In earlier posts, we described how a closely-held business may use a nonqualified deferred compensation (“NQDC”) plan to retain the services of, and to incentivize, a key executive employee. We also discussed the various requirements that such a plan must satisfy in order to successfully defer the inclusion in the employee’s income of the compensation provided under the plan and the imposition of the associated tax liability.
Because a substantial amount of compensation may be deferred under a NQDC plan, the IRS has an interest in ensuring that the plan is structured and operated in a way that complies with the applicable rules and, thereby, warrants such deferral.
Toward that end, the IRS recently updated its Nonqualified Deferred Compensation Audit Techniques Guide (the “Guide”). The Guide offers some insight into how the IRS will apply these rules. Thus, any employer that has a NQDC plan in place should become familiar with the Guide and plan accordingly.
What is a NQDC Plan?
Under a NQDC plan, employers generally only deduct expenses when income is recognized by the employee.
NQDC plans typically fall into four categories:
- Salary Reduction Arrangements defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary.
- Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses.
- Supplemental Executive Retirement Plans, or SERPs, are plans maintained for a select group of management or highly compensated employees.
- Excess Benefit Plans are plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are statutorily limited.
Within these general categories are particular kinds of NQDC plans, including those that are based upon the value of the employer’s stock, such as stock options, stock appreciation rights, and phantom stock.
Most NQDC plans are unfunded because of the tax advantages they afford participants.
An unfunded arrangement is one where the employee has only the employer’s “mere promise to pay” the deferred compensation in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to transfer amounts to a “rabbi trust” that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, in order to help keep its promise to the employee.
If amounts are segregated or set aside from the employer’s creditors for the exclusive benefit of the employee – they are identified as a source to which a participant can look for the payment of his or her benefits (a “funded” arrangement) – the employee may have currently includible compensation.
NQDC plans must be in writing. While many plans are set forth in extensive detail, some are referenced by nothing more than a few provisions contained in an employment contract. In either event, the form (in terms of plan language) of a NQDC arrangement is just as important as the way the plan is carried out.
According to the Guide, a NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. Two principle issues stemming from deferred compensation arrangements include the doctrines of constructive receipt and economic benefit. The Guide also states that the examiner should address if deferred amounts were properly taken into account for employment tax purposes, given that the timing rules for income tax and for FICA/FUTA taxes are different.
When are deferred amounts includible?
According to the Guide, employees must include compensation in gross income for the taxable year in which it is actually or constructively received. Under the constructive receipt doctrine, income, although not actually in the taxpayer’s possession, is constructively received by an employee in the taxable year during which it is credited to the employee’s account, set apart for the employee, or otherwise made available so that the employee may draw upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
Establishing constructive receipt requires a determination that the recipient had control of the receipt of the deferred amounts and that such control was not subject to substantial limitations or restrictions. According to the Guide, it is important to scrutinize all plan provisions relating to each type of distribution or access option. It also is imperative, the Guide states, to consider how the plan has been operating regardless of the existence of provisions relating to the types of distributions or other access options. The Guide identifies certain devices, such as credit cards, debit cards, and check books, that may be used to grant employees unrestricted control of the receipt of the deferred amounts. Similarly, permitting employees to borrow against their deferred amounts may achieve the same result.
Under the economic benefit doctrine, if an individual receives any economic or financial benefit as compensation for services, the value of the benefit is currently includible in the individual’s gross income if the employee has a non-forfeitable interest in the benefit.
If property is transferred to employee as compensation for services, the employee will be taxed at the time of receipt of the property if the property is either transferable or not subject to a substantial risk of forfeiture. If the property is not transferable and subject to a substantial risk of forfeiture, no income tax is incurred until the property is not subject to a substantial risk of forfeiture or the property becomes transferable.
Property is subject to a substantial risk of forfeiture if the individual’s right to the property is conditional on the future performance of substantial services, or if rights in the transferred property are conditioned upon the occurrence of a condition related to a purpose of the transfer.
