Non-Qualified Deferred Compensation

Deferred Compensation Arrangements: An Overview of Nonqualified Deferred Compensation Arrangements

The provision of compensation and benefits to owner-employees, key executives, and other highly skilled personnel is a persistent concern for organizations across various sectors. The increasingly stringent regulatory environment related to qualified retirement plans, coupled with the associated administrative costs, anti-discrimination regulations, and caps on contributions and benefits, has rendered executive benefit planning via nonqualified arrangements increasingly appealing.

Deferred compensation arrangements present employers with a nonqualified planning tool designed to reward selected individuals, thereby assisting them in achieving financial security in the contexts of retirement, death, or disability. Participants typically include one or more highly compensated employees, and in certain cases, independent contractors may also qualify. A nonqualified arrangement may serve as a supplement to or a replacement for a qualified retirement plan.

One of the primary benefits of such nonqualified arrangements is their inherent flexibility. Employers can offer generous benefits tailored to specific key employees, allowing for varying levels of benefits among different individuals. Furthermore, there are no government-imposed minimum vesting or funding standards, which facilitates the minimization of paperwork and administrative expenses.

These arrangements entail a contractual commitment between the employer and the participant, specifying the timing and conditions under which future compensation will be disbursed. When properly structured and administered, participants or their beneficiaries may defer federal income taxation on the deferred amounts until the benefits are disbursed. Given the serious tax implications that may arise from failure to adhere to applicable tax laws, it is imperative that any entity considering a deferred compensation arrangement consult with qualified tax and legal advisors to ensure compliance with the rigorous standards delineated in IRC §409A.

Distinctions Between Qualified and Nonqualified Plans

It is essential to discern the differences between nonqualified deferred compensation arrangements and qualified deferred compensation plans. A qualified plan encompasses pension, profit-sharing, or stock bonus plans that meet the qualification requirements set forth in IRC §401(a), with assets held in a tax-exempt trust under IRC §501(a) or allocated to life insurance and/or annuity contracts pursuant to IRC §403(a). Qualified plans receive approval from the Internal Revenue Service (IRS) and are issued a determination letter as evidence of their qualification.

Conversely, a nonqualified deferred compensation arrangement does not require IRS approval and is generally exempt from the qualification requirements applicable to qualified retirement plans. While qualified plans are subject to participation and eligibility criteria, employers utilizing nonqualified arrangements possess the latitude to discriminate in favor of selected employees. Additionally, when structured appropriately, nonqualified deferred compensation arrangements are not subject to the regulatory mandates of ERISA Title I.

The term "nonqualified deferred compensation" is frequently employed generically to describe a variety of arrangements.

Defined Benefit versus Defined Contribution

A defined benefit nonqualified deferred compensation arrangement stipulates that an employee will receive a predetermined sum for a specified duration or for their lifetime, commencing at retirement or another designated trigger date. Deferred amounts may also be articulated in defined contribution terms. In the event that an employee passes away after disbursements have commenced, remaining benefits are typically allocated to a designated beneficiary or the participant's estate.

True Deferral versus Salary Continuation

In its classical form, known as "true deferral," the arrangement allows employees to receive future compensation as a result of a current salary reduction or in lieu of a bonus or salary increase. In more contemporary practice, a “salary continuation” model has arisen, whereby the employer commits to providing future compensation in addition to current earnings, without reducing the employee's participation in the arrangement.

Suitability of Deferred Compensation

Deferred compensation is particularly advantageous under certain positive indicators:

1. The employer operates as a stable and profitable business with robust cash flow.

2. The employer seeks to provide benefits to a select group of management or highly compensated employees.

3. An owner-employee within a C corporation endeavors to enhance their compensation and benefits package while concurrently being in a higher tax bracket than the corporation.

4. The employer exhibits a need to attract, retain, or reward one or more key employees.

5. The participating employee has reached the maximum allowable contributions or benefits under the employer's qualified plan.

