Taxation policy of qualified and non-qualified deferred compensation plans
Qualified vs - Taxation policy of qualified and non-qualified deferred compensation plans introduction. Nonqualified Deferred Compensation
Qualified deferred compensation plan is a delayed or deferred compensation that honors the requirements of the Internal Revenue Code for favorable tax considerations or treatment. As a consequence, the employer is allowed to claim tax deductions immediately the funding of the plan is done, and the employee on the other hand is granted the opportunity of deferring taxation until such a time when he/she receives compensation. This implies that the employee gets the advantage of paying taxes at lower capital gains rate from this deferred compensation plan.
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When such a plan adheres to the Internal Revenue Code, it automatically becomes eligible to claim and receive certain stipulated tax benefits. The plan is exclusively meant to benefit employees or their beneficiaries in case of any unprecedented occurrence. Qualified plans are divided into two major groups namely; defined-contribution plans and defined-benefit plans. The 401 (k) plans, profit-sharing plans, and money-purchase pension plans are some good examples of define-contribution plans. The essential element of deferred compensation plans is to permit individuals to defer their compensations so that taxation takes place at a later date (Caruth, Handlogten, 2001, p.14). The most likely candidates to such a plan are employees who consider themselves as not being in immediate need of money, and at the same time they anticipate to be in a lower tax bracket in the future.
On the other hand, a nonqualified deferred compensation plan is any arrangement or written plan in which an employee has a right legally enforced by the law, to gain compensation which is payable in a later year or period of time. It is a plan that is not included in any other qualified plan under Section 401 (a). This kind of deferred compensation can either be in form of employees’ current compensation reduction or any other amount that is additionally credited to the current pay of the employee. Non-qualified plan therefore mean all types of tax-deferred and employer sponsored retirement plans that do not fall in the realm of an employee’s retirement income Act’s security.
Deferred compensation definition is very wide and includes amounts that are paid in later years for example a bonus that is earned for provided services in the current year, although paid towards the end of the year. It can also be rights of stock appreciation, restricted property, or any other such accrued benefits. On the same note, severance pay or any accrued vocational benefits are not considered as forms of deferred compensation in general. Furthermore, all benefits accrued within one year of termination are also not included in the category of deferred compensation (Aaron, Galper, 1988, p.32).
NQDC- Nonqualified Deferred Compensation basically implies any non-elective or any elective plan, arrangement, method, or agreement between the employee and the employer, in other words the service provider and the service recipient, to pay to the employee his or her compensation at some later time. NQDC plans do not satisfy or fulfill Section 401 (a) requirements like in the case of qualified plans. Due this provision, NQDC plans do not grant to the employees and the employers with the benefits associated with taxation like is the case in qualified plans.
NQDC fall into four major categories despite their interpretations. These plans include but are not limited to;
· Salary Reduction Arrangements- this is the condition that allows the employee to defer receipt a certain percentage of his/her salary that is otherwise currently includible of compensation.
· Bonus Deferral Plans- these are similar to salary reduction arrangements but they differ in the sense that they allow participants to postpone or defer receipt of their bonuses.
· Excess Benefit Plans- these are plans that grant benefits only to those employees whose benefits are limited by Section 415 under the employers’ qualified plan.
· SERPs- the Supplement Executive Retirement Plans are those which are primarily maintained for a particular group of individuals who are either highly compensated or those in the management level (Dema, Frazier, 1995, p.56).
NQDC plans can either be funded or unfunded, although most of them are intended to fall in the unfunded category due to the many tax advantages unfunded plans accord participants. Unfunded plans simply mean that the employee relies only on the employers’ promise to pay such deferred compensation to the employee in future without any formal security whatsoever. The employer simply uses a bookkeeping account system to keep track of the employees’ benefits. This plan may also voluntarily opt to make investments in form of securities, insurance or annuities arrangements as way to ensure capability of paying the employees’ compensation.
