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Economic benefit doctrine.
The economic benefit doctrine requires that any benefit granted to an individual that has economic or financial value be included as compensation for income tax purposes in the year the benefit is granted. If something of value is granted to an employee that has a real and measurable value in terms of money, then the current value is taxable to the employee. This is true even if the employee doesn't have a current right to receive the property in question.
Q: When is the economic benefit doctrine most frequently applied?
A: In cases involving a funded trust arrangement in which funds are irrevocably set aside for the benefit of the taxpayer.
For example...
In a famous court case ( Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d. per curiam, 194 F.2d 541 (6th Cir. 1952) ), an amount of money was set aside in an irrevocable trust for an employee. The trustee was directed to pay out principal and interest from the trust in subsequent years. The money in the trust was for the sole benefit of the employee, and non-forfeitable. The trust agreement contained no restrictions on the taxpayer’s right to assign or otherwise dispose of his interest in the property.
Although the employee didn’t have the right to draw on the money immediately, the courts ruled that the trust’s value was immediately taxable to the employee since an economic benefit was conferred upon him. As soon as there was no manner in which the trust value could be forfeited, it became taxable to the employee.
Q: What is the key to avoiding the imposition of the economic benefit doctrine?
A: The existence of a substantial risk of forfeiture. It is necessary for the plan to remain “unfunded.”
But an unfunded plan does not prevent an employer from purchasing mutual funds, life insurance, etc., as a reserve fund to cover its liability as long as the fund remains a general asset of the organization.
Risk of forfeiture. Both of the above design considerations emphasize that there should be a substantial risk of forfeiture in designing an NQDC plan. The best way to ensure this is to keep the plan unfunded. If there are assets in the plan, these assets must be subject to the general creditors of the organization in case of bankruptcy.
A New Standard for Deferred Compensation
With the enactment of Section 409A of the Internal Revenue Code in October 2004 as part of the American Jobs Creation Act, deferred compensation must meet additional requirements. Section 409A provides for immediate taxation and an additional 20% tax on NQDC that does not conform with specified election, distribution, and other requirements. The rules apply to any deferred compensation earned and vested under a NQDC plan after December 31, 2004. In addition to traditional elective deferral plans and SERPs, Section 409A can cover many arrangements that would not normally be considered "NQDC," such as:
- stock options and other forms of equity compensation
- severance agreements
- bonus plans
- post-retirement reimbursements
On April 10, 2007, the IRS issued Section 409A final regulations effective January 1, 2008 and they included:
- The election to defer compensation must continue to be made before compensation is earned.
- Changes in time and form of distribution may not take effect until at least 12 months after the date on which the election is made.
- Distributions are allowed only upon separation of service, disability, death, a time specified in the plan at the date of deferral, a change of company ownership, or the occurrence of an unforeseeable emergency.
- Whether a participant or beneficiary is faced with an unforeseeable emergency depends on the facts and circumstances. However, a distribution is not on account of an unforeseeable emergency to the extent that the emergency can be relieved through reimbursement or compensation from insurance, liquidation of the participant's assets, or cessation of deferrals under the plan.
- A distribution on account of an unforeseeable emergency must not exceed the amount reasonably necessary to satisfy the emergency need. The law requires compliance with numerous and complex regulations and dramatically affects valuations.
Memory Jogger
Economic benefit is avoided by: