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Segregated Asset Plan  Type III  

Suppose you keep the deferred amounts in an account that belongs to the employee, is separate from the company’s funds, and is not accessible to the employer’s general creditors. In that case, the deferred amount is considered taxable at present. Nonetheless, it is possible to separate an amount in an account that is not accessible to the employer’s creditors and avoid employee taxation as long as you meet the standards outlined in §83.

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Section 83 Approach

There is a limited exception to the requirement that deferred compensation benefits must be “unfunded” (or funded exclusively from the general assets of the corporation). That is called the “Section 83” approach. Under this approach, you transfer funds to cover the payment of future obligations to an outside account. However, the benefits are subject to a “substantial risk of forfeiture,” as defined under Reg. §1.83(c)(1). This approach also requires that the funding arrangement qualify as a “transfer” of “property” under §83

 

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Section 83

Sometimes referred to as the “restricted property” provision, §83 provides the rules for the taxation of stock or other property that is transferred, subject to restrictions, as compensation for services rendered by employees. While drafted with stock and stock options plans as the primary target, §83 also applies to funded deferred compensation plans. It embraces all real and personal property. However, it does not apply to unfunded plans or qualified retirement plans. For this section to apply the property must be transferred for the performance of services.

Publication 535 (2017), Business Expenses, By IRS

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Tight Rope Format

By actually funding the liability (but making the liability itself contingent on future services), the employer walks the thin line between a “vested” right to an unfunded obligation and a completely “non-vested” right to an actual fund (in a trust or escrow). You need to be highly cautious when walking this thin line.

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ERISA Question

No trust or escrow should be used, and future deferred compensation benefits should be made subject to a substantial risk of forfeiture. Also, the “Section 83″ approach has not been tested under ERISA reporting requirements. It is possible that §83” funding” of a deferred compensation plan would trigger the full array of ERISA reporting and other requirements.

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Transferable or Not Subject To A Risk of Substantial Forfeiture

 You can govern plans funded using segregated assets by the rules of §83 that apply to property transfers for services. Under §83(a), the executive is taxable on a funded plan when the right to such funds is either:

(a) Transferable, or

(b) Not subject to a risk of substantial forfeiture.

Note the dual criteria of transferability and lack of substantial restriction. A property is transferable only if the rights of a transferee are not subject to a significant risk of forfeiture. From a practical viewpoint, therefore, while the statute sets two criteria for the recognition of taxable income, there is only one – the presence or absence of a substantial risk of forfeiture. Section 83(c)(1) provides that rights are subject to a significant risk of seizure when full enjoyment is dependent on the future performance (or refraining from undertaking) of substantial services by any individual. Such a threat does not exist if the forfeiture occurs only on death, disability, criminal activity, or violation of a covenant not to compete. (See Reg. §1.83).

 

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Substantial Restrictions

Some examples of significant restrictions might be:

Redemption or Forfeiture

Transferring property to an employee subject to a binding commitment to resell the property to the employer at its original value or even forfeit the property entirely if the employee leaves employment for any reason during a test period would be a substantial restriction. To the extent that rights to benefits are profitable, no immediate help is derived, even though:
(a) The employer acknowledges the liability of benefit payment by setting up a liability account on the employer’s balance sheet, called a “deferred compensation account,” on behalf of the employee; and
(b) The employee has a legal right to the benefits as long as the employee continues to work for the employer until retirement (or until the end of the deferral period).

 Related Condition  to a Purpose of the Transfer

A requirement that property transferred to an employee be returned if the total earnings of the company do not increase could be a condition related to the purpose of the transfer.

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Noncom petition

Factors that may be taken into account in determining whether a covenant-not-to-compete constitutes a substantial risk of forfeiture are the age of the employee, the availability of alternative employment opportunities, the likelihood of the employee’s health, and the practice of the employer to enforce such agreements. See  Cornell University

Consultation

Property transferred to a retiring employee subject to the sole requirement that it be returned unless he renders consulting services upon the request of his former employer will not be considered subject to a substantial risk of forfeiture unless he is in fact expected to perform “substantial services.” See Cornell University

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Time Alone is Not Enough

The IRS takes the position that:

• If deferred amounts are placed in an irrevocable trust or escrow account
• Are not subject to a substantial risk of forfeiture, but only to the mere passage of time, then the deferred amounts will be currently taxed to the employee (See E.T. Sproull v. Commissioner 16 T.C. 244 (1951) and Jacuzzi v. Commissioner 61 T.C. 262 (1972)).

Realization & Taxation

When the property becomes transferable or not subject to a substantial risk of forfeiture, the employee is then taxed on the excess of the fair market value of the property received over the amount the employee paid for that property. If the recipient of the property sells or otherwise disposes of it before it is released from the substantial risk of forfeiture, income is realized at that time.

Group-Term Life Insurance IRS

30-Day Election Period

The employee may elect to be taxed at the time that his or her rights to the property become transferable or are no longer subject to a substantial risk of forfeiture. Such an election must be made within 30 days after the transfer or grant of the funded deferred compensation arrangement.

Deduction Allowed

Section 83 allows a deduction to the employer when the employee realizes income as a result of:

(1) Receiving nonprofitable property,

(2) The property becomes nonprofitable because it is relieved of forfeiture restrictions, or

(3) The employee elects to report the income in the year the property is received.

Timing

Under §162 a deduction is allowed in an amount equal to the income reported by the employee. However, the taxable year for the employer’s deduction is the taxable year in which the taxable year of the employee ends.

Withholding

Also, the employer must deduct and withhold income taxes as required by §3402 otherwise the deduction will be disallowed (Reg. §1.83-6(a))2)). 8-21

Thanks for reading, Paystubs team hope that you enjoyed learning about-Qualified Deferred Compensation 

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