The employer may similarly transfer some amounts to a trust fund that will remain as a part of his/her general assets. This is however, subject to the employers’ creditors claims concerning the situation that may arise if the employers become insolvent for example, so that they can assist in paying the employees’ compensation. The amounts shouldn’t be set aside (from an employer’s creditors) exclusively for employees benefit in order to be worth of the income tax deferral benefits. Doing this would make the employee to have current includible compensation (Fiore, 1995, p.35).
A funded arrangement on the other hand will generally exist if the assets are set aside from the employers’ creditors claims. Examples of this are putting the money in an escrow account or trust. A classic funded plan for example is in the form of a qualified retirement plan. These set aside or segregated assets are identified as accessible sources by the participants who look forward to payment of their accrued beneficial interests, which are likely to be taxable under Section 83 and 402 (b).
In addition, NQDC plans could be formal or informal and they don’t necessarily need to be made in writing. Some of them are mere indications contained in the employment agreement or contract while others may be extensively detailed. Any NQDC plan must evaluate the appropriate time when any employee’s deferred compensation should be includible in one’s gross income and at the same time when such amounts should be deductible on the employer’s part. Moreover, it should also address the issue of when such amount should be considered for the employment taxation purposes. The rules for FICA or FUTA and income taxes timing are quite different (Bradshow, Papalia, 2005, p.73).
In understanding these concepts of qualified and unqualified deferred compensation, it is imperatively important to consider the factors that determine when deferred amounts become includible in an employee’s gross income. The first consideration in this sense should evaluate:
· The economic benefits of funded plans and
· The constructive receipt doctrine of the unfunded plans.
Under the funded plans economic benefit doctrine, the value of the property or the benefit should be currently includible in the gross income of the employee, in case an employee receives any financial or economic benefit or compensation in form of property for services provided. It explicitly requires that the employee currently include asset value for those assets that were irrevocably and unconditionally transferred in form of compensation, for his/her sole benefit, into a fund to currently appear in his/her current gross income. This is done immediately the employee realizes that he/she does not have a non-forfeitable interest in such a fund. The service provider will always be taxable at the time the property is received in the case the property is not substantially subject to forfeiture risk or if it is transferable, and after it has been transferred as compensation for the individual’s services. This is as codified by Section 83 that ratifies the economic benefit doctrine in employment contexts (Fiore, 1995, 41).
In the event that the property is not transferable and at the same time is substantially subject to forfeiture risk, then no income tax can be incurred until such a time it will be deemed not subject to such substantial forfeiture risk or when it is made transferable. Section 83 clearly indicates that this term “property” categorically includes personal as well as real property which could be anything else other than money, or unsecured and unfunded future money payment promise. The term also includes, however, assets beneficial interests, including any money that is transferred or which is set aside from creditors claims of the transferor such as in an escrow account or a trust.
It is fundamentally important to consider the cash equivalency doctrine any time a NQDC arrangement is made. This allows that, if there is an assignable and unconditional payment promise to a solvent obligor, one that is not subject to any set-offs, and its nature is such that it frequently gets transferred to investors or lenders at a non substantial discount, then such a promise is equated to cash and therefore in the same manner that cash is. This is also considering that the case should be taken as such had the taxpayer received it rather than being received by the obligation 9Caruth, Handlogten, 2001, p.18). In simpler terms, this means that if future payment receivership is granted through writing and is made transferable like in the case of a bond or a note, then this right becomes equivalent of cash. The right’s value is therefore supposed to be includible in the individual’s gross income.
A constructive receipt doctrine of unfunded plans indicates that taxpayers of the cash basis must include income, gains, and profits in gross income for a particular taxable year in which they are constructively or actually received. Under this doctrine which is codified in Section 451 (a), income is constructively received by the taxpayer, although it is in actual terms not reduced to his/her possession, during the taxable year in which it has been credited to his/her account, has been set apart for him/her, or it has otherwise been made available such that it can be drawn upon at any time.
