Glen Head, NY

Deferring the receipt of income--and postponing the tax on that income--has always been attractive. The plan would be to receive the income (which might grow without the imposition of taxes) in a later year when the taxpayer would expect to be in a lower tax bracket.

(This discussion concerns what is known as “non-qualified deferred compensation arrangements and does not concern qualified employer plans--pension, profit sharing and 401(k) plans which have their own rules.)

Rules have long been in effect regarding non-qualified deferred compensation arrangements. One of those rules provides that the amount deferred must not be constructively received by the taxpayer or it will be taxed currently. This means that the deferred amount must remain subject to claims of creditors of the employer. Depending on the financial condition of the employer, this might be a real problem for the taxpayer employee--especially if the arrangement is to continue for a long period of time.

Prior to the American Jobs Creation Act of 2004, the failure to follow the rules on deferred compensation arrangements would result only in the current taxation of that income (which might have been a problem if the funds from the deferred compensation arrangement were to be used to pay the tax and if those funds couldn't be reached). The 2004 legislation, however, substantially rewrote the deferred compensation rules and failure to comply with these new rules will cause a real tax headache.

Section §409A provides that failure to follow its rules results in:

• immediate taxation of the deferred amount;

• a 20% penalty of the compensation that was to be included in income. That's a 20% penalty on the compensation--NOT on the tax! Truly a Draconian penalty!

• interest at the underpayment rate plus one percentage point on the underpayment.

And the rules are not so simple to accept and follow.

For example, under the new rules distributions of the funds cannot be made before: (1) separation from service; (2) disability or death; (3) a specified time or pursuant to a fixed schedule; (4) a change in ownership or control of the corporation (as defined by regulations); or (5) an unforeseen emergency.

However, to make matters worse for key employees of public companies, distributions resulting from separation from service are subject to a six month waiting period following termination of employment. That means that claims that may arise against the departing key employee whether justified or not may hold up the payment of what the employee thought was his and what he expected to receive.

And §409A and its regulations have many requirements dealing with deferred compensation arrangements including: (1) when elections to defer compensation must be made; and (2) what constitutes a disability, a change in control or an “unforeseen emergency” so as to permit a distribution that will not violate its provisions and result in its severe penalties.

Rev. Rul. 60-31 is a famous reference for what constitutes “constructive receipt” for deferred compensation arrangements and it must be kept in mind that when that ruling was released back in 1960, the highest income tax rate was 91%! Today the top rate is 35% (and based on the political climate today, it is likely to go higher in the near future). Perhaps it would make more sense to “take the money” now and pay tax at the current rates and not have to navigate the complex rules of §409A and its regulations and be subject to its harsh requirements and penalties. Assuming one has that choice, of course.

(This discussion concerns only income taxes. FICA taxes should also be considered. In general, any amount deferred under a non-qualified deferred compensation plan is considered income for FICA and Medicare tax purposes as of the later of : (1) when the services are performed; or (2) when there is no substantial risk of forfeiture of the rights to such amount. (§3121(v)(2)(A).) So these taxes might be imposed years before the amounts become subject to income taxes. If at a subsequent date the recipient can't or won't get his deferred compensation upon which he's already paid FICA and Medicare tax, he is not entitled to a refund of those taxes according to CCA 200823001.)

But let's assume there is no choice and that deferred compensation is included in the compensation package given to the employee. Let's assume: (1) an employee who we will call here Joseph Job has been given a non qualified deferred compensation plan; (2) that violates §409A as it concerns Mr. Job; and (3) before the corporation gets to make the payment it goes out of business and the deferred compensation, which is subject to the claims of creditors, does indeed go to creditors and Mr. Job gets nothing. What are the results to him?

Well, let's say that Mr. Job meets with Ms. Zophar, his tax advisor and she explains to him that:

• Since the plan violated §409A, he must pay tax on the money he never received as set forth above. That is the tax on the deferred amount together with an additional 20% on that amount as well as interest (at the underpayment rate plus 1%).

• When Mr. Job asks Ms. Zophar shouldn't he get a deduction for the deferred compensation that he has lost she smiles sadly and explains that based on a Tax Court Memo decision (Graves v. Comr., T.C. Memo 2004-140):

•• Yes, the loss of the deferred compensation is a business bad debt.

•• It must, however, be deducted “from” and not “for” adjusted gross income and as such it is subject to the 2% rule meaning that only to the extent that this and other similar deductions exceed 2% of his adjusted gross income would it be deductible.

A glimmer of hope shines in Mr. Job's eyes but Ms. Zophar explains further that:

• Mr. Job is subject to the alternative minimum tax and under that tax, deductions that are subject to the 2% floor--like employees' business bad debts--are not deductible at all.

• Ms. Zophar agrees that Joseph Job is being severely hurt by his tax situation and offers sympathy.

Is there anything Mr. Job could have done other than just refusing this “benefit” when first offered by the employer?

Well:

• He could meet with the employer (perhaps with Ms. Zophar) to see if the §409A violations can be corrected.

• If they can't then Mr. Job should try to ascertain why the employer wants the deferred compensation arrangement. Perhaps the employer: (1) can't afford to expend the additional cash for salary; or (2) wants Mr. Job to have a financial stake in the company.

If these are the reasons and the violations cannot be corrected, then perhaps Mr. Job can convince the employer to pay the deferred amount immediately (or include it in his regular compensation) and Mr. Job can agree to lend the company an amount approximating the after tax amount of the additional pay.

Then:

•• Mr. Job will pay tax currently and there will be no deferred compensation subject to §409A.

•• The company will receive a current tax deduction for the additional compensation paid to Mr. Job. (Of course this assumes that the company is profitable--or expects to be in the future so as to be able to use the tax deduction. If Mr. Job learns that's not the case he should consider his own future with that company.)

•• The loan can be structured with an appropriate interest rate and provide appropriate repayment terms. This will: (1) give the company the cash it is seeking; and (2) give Mr. Job a financial stake in the company.

Deferred compensation arrangements have become quite complex and require review by tax professionals

(It must be kept in mind that other arrangements that defer income may fall within these rules including split-dollar life insurance arrangements, stock option plans with an exercise price at less than fair market at the time of the grant, stock appreciation plans, etc.)

For more information, in the Tax Management Portfolios, see Brisendine, Veal & Drigotas, 385 T.M., Deferred Compensation Arrangements, and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation, and ¶1170, Retirement and Death Benefits.