6. The employer does not maintain a qualified retirement plan and is disinclined to establish one.

It is important to note that deferred compensation is unsuitable for publicly traded employers that are either bankrupt, possess an "at-risk" defined benefit plan (typically defined as less than 80% funded), or have a plan that has terminated without adequate assets to satisfy all benefits. The Pension Protection Act prohibits such employers from establishing a reserve to fund deferred compensation benefits. If an affected employer proceeds to fund a deferred compensation benefit, the CEO and the other top four executives who benefit must report immediate income (to the extent vested at the time of funding), along with any applicable interest, and may incur a 20% penalty. Should the employer increase the compensation of affected executives to account for the tax and penalty implications, these gross-up amounts will also be subject to immediate taxation.

Design Considerations

A nonqualified deferred compensation arrangement constitutes a contractual agreement that commits to providing future benefits to one or more "top-hat" employees. These arrangements are characterized by their inherent flexibility, enabling the design to align with the specific goals and objectives of the business or the individual employees involved.

However, extreme caution is warranted when structuring a nonqualified deferred compensation arrangement that benefits a controlling shareholder of a corporation. It is crucial to consider the legal and tax implications of the business's structure. If the business operates as a partnership, a limited liability company treated as a partnership, or a corporation classified under Subchapter S, an owner-employee or controlling shareholder is generally precluded from benefiting from a nonqualified deferred compensation arrangement due to the pass-through nature of these entities for tax purposes. Conversely, if the business is structured as a corporation under Subchapter C, it is feasible to design a nonqualified deferred compensation plan that benefits the controlling shareholder.

Typical Goals for Businesses

Businesses generally seek to achieve one or more of the following objectives:

1. Recruit key employees.

2. Retain productive and profitable employees.

3. Provide incentives for outstanding performance.

4. Offer attractive retirement packages to key employees upon their retirement.

Typical Goals for Employees

Highly compensated employees frequently aim to secure future income while minimizing current tax liabilities, thereby enabling the deferred amounts and associated earnings to accumulate on a pre-tax basis.

Considerations in Drafting Arrangements

When drafting compensation arrangements, attorneys must consider several crucial factors:

- The eligibility criteria for key individuals, particularly their classification as members of the select group of management or highly compensated employees.

- The conditions that would lead to the forfeiture of benefits.

- The performance or service incentives upon which benefits are contingent.

- The vesting schedules for benefits.

- The limitations imposed by federal tax regulations.

Funded vs. Unfunded Arrangements

The distinctions between funded and unfunded arrangements warrant careful examination, particularly regarding their tax implications, which will be addressed in the "Participant Taxation" section.

Unfunded Arrangements

In unfunded arrangements, participants possess only a contractual right—an unsecured promise to receive future benefits. An arrangement is classified as unfunded if:

- No reserves are established to pay the promised benefits, or reserves exist but remain general assets of the employer, thus subject to claims from the employer's creditors.

- The employee lacks any current beneficial interest in any funds that have been set aside.

Funded Arrangements

In contrast, funded arrangements occur when the employer allocates specific assets to fulfill future obligations, designating the select employee as the beneficiary. These assets are protected from claims by the employer's general creditors, rendering the arrangement funded for tax purposes.

From an income perspective, a funded arrangement necessitates the inclusion of deferred amounts in the employee’s taxable income as soon as there is no longer a substantial risk of forfeiture. Consequently, nonqualified deferred compensation arrangements are typically structured as unfunded arrangements, frequently employing a rabbi trust to enhance the security of future payments.

Participants often express concerns about the security of nonqualified deferred compensation arrangements. They may fear that unfavorable business conditions, hostile takeovers, friendly business sales, recessions, or other shifts in circumstances could jeopardize the business’s capacity to disburse benefits as promised. As a fully secure fund may prompt immediate taxation, the planner's challenge lies in achieving a balance between financial security and tax deferral.

One financial instrument often utilized is known as a rabbi trust. This trust, named after a historical arrangement between a rabbi and their congregation, serves to hold assets in an irrevocable trust, thus placing them beyond the reach of the employer and any of the employer's successors. Such a structure provides participants with a degree of security while enabling tax deferral. The Internal Revenue Service (IRS) has recognized these trusts and has issued a model rabbi trust agreement (Rev. Proc. 92-64, 1992-2 C.B. 422).

While rabbi trusts generally provide protection against employer access to funds, it is important to note that these assets are not safeguarded from claims by the employer’s general creditors in the event of bankruptcy or insolvency. In such circumstances, a general creditor may assert claims against the rabbi trust. Consequently, the IRS has determined that the employee's entitlement to benefits is forfeitable, a consideration critical for achieving income tax deferral. As a result, a rabbi trust is classified as an unfunded nonqualified deferred compensation arrangement, meaning employees do not recognize taxable income until they receive payments under the plan, provided it complies with all stipulations of IRC §409A.

Conversely, a secular trust, distinguished from a rabbi trust, seeks to offer participants an enhanced level of security, albeit without the benefit of tax deferral. Contributions made to a secular trust, along with any earnings on those contributions, are typically included in the employee's gross income in the year in which they vest. Most secular trusts are designed to be insulated from claims by general creditors. Additionally, some secular trusts have provided for current distributions to cover taxes owed by the employee on deferred amounts.

The IRS has issued letter rulings that introduce significant complications to the common provisions found in many secular trusts. In one particular ruling, employees were taxed on current contributions while the employer was denied a current tax deduction, creating a scenario of "double taxation." The IRS ruled that no deduction was permissible due to the absence of a separate account for contributions. Furthermore, the IRS highlighted that the employer's ability to reallocate trust income from the accounts of employees not yet receiving benefits violated the requisite separate account principle. As a result, the employer is not eligible to claim deductions for contributions until participants begin to receive benefits. As a funded arrangement, a secular trust may also be subject to the regulatory provisions specified under ERISA Title I.

A secular trust may be advantageous when both the participant and the employer are prepared to navigate the potential tax and ERISA complexities to provide the participant with greater security against employer insolvency and other contingencies.

Fulfillment of Employer’s Deferred Compensation Obligations

Organizations that offer deferred compensation benefits typically allocate funds to meet future obligations. To prevent immediate taxation on contributions for the participant, the organization should retain all property during the accumulation period, exercising caution to ensure that no vested rights to any assets are conferred upon participants prior to the disbursement of benefits.

Life Insurance

Life insurance can serve as a viable method to "informally fund" an unfunded deferred compensation arrangement while maintaining income tax deferral. This cost-effective strategy can facilitate employers in meeting their promised benefits with minimal impact on future earnings. In this context, the selected employee is designated as the insured individual, with the employer acting as the policy owner, premium payer, and beneficiary. The policy, regarded as a business asset, remains accessible to creditors, and the employee holds no beneficial ownership rights to it. Employers often utilize various forms of permanent life insurance—such as universal life, variable life, whole life, or limited pay—to accumulate cash value, which can subsequently be utilized to satisfy benefit obligations. It is important to acknowledge, however, that loans and withdrawals may diminish both cash value and death benefits and could potentially result in tax implications.

The advantages of utilizing life insurance are considerable and diverse:

1. Cost Recovery: Employers may recover their plan costs and contributions through the death benefits associated with life insurance policies.

2. Availability of Funds: Life insurance proceeds assure that funds will be accessible to fulfill promised benefits, irrespective of the timing of death. This is contingent upon the claims-paying capacity of the insurer, provided that all premiums are paid timely and that there are no significant withdrawals, policy loans, or interest complications.

3. Tax-Deferred Accumulation: The cash value of a life insurance policy accumulates on a tax-deferred basis, unlike other investment vehicles that may necessitate the employer to incur tax obligations during the accumulation phase. It is essential to acknowledge that withdrawals and loans can diminish both the policy's cash value and the death benefit, with potential tax implications.

4. Flexibility: Life insurance policies incorporate various settlement options, nonforfeiture provisions, and features such as dividends or policy loans, which facilitate flexible accumulation and distribution. Nonetheless, these features may also lead to a reduction in the death benefit.

5. Tax-Free Death Benefits: Life insurance death benefits can be exempt from federal income taxation, provided that the employer adheres to the Notice and Consent requirements stipulated in IRC §101(j). Additionally, compliance with specific recordkeeping and reporting obligations is necessary.

It is prudent for financial planners to establish a "firewall" between the deferred compensation arrangement and the life insurance policy. The agreement between the employer and participant should not reference the life insurance policy, and the application for insurance should avoid any mention of the deferred compensation arrangement. In some scenarios, a deliberate mismatch may exist between the policy's face value and the employer's obligations.

However, there are two notable disadvantages associated with the use of life insurance to accumulate funds for benefit payments:

1. Limitations may apply to corporate deductions for interest paid on policy loans when the employer opts to borrow against cash values.

2. Specific regulations govern the taxation of life insurance proceeds when the employer serves as both the policy owner and beneficiary. These regulations are applicable to all employer entities, not solely corporations.

Despite the potential inclusion of certain death benefits in the employer's taxable income, the employer is entitled to a corresponding deduction for the amounts disbursed as income to the employee's beneficiaries under the terms of the nonqualified deferred compensation agreement.

Annuities: Income derived from an annuity owned by a corporation is subject to immediate taxation, lacking the opportunity for tax-deferred accumulation available with life insurance. Consequently, utilizing annuities to fund deferred compensation benefits results in a forfeiture of the tax-deferred advantage.

Mutual Funds: For employers and employees who are inclined toward the benefits and risks inherent in stock and bond market investments, mutual funds present a viable informal funding alternative. Although mutual funds provide professional management and diversification, it is important to recognize that diversification does not eliminate the risk of investment loss. Utilizing tax-exempt municipal bond funds can provide an equivalent of tax-free accumulation.

Participant Taxation: Comprehending the taxation of unfunded deferred compensation necessitates an understanding of two foundational tax principles: the economic benefit doctrine and the constructive receipt doctrine. Each principle delineates income that is taxable even if it has not been formally "received" by the taxpayer.

1. Economic Benefit Doctrine: Under this doctrine, when funds are irrevocably transferred for the benefit of an employee, the employee possesses an irrevocable right to future benefits, thereby conferring a current economic benefit that is subject to taxation. This doctrine typically does not apply when benefits are encumbered by the rights of the employer's creditors.

2. Constructive Receipt Doctrine: This doctrine establishes that if an employee has access to income, such income is deemed taxable even if the employee does not take possession of it. If an employee has the right to request income at any moment, it will be taxed immediately. Conversely, if the employee's right to income is subject to significant restrictions—referred to as "substantial risk of forfeiture" under IRC §409A—then the income is not considered constructively received and will not be taxed until it is actually received.

An unsecured promise to pay, as is typical in unfunded deferred compensation arrangements, generally does not trigger constructive receipt or render the promised amounts taxable. A substantial risk of forfeiture exists when the entitlement to compensation is contingent upon the performance of significant future services or the satisfaction of conditions relevant to the purpose of the compensation, thereby making the possibility of forfeiture substantial.

A covenant not to compete cannot be considered a substantial risk of forfeiture for the purposes of Section 409A. Deferred amounts in an unfunded arrangement—where no funds are specifically set aside for particular programs or payments—are generally taxable when actually or constructively received. In contrast, amounts set aside by the employer in a funded arrangement are typically included in the participant's gross income for the first taxable year in which the participant's rights are transferable or no longer subject to a substantial risk of forfeiture.

IRC Section 409A

Since 2005, IRC §409A has generally governed the taxation of nonqualified deferred compensation arrangements. If a nonqualified deferred compensation plan fails to meet the requirements of IRC §409A or is not operated according to these requirements, all amounts deferred under the plan for the taxable year and all prior taxable years become includible in gross income for the taxable year, to the extent that these amounts are not subject to a substantial risk of forfeiture and have not been previously included in gross income.

It is important to note that IRC §409A is not the only tax consideration in this area. The IRS has cautioned that deferred compensation not required to be included in income under IRC §409A may still need to be included under IRC §451 (the constructive receipt doctrine), the cash equivalency doctrine, IRC §83 (the economic benefit doctrine), or any other relevant provision of the Internal Revenue Code or common law tax doctrine. Therefore, it is essential for business owners to consult legal counsel when implementing any deferred compensation arrangement.

In the past, some deferred compensation arrangements contained design features known as "haircut provisions," which allowed participants to receive distributions ahead of their scheduled retirement or other distribution start dates. However, under IRC §409A, if a participant has early access to deferred amounts or prohibited control over them, the ability to defer income tax is lost. These amounts included in the participant's gross income are subject to an additional 20% penalty tax, plus interest.

Amounts deferred under a nonqualified deferred compensation arrangement are includible in the participant's gross income for all tax years in which those amounts are not subject to a substantial risk of forfeiture if the arrangement fails to meet any of three requirements: distribution requirements, no-acceleration-of-benefits requirements, and deferral election requirements. IRC §409A is a complex code section and should not be approached lightly. Final regulations were issued in 2007. For more information on technical guidance helping plan sponsors to properly administer a deferred compensation arrangement subject to IRC §409A, further resources are available.

457(f) Plans

IRC §457 governs nonqualified deferred compensation arrangements for employees of governmental and tax-exempt organizations. IRC §457(b) is known as an "eligible plan" of deferred compensation, and the rules of IRC §409A do not apply to it. Conversely, IRC §457(f) is referred to as an "ineligible plan" of deferred compensation, to which the rules of IRC §409A do apply. Ineligible deferred compensation plans governed by IRC §457(f) must comply with both the rules of IRC §409A and the specific rules applicable to ineligible plans for employees of governmental and tax-exempt organizations.

Under IRC §457(f), any deferred compensation is includible in a participant’s gross income in the first taxable year in which there is no substantial risk of forfeiture, even if the plan otherwise adheres to the IRC §409A rules. For the purposes of IRC §457(f), a substantial risk of forfeiture exists when the participant's rights to compensation are contingent upon the future performance of significant services.

For example, consider a tax-exempt organization that establishes a nonqualified deferred compensation plan for its key executives. If the plan features a 10-year cliff vesting schedule (with 0% vesting before 10 years of service and 100% vesting thereafter) and provides for distributions upon death, disability, separation from service with the employer, or at age 65, the deferred compensation would first be included in the key executives’ income when a distributable event occurs.

Under Internal Revenue Code (IRC) §457(f), deferred compensation is included in the taxable income of key executives on the date when there is no longer a substantial risk of forfeiture, such as after 10 years of service, even if this date precedes the executive's entitlement to a distribution under the relevant plan.

Separation Pay Plans: A separation pay plan that disburses payments solely upon involuntary separation or pursuant to a window program does not qualify for the deferral of compensation under IRC §409A, provided that the separation pay, or any applicable portion thereof, does not exceed two times the lesser of the following calculations: (1) the annual compensation based on the annual rate of pay for services rendered in the taxable year preceding the year of separation, adjusted for any anticipated increases that would have continued indefinitely had the individual not separated from service; or (2) the maximum compensation permitted under a qualified plan in accordance with IRC §401(a)(17) for the taxable year in which the separation occurs, which is set at $350,000 for 2025. Furthermore, the plan must stipulate that separation pay shall be disbursed no later than the last day of the second taxable year subsequent to the year of separation from service.

Stock Options and Stock Purchase Plans: Incentive stock options (ISOs) as outlined in IRC §422 and employee stock purchase plans under IRC §423 are not subject to the provisions of IRC §409A. Nonqualified stock options (NSOs) are likewise exempt from these regulations, contingent upon the condition that they are not issued at a discount.

Stock Appreciation Rights: Rights to compensation based on the increase in value of a specified number of shares of the service recipient’s stock do not constitute deferred compensation subject to IRC §409A if specific requirements are satisfied.

Reimbursements and Other Separation Payments: The following reimbursements and payments from the service provider to the service recipient are excluded from the scope of IRC §409A: reimbursements that are not otherwise excludable from gross income for expenses that the service provider may deduct as business expenses; reasonable outplacement expenses and reasonable moving expenses incurred as a result of the termination of services; medical benefits provided under a separation pay arrangement; and certain in-kind payments from the service recipient to the service provider, provided such payments are not otherwise governed by IRC §409A.

Split-Dollar Arrangements: For further information, refer to the section regarding IRC §409A's implications for split-dollar arrangements.

Funding Restrictions Implemented by the Pension Protection Act (PPA):

The PPA established specific limitations on the funding of nonqualified deferred compensation plans by publicly traded corporations that maintain underfunded or terminated single-employer defined benefit plans. These limitations are effective for transfers or reservations of assets conducted after August 17, 2006. If a publicly traded entity manages a single-employer pension plan that is classified as “at-risk” under pension funding rules, it is prohibited from allocating assets to cover nonqualified deferred compensation for certain employees during a "restricted period." The individuals affected include the chief executive officer, the four highest compensated officers (excluding the CEO) for the taxable year, and individuals governed by section 16(a) of the Securities Exchange Act of 1934, thereby encompassing those who are beneficial owners of more than 10% of any class of registered equity security or who serve as directors or officers of the issuer.

