Non-qualified Deferred Compensation effects payroll. 2021

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Timing

The deferral must occur before the employee has a right to the income. Where compensation is deferred after all services have been performed and deferral is attempted after the agreed payment date, the income will be subject to current taxation (Joseph Frank, 22 T.C. 945 (1954) and Richard R. Deupree, 1 T.C. 113 (1942)). The chances of the constructive receipt doctrine being applied can best be minimized if the individual decides to enter into the arrangement before the amount is even earned (Ray Robinson, 44 T.C. 20).

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Note: Some conservatively interpret this as before January 1 of the year on which the deferred compensation is agreed upon citing R.R. 69-650 which indicated that a decision by December 31 was required in connection with compensation to be earned during the following year.

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After-the-Fact Contract

An agreement entered into after the services have been rendered, but before the compensation becomes payable might be an effective deferral if the arrangement is done in good faith. See Howard Veit, 8 T.C.M. 919 (1949); Ernest K. Gann, 31 T.C. 211; Rev. Proc. 71-19; and R.R. 67-449. If the Service feels that circumstances do not reflect good faith, they will attempt to apply the constructive receipt doctrine (Willits v. Commissioner 50 T.C. 602 (1968), acq.). Certainly, the more time between the decision and the event, the less likely there is to be a problem with the IRS. R.R. 71-19 sets forth the conditions under which IRS will issue an advance ruling in this matter.

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Amendment to Existing Contract

Nevertheless, an amendment to an existing deferred compensation arrangement to further defer a payment date will not constitute constructive receipt of the payment if the amendment is made before the time in which a taxpayer commits to receiving the deferred amounts. (Goldsmith v. U.S. 586 F.2d 810 (Ct. Cl. 1978))

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Economic Benefit

Another tax principle closely allied with the doctrine of constructive receipt is the theory of economic benefit. This theory of income taxation has been applied by the courts to impose current tax liability on taxpayers who receive an “economic benefit” or a “cash equivalent.” A receipt is not the issue “something” generally has been received. The issue is whether the “something” has a market value.

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Has Something of Value Been Transferred?

The economic benefit concept is that income may be received in-kind as well as in cash. Under §61, gross income means “all income from whatever source derived.” including this as income a property interest having good market value. Under this concept, the IRS attempts to interpret an action by the employer as resulting in something of the market value being given to the employee.

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For example:

Insurance Coverage Has a Calculable Value

A simple promise made by the company to pay income in the future may have no economic value (R.R. 60-31). In case that the payment is funded through a “split-dollar” insurance contract providing a death benefit, then an economic value can be calculated, using a yearly basis by comparing the employee’s cost with the imputed value of the premium. The employee got the promise of an insurance company to pay him benefits in the future. It is the promise of an insurance company and not the mere promise of the employer that has economic value (see Brodie, 1 T.C.275 (1942)).

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Segregated Funds Have Immediate Economic Value

If an employer sets up a trust or escrow account to which the employee has nonprofitable rights but which is not currently made available to him, then the amount of an annual contribution will be construed to be an economic benefit and the employee will be taxed that year on the value of that contribution. Establishing the trust or escrow places the funds beyond the range of corporate creditors and the risks of the business. The employer’s promise is a secured one and now has an economic or financial value that can be measured. Time alone is not deemed to be a “substantial restriction.” Thus, the employee has current taxable income.

Value v. Control

The economic benefit is not concerned with the taxpayer’s control over income but rather what has value and thus may constitute income. The basic requirements for the application of the doctrine to deferred compensation arrangements are:

(1) The benefit or interest transferred must have an ascertainable fair market value; and

(2) The benefit or interest must be nonprofitable or transferable.

Revenue Ruling 60-31

The most comprehensive statement of the IRS’s position on deferred compensation is R.R. 60-31. This ruling sets forth five factual patterns and speaks to the taxability of each.

Situation 1

The taxpayer/employee and his employer enter into an arrangement whereby the taxpayer is entitled to receive certain amounts of additional compensation that would be credited to a bookkeeping reserve to be accumulated and paid in annual installments equal to one-fifth of the reserve. The payments will begin only after termination of the employment of the taxpayer, the taxpayer becoming a part-time employee, or the taxpayer becoming partially or disabled. The reserve amounts are only a contractual obligation, and there is no intent that the employer would hold the amounts in trust for the Benefit of the employee. This additional compensation was held to be taxable only when received by the taxpayer.

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Situation 2

The employer established a plan whereby a percentage of the earnings of the company, were designated for division among the participants in a deferred compensation program. The amount was not currently paid to the participants but was set aside on the company’s books as a separate account for each participant. Each account was also credited with the net earnings realized from investing any portion of the amount in an employee’s account. Distribution was made when the employee reached the age of 60, was no longer employed by the company, or became disabled. Payments were contingent on a noncompetition agreement and the employee making himself available for consultation after retirement. Such amounts were held to be nontaxable until received.

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Situation 3

The taxpayer entered into a publishing agreement with a company for the payment of royalties. An additional agreement was signed the same day providing that the publisher would not pay the taxpayer more than $100 in any one calendar year. Any sum more than this amount was to be carried over into succeeding accounting periods. These amounts were not segregated from the publishing company’s other resources. The agreements were entered into before the royalties were earned and before the time the services were performed. The ruling holds that the payments were taxable only upon receipt.

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Situation 4

A football player entered into a contract under which he was to receive a bonus of $150. The contract provided that this sum was to be paid to an escrow agent designated by the football player, and the escrow agent agreed to pay this sum plus interest to the taxpayer in payments over a period of five years. The ruling holds that the taxpayer was taxable in the year the club unconditionally paid the amount over to the escrow agent.

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Situation 5

The Service held that the profit-sharing arrangement between a boxer and a promoter constituted a joint venture, and the taxpayer’s share of the receipts was currently taxable in his income under the general theory of partnership taxation 3.

Employer-Employee Relationship

Situation 5 above points out that the successful structuring of a deferred compensation arrangement is dependent on an employer-employee or at least a principal-agent relationship. Where a joint venture or partnership exists, an agreement between the partners that one of the partner’s shares of profits will be distributed at a later date does not defer tax on such share until the later date because income is taxable to a partner or venture when the partnership or venture receive it. 8-10

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