Fringe benefits are often viewed
as a way to provide tax-deferred or tax-free compensation to employees.
However, some employee benefits have very little to do with tax planning.
Nonqualified deferred compensation plans are generally designed to reward
certain employees who become too valuable to lose.
Constructive Receipt
Income is constructively received when it
is made available or becomes subject to the control of the taxpayer. The
taxpayer does not actually have to take possession of or withdraw the
amount.
Events That Can Trigger Constructive
Receipt:
• Assets become transferable.
• Risk of forfeiture lapses/assets become secure.
• Substantial vesting occurs.
• Economic benefit occurs.
FICA Tax — Special Timing Rules
Generally, an employer must withhold FICA
tax on any amount of deferred compensation for an employee under a nonqualified deferred
compensation plan by the later of:
1) When services are provided, or
2) When there is no substantial risk of right to the amount.
The nonduplication rule prevents double
taxation by providing that once a deferred compensation amount is taken into account as FICA
wages, the amount (and any income attributable to it) is not treated as
FICA wages when paid. [IRC §3221(v)(2)]
Final regulations issued in early 1999
explain the rules for timing of FICA tax withholding and deposits on deferred compensation. [Reg.
§31.3121(v)(2)-1]
Plans Not Subject to the Special Timing
Rules: Stock option plans, severance pay arrangements, early
retirement windows, and excess golden parachute payments are not subject
to the special timing rules. FICA and income tax are withheld when
benefits are paid.
Plans Subject to the Special Timing
Rules Include:
• Account balance plans where a specified
amount is credited to a participant’s account (such as 10% of
compensation). Typically, deferred compensation deferrals are taken into account each pay period
as amounts are credited to the plan.
• Nonaccount balance plans where the benefit is defined in any other way
(such as 50% of final average pay less benefits under the employer’s
qualified plans). "Reasonable actuarial assumptions" must be
used to determine the participant’s deferred compensation accrual for the period.
General
Timing Rules:
• A substantial risk of forfeiture
generally is present only if the employee must perform additional services
to be entitled to the deferred compensation benefit.
• For administrative convenience, an employer may treat all deferred compensation deferrals
during the year as if paid on the last day of the year. This choice,
however, requires any income attributable to the deferred compensation amounts to be
subject to FICA tax.
Funding Options
• Rabbi Trust: An
employer sets up an irrevocable grantor trust for purposes of holding
contributions of the deferred compensation amounts. This provides the employee with
some security that the agreed to deferred compensation will be paid at the
appropriate time and provides assurance that the employer cannot divert
the funds for other purposes. The terms of the trust must contain a
provision that subjects the trust assets to claims by the employer's creditors in
order to avoid constructive receipt of deferred compensation as income by the employee. The term
"Rabbi Trust" is used because the first IRS-approved arrangement
of this type was set up for a rabbi by his congregation.
• Taxable Trust: An
irrevocable trust can be set up to receive deferred compensation contributions.
Unlike a Rabbi Trust, taxable trust assets are protected from employer creditors. The amounts are
considered "constructively received," and
the employee pays tax on the income at the time the deferred compensation contributions are
made. A taxable trust will generally make periodic distributions to
the employee in amounts sufficient to pay income tax on future deferred compensation
contributions, as well as paying tax on the trust’s earnings. Since
the taxes are paid up front, future distribution of trust assets to the
employee are tax free. This type of arrangement provides the greatest
degree of security to the employee.
• Life Insurance: A
company may purchase a life insurance policy on an employee. When the employee is to
receive the deferred compensation, the company can either cash
in the policy or borrow against it. A life insurance policy will
also provide funds to pay benefits in the event of the employee’s
death.
• Stocks And Bonds: The
long-term growth potential of stocks along with dividend received deductions for
corporations, make stock purchases an attractive means of
funding deferred compensation for some companies. Bonds can also be an attractive
option considering the ability to coordinate maturity dates with the date
payments are due, as well as the favorable tax treatment of
interest earned from municipal bonds.