The "restricted period" is defined as: (1) any timeframe during which a single-employer defined benefit pension plan is classified as "at-risk"; (2) any duration in which the employer is in bankruptcy; and (3) the six months preceding and following the involuntary or distress termination of any defined benefit pension plan of the employer. Funding a nonqualified deferred compensation plan during this restricted period results in immediate inclusion of the funding amount, along with interest and a 20% penalty, in the taxable income of the affected employees. Moreover, should the employer increase the executives' compensation to compensate for the incurred taxes and penalties, these gross-up amounts shall also be subject to immediate taxation.

Estate Planning Considerations Regarding Nonqualified Deferred Compensation:

In the event that an employee entitled to a benefit under a nonqualified deferred compensation plan passes away, the present value of such benefit shall be accessible to the designated beneficiary.

The present value of a beneficiary's right to receive payments under a death benefit plan following the employee's death is deemed to be included in the employee's gross estate for federal estate tax purposes, as dictated by Internal Revenue Code (IRC) §2039(a). This inclusion occurs if the employee was either currently receiving payments or was entitled to receive future payments under the plan. Conversely, if the plan qualifies as a death benefit only (DBO) plan, the present value of the survivor benefit does not enter the employee's gross estate, provided the employee is not entitled to any benefits under the plan.

Beneficiaries receiving payments from the plan posthumously must include these payments in their taxable income as income in respect of a decedent in accordance with IRC §691(a).

Employer Taxation

Employers are permitted to deduct benefits in the same taxable year in which the benefits are reported on the participants' income tax returns. However, premiums for life insurance or additional contributions utilized to informally fund the arrangement are not currently deductible. Under IRC §409A, the timing of the employer's deduction for nonqualified deferred compensation amounts remains unchanged; thus, such amounts continue to be deductible when the employee includes them in gross income.

FICA Tax Aspects of Nonqualified Deferred Compensation

Nonqualified deferred compensation is generally classified as wages for Federal Insurance Contributions Act (FICA) tax purposes at the time when the employee provides services that give rise to the accrual of the deferred compensation. If the deferred compensation is not vested—meaning it is subject to a substantial risk of forfeiture—it shall not be included in FICA wages until such time as it becomes vested. According to the nonduplication rule, any nonqualified deferred compensation that has previously been included in FICA wages during the accrual period will not be included again upon payout.

When determining the amount of FICA tax owed on deferred compensation, accruals of such compensation are aggregated with other amounts received by the employee that constitute wages for FICA tax purposes. Typically, the additional FICA taxes that arise from the inclusion of nonqualified deferred compensation equal only 2.9% of the deferral amount (or 3.8% if the employee is subject to the Medicare tax for higher income earners), which corresponds to the Hospital Insurance (HI) portion of the tax. This situation arises because employees engaged in nonqualified deferred compensation plans usually receive other FICA wages that exceed the taxable wage base.

General Rules Regarding Reporting and Wage Withholding Under IRC §409A

Special reporting requirements are applicable to both the deferral of compensation subject to IRC §409A and the inclusion of such compensation in the service provider's income. Amounts that are includible in income under IRC §409A are also subject to income tax withholding. These rules generally take effect for amounts deferred following December 31, 2004; however, special reporting and wage withholding requirements under IRC §409A remain in effect until the Internal Revenue Service issues additional guidance (Notice 2008-115).

S Corporations

Due to the distinctive tax treatment of S corporations, nonqualified deferred compensation is generally not advisable for S shareholders, as the arrangement typically does not afford the customary tax deferral associated with such plans.

ERISA Exemptions

There exist two primary exemptions from compliance requirements under ERISA Title I, and only "unfunded" arrangements qualify for these exemptions. The first is the "excess benefit plan" exemption, which applies when the arrangement aims to provide benefits in excess of the limits imposed on qualified plans. The second is the "top-hat" exemption, which pertains to arrangements exclusively for a select group of management or highly compensated employees. Numerous deferred compensation arrangements are likely to fall within the ambit of one of these exemptions. In such cases, minimal reporting to the Department of Labor is required, specifically in the form of a notice filed within 120 days following the establishment of the plan, which provides basic information regarding the arrangement and the basis for its exemption.

