual's Form W-2 for the year deferred even if the amount is not currently includible in income for that taxable year.
The proposal is not intended to preclude the application of other rules that would require earlier income inclusion. The proposal provides the Secretary of the Treasury authority to prescribe regulations as are necessary to carry out the proposal.
proposal is effective for amounts deferred in taxable years beginning after
195 Secs. 404(a)(5), (b) and (d) and sec. 83(h).
This conclusion was first provided in a 1980 private ruling issued by the IRS
with respect to an arrangement covering a rabbi; hence the popular name
198 A plan includes an agreement or arrangement.