In general, property is considered transferable if a person can transfer his or her interest in the property to anyone other than the transferor (usually the employer) from whom the property was received.
General Audit Steps
The Guide explains that issues involving constructive receipt and economic benefit generally will present themselves in the administration of the plan, in actual plan documents, employment agreements, deferral election forms, or other communications (written or oral, formal or informal) between the employer and the employee.
The Guide directs examiners to ask the following questions and to request documentary substantiation where appropriate:
- Does the employer maintain any qualified retirement plans?
- Does the employer have any plans, agreements, or arrangements for employees that supplement or replace lost or restricted qualified retirement benefits?
- Does the employer maintain any NQDC arrangements, or any trusts, or separate accounts for any employees? If yes, the examiner should obtain complete copies of each plan including all attachments, amendments, restatements, etc.
- Do employees have individual employment agreements?
- Do employees have any salary or bonus deferral agreements?
- Does the employer have an insurance policy or an annuity plan designed to provide retirement or severance benefits for executives?
- Are there any board of directors’ minutes or compensation committee resolutions involving executive compensation?
- Is there any other written communication between the employer and the employees that sets forth “benefits,” “perks,” “savings,” “severance plans,” or “retirement arrangements”?
When reviewing the answers and documents received in response to these questions, examiners are instructed to look for indications that –
A. the employee has control over the receipt of the deferred amounts without being subject to substantial limitations or restrictions. If the employee has such control, the amounts are taxable under the constructive receipt doctrine. For example, the employee may borrow, transfer, or use the amounts as collateral, or there may be some other signs of ownership exercisable by the employee, which should result in current taxation for the employee; or
B. amounts have been set aside for the exclusive benefit of the employee. Amounts are set aside if they are not available to the employer’s general creditors if the employer becomes bankrupt or insolvent. Examiners are also asked to confirm that no preferences have been provided to employees over the employer’s other creditors in the event of the employer’s bankruptcy or insolvency. If amounts have been set aside for the exclusive benefit of the employee, or if the employee receives preferences over the employer’s general creditors, the employee has received a taxable economic benefit. Examiners are told to verify whether the arrangements result in the employee receiving something that is the equivalent of cash.
In addition to providing the “general audit steps” described above, the Guide advises examiners to interview the employer-company personnel that are most knowledgeable on executive compensation practices, such as the director of human resources or a plan administrator.
Examiners, the Guide says, should determine who is responsible for the day-to-day administration of the plans within the company. For example, who processes the deferral election forms and maintains the account balances?
Examiners are also instructed to review the deferral election forms and to determine if changes were requested and approved. They are told to review the notes to the company’s financial statements, as well as any materials that are disclosed to shareholders if they are asked to vote on a compensation plan.
Examiners are asked to determine whether the company paid a benefits consulting firm for the executive’s wealth management and, if so, to review a copy of the contract between the consulting firm and the corporation. They must determine who is administering the plan, what documents were created by the administrator, and who is maintaining the documents.
In addition, examiners are directed to review the ledger accounts/account statements for each plan participant, noting current year deferrals, distributions, and loans. They are told to compare the distributions to amounts reported on the employee’s Form W-2 for deferred compensation distributions, and to determine the reason for each distribution. They are instructed to check account statements for any unexplained reduction in account balances, and to review any distributions other than those for death, disability, or termination of employment.
IRC § 409A
Finally, the Guide reminds examiners that, under Section 409A, all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are satisfied.
Forewarned is Forearmed
It may sound trite, but it is preached every week in this blog.
If a closely held-business knows what the IRS is looking for when it examines a NQDC plan, then it knows what provisions to include in the plan, what pitfalls to avoid, and what documentation to prepare and maintain. In this way, it can proceed with confidence that the plan it has implemented will withstand IRS examination and will deliver the anticipated benefits to its key employee.