Further Insights on the Top-Hat Exemption

A top-hat plan is defined as an unfunded, nonqualified deferred compensation plan maintained by an employer primarily for the purpose of offering deferred compensation or welfare benefits to a select group of management or highly compensated employees (ERISA §201(2)). Top-hat plans are exempt from numerous reporting and disclosure requirements set forth in ERISA Title I, which are overseen by the U.S. Department of Labor. Advisory opinions from the Department of Labor restrict top-hat employees to those who, by virtue of their position or compensation level, possess the ability to affect or significantly influence the design and operation of their deferred compensation plan. It is uncertain whether this restrictive standard would stand up to judicial scrutiny if an employer attempted to adopt a broader definition of "top-hat employees." Should the arrangement fail to qualify for an ERISA exemption, it will be subject to participation, vesting, funding, and fiduciary duty requirements under ERISA.

Controlling Shareholders

When a participant is a controlling shareholder-employee, several special considerations come into play. The IRS has indicated that it will not issue a private letter ruling to approve such arrangements, primarily due to concerns that a controlling shareholder might use their corporate authority to access deferred amounts before the designated time. To establish a deferred compensation arrangement for a controlling shareholder-employee, it is essential to demonstrate that the arrangement is legitimate. This can be done by setting up a similar arrangement for other employees and ensuring that benefits for the controlling shareholder-employee are not excessive. Additionally, the issue of reasonable compensation may arise for shareholder-employees. If the total compensation for a shareholder-employee is deemed "unreasonable," the IRS may disallow deductions for employer payments that are not considered ordinary and necessary business expenses.

Review of Employer Advantages

Employers enjoy several advantages with deferred compensation arrangements:

- They can select participants from a specific group of management or highly compensated employees, ensuring confidentiality (except where disclosed in accounting statements).

- Employers can recover costs through benefits paid upon death.

- These arrangements can be instrumental in recruiting, retaining, rewarding, and retiring valuable employees.

- They may provide benefits in addition to or instead of qualified plans.

- No IRS approval is necessary.

- If life insurance is included, the policy's cash value accumulates on a tax-deferred basis.

- Benefits paid out are generally tax-deductible for the employer.

Review of Participant Advantages

Participants benefit from these arrangements in the following ways:

- The terms can be tailored to address the specific needs of covered participants.

- Typically, participants do not pay taxes on benefits until they are received.

- These arrangements can supplement retirement benefits offered under qualified plans or personal savings.

- They can also include provisions for disability, death, and post-retirement survivor benefits.

Case Citations:

1. Northwestern Mutual Life Insurance Company v. Resolution Trust Corporation, 848 F. Supp. 1515 (N.D. Ala. 1994)

2. Hollingshead v. Burford Equipment Co., 747 F. Supp. 1421 (D.C. Ala. 1990)

3. Loffland Brothers v. Overstreet, 758 P.2d 813 (Okla. 1988)

4. Duggan v. Hobbs, 99 F.2d 307 (9th Cir. 1996)

5. Plazzo v. Nationwide Mutual Insurance Co., 697 F. Supp. 1437 (N.D. Ohio), reversed, 892 F.2d 79 (6th Cir. 1989), cert. denied, 498 U.S. 950 (1990)

Legal Doctrines and Regulations:

- Constructive Receipt Doctrine

- Reg. Sec. 1.451-2(a)

- Commissioner v. Oates, 207 F.2d 711 (7th Cir. 1953), affirming 18 T.C. 570 (1952), acq. 1960-1 C.B. 5

- Veit v. Commissioner, 8 T.C. 809 (1947), acq. 1947-2 C.B. 4

- Veit v. Commissioner, 8 T.C.M. 919 (1949)

- Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100

- Rev. Rul. 67-449, 1967-2 C.B. 173

- Letter Ruling 8741078

Economic Benefit Doctrine

- Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100

- Sproull v. Commissioner, 16 T.C. 244 (1951), affirmed per curiam, 194 F.2d 541 (6th Cir. 1952)

