I. When are deferred amounts includible in an employee’s gross income?
a. Constructive Receipt Doctrine — Unfunded Plans Cash basis taxpayers must include gains, profits, and income in gross income for the taxable year in which they are actually or constructively received. Under the constructive receipt doctrine [codified in IRC § 451(a)], income although not actually in the taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. See § 1.451-2(a) of the regulations.
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. It is important to scrutinize all plan provisions relating to each type of distribution or access option. It also is imperative to consider how the plan has been operating regardless of the existence of provisions relating to the types of distributions or other access options. Devices such as credit cards, debit cards, and check books may be used to grant employees unrestricted control of the receipt of the deferred amounts. Similarly, permitting employees to borrow against their deferred amounts achieves the same result. In many cases, the doctrine of constructive receipt defeats the objective of deferring income.
b. Economic Benefit — Funded Plans Under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual’s gross income. More specifically, the doctrine requires an employee to include in current gross income the value of assets that have been unconditionally and irrevocably transferred as compensation into a fund for the employee’s sole benefit, if the employee has a non-forfeitable interest in the fund.
IRC § 83 codified the economic benefit doctrine in the employment context by providing that generally if property is transferred to a person as compensation for services, the service provider 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.
For purposes of IRC § 83, the term “property” includes real and personal property other than money or an unfunded and unsecured promise to pay money in the future. However, the term also includes a beneficial interest in assets, including money that is transferred or set aside from claims of the creditors of the transferor, for example, in a trust or escrow account.
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 on the nonperformance of services. In addition, a substantial risk of forfeiture exists if rights in the transferred property are conditioned upon the occurrence of a condition related to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur.
Property is considered transferable if a person can transfer his or her interest in the property to anyone other than the transferor from whom the property was received. However, property is not considered transferable if the subsequent transferee’s rights in the property are subject to a substantial risk of forfeiture.
NOTE: The cash equivalency doctrine must also be considered when analyzing a NQDC arrangement. Under the cash equivalency doctrine, if a solvent obligor’s promise to pay is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in a like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation. More simply, the cash equivalency doctrine provides that, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income.
II. When are deferred amounts deductible by the employer?
The employer’s compensation deduction is governed by IRC §§ 83(h) and 404(a)(5). In general, the amounts are deductible by the employer when the amount is includible in the employee’s income. Interest or earnings credited to amounts deferred under nonqualified deferred compensation plans do not qualify as interest deductible under IRC § 163. Instead, it represents additional deferred compensation deductible under IRC § 404(a)(5).
III. When are deferred amounts taken into account for employment tax purposes?
Note: The timing of when there is a payment of wages for FICA and FUTA tax purposes is not affected by whether an arrangement is funded or unfunded. However, whether an amount is funded is relevant in determining when amounts are includible in income and subject to income tax withholding.
NQDC amounts are taken into account for FICA tax purposes at the later of when the services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts in a later calendar year. Thus, amounts are subject to FICA taxes at the time of deferral, unless the employee is required to perform substantial future services in order for the employee to have a legal right to the future payment. If the employee is required to perform future services in order to have a vested right to the future payment, the deferred amount (plus earnings up to the date of vesting) is subject to FICA taxes when all the required services have been performed. FICA taxes apply up to the annual wage base for Social Security taxes and without limitations for Medicare taxes.
NQDC amounts are taken into account for FUTA purposes at the later of when services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts up to the FUTA wage base.
c. Income Tax Withholding
Employers are required to withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee.
d. Interest Credited to Amounts Deferred
In general, the non-duplication rule in Treas. Reg. § 31.3121(v)(2)-1(a)(2)(iii) operates to exclude from wages interest or earnings credited to amounts deferred under a NQDC plan. However, Treas. Reg. § 31.3121(v)(2)-1(d)(2) limits the scope of the non-duplication rule to an amount that reflects a reasonable rate of return.
In the context of an account balance plan, a reasonable rate of return is a rate that does not exceed either the rate of return on a predetermined actual investment or a reasonable rate of interest. Examples of a reasonable rate of interest are Moody’s Average Corporate Bond Yield and the rate of total return on the employer’s publicly traded common stock. Fixed rates are permitted as long as the rate is reset no later than the end of the fifth calendar year that begins after the beginning of the period for the amount deferred. For further information on reasonable rates of return please see examples in Treas. Reg. § 31.3121(v)(2)-1(d). In the context of a plan that is not an account balance plan, the non-duplication rule only applies to an amount determined using reasonable actuarial assumptions.
An account balance plan segregates each employee’s deferred compensation account balance on the company’s books. An accounting record (an account) is kept for each participant. The amount an employee elects to defer is credited to his account, as are the related earnings. The employee’s future payments under the plan are based on the amounts credited to his account as deferred compensation and the income credited to the employee’s account. See Treas. Reg. § 31.3121(v)(2)-1(c)(1)(ii). This is generally a bookkeeping entry only.
Amounts are taken into account for an account balance plan at the later of when the services are completed, or when there is no substantial risk of forfeiture. See Treas. Reg. § 31.3121(v)(2)-1(e)(1).
A non-account balance plan will not have “hypothetical” bookkeeping accounts that record the employee’s deferrals and employee “contributions” and investment earnings. The amount deferred for a period is not necessarily an amount the worker has elected not to receive. Rather, the amount deferred, and thus required to be taken into account, is the present value of the payments the plan participant has a right to receive in the future. See Treas. Reg. 31.3121(v)(2)-1(c)(2)(i). Conceptually, the plan is similar to a defined benefit plan. Thus, if a NQDC plan credits the deferral with excessive interest, or pays benefits based on unreasonable actuarial assumptions, additional amounts are taken into account when the excessive or unreasonable amounts are credited to the participant’s account. If the employer does not take the excess amount into account, then the excess amount plus earnings on that amount are FICA taxable upon payment.
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