Accumulated Earnings and Deferred Compensation

Design of nonqualified plans

When designing a nonqualified deferral compensation (NQDC) plan, there are three points that should be considered to assist in avoiding current income taxation for the employee.

1. constructive receipt
2. economic benefit
3. risk of forfeiture

Constructive receipt. Under the constructive receipt doctrine, an amount may become currently taxable to a cash-basis taxpayer before it is actually received. The tax code states that cash-basis taxpayers should include amounts as income when they are actually or constructively received.

Cash-Basis Taxpayer: a taxpayer who reports their income and deductions in the year that they are actually paid or received by the taxpayer, regardless of when these transactions occurred (income earned, expenses incurred). Most individual taxpayers are cash-basis.

The amount will be considered in constructive receipt and will be taxable if it is:

• currently credited to the employee’s account
• set aside for the employee
• otherwise made available to the employee

Once income is unconditionally subject to the taxpayer’s demand, that income must be reported even if the employee chooses not to currently accept the income. Thus, corporate payments to an executive who is a cash-basis taxpayer will be currently taxable as soon as the money is made available to the taxpayer (as long as there are no restrictions on the right to be paid).

IRS rules. The IRS has issued a number of revenue procedures that specifically deal with guidelines to avoid constructive receipt – Rev. Proc. 71-19 and Rev. Proc. 92-65. There are three criteria that must be met to avoid constructive receipt in a nonqualified deferred plan (NQDP).

Basically, the IRS requires that:

1. The election to defer must be made before the year in which the compensation is earned. The plan, including amount to be paid, payment schedule, and limitation on receipt must be in writing.

2. There must be a substantial limitation or restriction over the receipt. Income will not be considered constructively received if the employee's control over the receipt is subject to a substantial limitation or restriction. A common substantial limitation is the passage of time (i.e., the employee cannot receive the money until retirement, termination, disability, death, or an unforseen emergency).

3. The plan must remain unfunded. To successfully avoid constructive receipt of NQDC, the plan must remain unfunded. A plan is unfunded when there are no formal assets set aside in trust to pay plan benefits. Ghost accounts are maintained and cash contributions are only made to pay benefits. The employer may establish informal funding by purchasing mutual funds, life insurance, etc. as a reserve fund to cover their liability, as long as the fund remains a general asset of the corporation.

   Any informal assets associated with the plan must be subject to the corporation's general creditors. If the plan is unfunded, constructive receipt will be avoided, even if the employee is 100% vested in his benefits (i.e., the benefits are non-forfeitable except for the employer's refusal or inability to pay). The employee, in essence, has an unsecured promise from the employer to pay the benefits, and is put in the position of a general creditor. There are techniques that allow companies to dedicate assets to the plan (in particular utilizing Rabbi Trusts) that can improve the security level for the participating executives, without incurring immediate taxation.

The above does not prevent the employer from establishing informal funding by purchasing mutual funds, life insurance, etc. as a reserve fund to cover their liability, as long as the fund remains a general asset of the corporation.

The IRS has stated that it will not issue favorable rulings on plans that don't satisfy the guidelines contained in these two revenue procedures (Rev. Proc. 71-19 and Rev. Proc. 92-65).