- Minor v. United States, 772 F.2d 1472 (9th Cir. 1985)

- Goldsmith v. United States, 586 F.2d 810 (Ct. Cl. 1978)

Unfunded Plans

- IRC §§ 83, 409A

- Reg. Sec. 1.83-3(c)(3)

- Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100

- Rev. Rul. 67-449, 1967-2 C.B. 173

- Rev. Rul. 69-50, 1969-1 C.B. 140, as amplified by Rev. Rul. 77-420, 1977-2 C.B. 172

- Rev. Rul. 69-474, 1969-2 C.B. 105

- Rev. Rul. 69-649, 1969-2 C.B. 106

- Rev. Rul. 69-650, 1969-2 C.B. 106

- Rev. Proc. 71-19, as amplified by Rev. Proc. 92-65, 1992-2 C.B. 428

- Rev. Rul. 71-419, 1971-2 C.B. 220

- Robinson v. Commissioner, 44 T.C. 20 (1965), acq. 1970-2 C.B. xxi, 1976-2 C.B. 2

- Martin v. Commissioner, 96 T.C. 814 (1991)

- TAM 8632002

- Letter Rulings 9122019 to 8507040

Informal Funding with Life Insurance

- Casale v. Commissioner, 247 F.2d 440 (2d Cir. 1957)

- Frost v. Commissioner, 52 T.C. 89 (1969)

- Centre v. Commissioner, 55 T.C. 16 (1970)

- Rev. Rul. 59-184, 1959-1 C.B. 65

- Rev. Rul. 68-99, 1968-1 C.B. 193

- Rev. Rul. 72-25, 1972-1 C.B. 127

- TAM 8828004

- Letter Rulings 9517019 to 9142020

Income Taxation of Payments

- IRC § 101(j)

- IRC § 409A

- IRS Reg. 158080-04 (proposed regulations)

- IRS Notice 2005-1

- Gambling v. Commissioner, 82-1 USTC 9403 (2d Cir. 1982)

- Metcalfe v. Commissioner, T.C. Memo 1982-273

- Goldsmith v. Commissioner, 78-1 USTC 9312 (Ct. Cl. 1978), affirmed and adopted per curiam, 586 F.2d 810 (1978)

- Minor v. United States, 772 F.2d 1472 (9th Cir. 1985)

- Centre v. Commissioner, 55 T.C. 16 (1970)

- Rev. Rul. 77-25, 1977-1 C.B. 301

- Rev. Rul. 82-46, 1982-1 C.B. 158

- Letter Rulings 8119020 to 9036007

Income Tax Reporting and Withholding

- Notice 2008-115

Estate Taxation at Employee's Death

- IRC § 2039

- Reg. Sec. 20.2039-1(b)

- Goodman v. Granger, 243 F.2d 264 (3rd Cir. 1957)

- Estate of Barr v. Commissioner, 40 T.C. 227 (1963), acq. in result, 1978-1 C.B. 1

- Neely v. United States, 613 F.2d 802 (Ct. Cl. 1980)

- Silberman v. United States, 333 F. Supp. 1120 (W.D. Pa. 1971)

- Courtney v. United States, 84-2 USTC 13,580 (N.D. Ohio 1984)

- Letter Rulings 8005011

Gift Taxation (if the employee irrevocably assigns nonforfeitable benefits)

- Reg. Sec. 25.2511-1(h)(10)

- Rabbi Trusts

- IRC § 409A

- Letter Rulings 8113107 (the original rabbi trust)

- Rev. Proc. 92-64, 1992-2 C.B. 422 (IRS model rabbi trust)

Cases Related to Resolution Trust Corporation

- McAllister v. Resolution Trust Corporation, 201 F.3d 570 (5th Cir. 2000)

- Goodman v. Resolution Trust Corporation, 7 F.3d 1123 (4th Cir. 1993)

- Nagy v. Riblet Products Corp., 13 E.B.C. 1743 (N.D. Ind. 1990)

- GCM 39230 (1984)

- Letter Rulings 8906022 to 8634031

Independent Contractors

- Rev. Proc. 99-3, 1999-1 C.B. 103, Sec. 3.01(31)

- Rev. Rul. 88-68, 1988-1 C.B. 556

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