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Basic Types of Non-qualified Deferred Compensation
• Type I: Unfunded Bare Contractual Promise Plan Employee bears all risk
• Type II: Funded Company Account Plan Limited Protection:
• The employer may invest deferred amounts
• The employer may obtain life insurance to fund payment on death
• A contract can be guaranteed by third parties
• Type III: Segregated Asset Plan Must meet requirements of §83
• Subject to a substantial risk of forfeiture
As a general creditor, the employee is at risk, concerning the deferred benefits, and depends upon the survival and soundness of the company. If the company goes bankrupt, or if all company assets and income become subject to the claims of creditors, the employee may lose some or all of the deferred benefit. It is the employer’s “bare-bones promise to pay” that “funds” the employee’s deferred benefit. To be able to achieve deferral, the employee must be willing to take the risk of being a general creditor of the employer. While every company expects to exist in near perpetuity, there are enough bankruptcies to require serious assessment of this probability.
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Funded Company Account Plan – Type II
Although deferred cash compensation arrangements usually are unfunded and evidenced by a mere contractual promise of the employer, such agreements may also be funded by company assets or bookkeeping accounts. Financed plans certainly raise the specter of constructive receipt and thus tax-ability to the employee. However, with careful planning, employee taxation can be avoided.
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Ownership & Segregation
The tax treatment of the employer and employee will vary based on how the deferred amounts in a funded plan are segregated and to whom they belong. If funds are set aside, they should belong to the employer, not the employee.
Funded Benefits Subject to Forfeiture
Even if the funds are improperly segregated and necessarily “belong” to the employee all is not lost. If the funded benefits are subject to a substantial right of forfeiture, employee taxation can still be deferred with appropriate action (See discussion of Type III plans and §83). The tax consequences of a non-qualified deferred compensation plan, except for incentive stock option plans, are initially determined based upon whether the plan is funded or unfunded. If the plan is funded with assets outside the company, then the next issue is whether the employee’s interest in the plan is forfeit-able or unenforceable.
Bookkeeping Reserve or Separate Account
Although the employer may not transfer assets to escrow or trust (and may not give the employee a collateral interest or negotiable instrument), the employer may, under limited circumstances, designate some of its assets as a “deferred compensation fund.” Even if the deferred amounts are credited to a bookkeeping reserve or also placed in a separate account, so long as the funds belong to the employer and are subject to claims by the general creditors of the employer, deferral will still result (R.R. 60-31).
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Setting Up Accounts
The assets must remain solely the property of the employer, and designation of those assets as a fund designed for future payment of deferred compensation liabilities may not, in any way, create any rights of the employee. Funds set aside for this purpose should be labeled “special account” or a similar designation on the company books to avoid any indication that those funds “must” be used for payment of deferred compensation. Similarly, the corporation should acknowledge, by Board of Directors resolution, that the funds set aside are available for paying deferred compensation liabilities or any other liabilities of the corporation.
Employee Still Bears Economic Risk
Because it is necessary that the deferred amounts remain subject to the general creditors of the employer to achieve deferral for tax purposes, the economic viability of the employer must be weighed carefully.
There are methods available that have been approved by the IRS to afford the employee some limited protection. Examples are:
Investment of Deferred Amounts
Based on R.R. 60-31, it appears clear that the employer may invest deferred amounts and the employee will still qualify for tax deferral. Although invested amounts must remain subject to the claims of general creditors of the employer, an investment arrangement offers the employee some protection in that; if the employer invests wisely, the plan will increase the number of assets available to the employer to pay the deferred amounts. According to the IRS, the employer cannot be specifically required to hold any particular asset as a funding device, and the employer must retain the right to veto any employee investment direction. 8-16
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Disclaimer: John Wolf and paystubmakr.com are making a total effort to offer accurate, competent, ethical HR management, employer, and workplace advice. We do not use the words of an attorney, and the content on the site is not given as legal advice. The website has readers from all US states, which all have different laws on these topics. The reader should look for legal advice before taking any action. The information presented on this website is offered as a general guide only.