For the purpose of a constructive receipt establishment, a taxpayer’s deferred amounts receipt control has to be determined. This should also seek to establish that such control had not been in any way substantially limited or restricted. All the plans provisions must be keenly scrutinized as they relate to every form of access or distribution option. Additionally, it is imperative to evaluate how the plan has previously operated irrespective of the underlying provisions in fields such as distribution types and other options of access (Bradshow, Papalia, 2005, p.82). Employees can use several devices such as check books, debit cards, or credit cards as tools for unfettered control over the deferred amounts receipts.
Having established all the facts as stipulated in the above mentioned doctrines, it is crucial at this point to find out when deferred amounts become deductible by the employer. Sections 83 (h) and 404 (a), (5) are the parts that governs employer’s compensation deduction. Generally, it is only when the amounts are includible in the employees’ incomes that the employer gets the right to make deductions. Under Section 163, earnings or interests that are credited to the deferred amounts under nonqualified deferred compensation plans do not qualified to be regarded as interest deductible. Instead, under Section 404 (a), (5), this represents additional deferred compensation that is deductible under this section.
For employment tax deduction, timing of wages payment under FUTA and FICA tax is not affected by the nature of whether a given arrangement is unfunded or funded. However, the condition of whether an amount is funded becomes relevant in determination of when amounts get includible in income and also subject to withholding income tax. Deferred amounts are only taxable for FICA or social security and Medicare and FUTA at a later time when services performance has created the right to certain amounts. It may also be when the amounts no longer are subject to substantial forfeiture risk (Dema, Frazier, 1995, p.65). Unless such deferred amounts are substantially at risk of forfeiture, they should be included in the wages for year of the service provision for the purposes of FICA and FUTA since a right of the amounts has been created.
Some employer matching contributions are offered at the time of arrangements in some NQDC plans. At the later of when such mentioned services were performed and the employer’s right to contribution has been created, any contribution by the employer must be taken into account for the purposes of the FUTA and FICA taxes. This should also be done in consideration of whether the contribution is substantially at forfeiture risk. At the same time, it is of paramount importance to understand that the employer cannot at any one time take any tax deductions for the purpose of matching contributions if such amounts are not already includible in the income of the employee. All employer deductions must coherently match inclusions by the employee in the compensation income. The employer must therefore be able to account for all the deferred compensation amounts by making sure that all reported figures matches with the deferred amounts (Aaron, Galper, 1988, p.79). Netting the current year’s deferrals against any distributions that have made during the year will always obscure non deductible amount. Such amounts that may decrease taxable income should be adjusted appropriately for accountability reasons.
In conclusion, there are clearly stipulated rules and regulations that control and govern the procedures and methods that must be followed to the later regarding NQDC arrangements. Some newer and more comprehensive rules are well stated in Section 409 (a) of the American jobs creation Act (2004) for example, and states that all taxable years (provided they are not under substantial risk of forfeiture and had previously been excluded in gross income) should be currently includible in gross income. Unless there is satisfaction of certain requirements of this section, it is important for all employees and employers to adhere to the rules, and more so to acquaint themselves with these regulations.
Aaron, H & Galper, H. (1988). Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax. New York: Brookings Institution, pp.34, 79
Bradshow, B & Papalia, M (2005) Play by the Rules: IRC Section 409A Imposes New Requirements on Nonqualified Deferred Compensation. Journal of Accountancy, Vol.200, pp.73, 82
Caruth, D & Handlogten, G. (2001) Managing Compensation (And Understanding It Too): A Handbook for the Perplexed. Westport, CT: Quorum Books, pp.14, 18
Dema, R & Frazier, K (1995) The Real Cost of Nonqualified Deferred Compensation Plans. Journal of Accountancy, Vol.179, pp.56, 65
Fiore, N (1995). Nonqualified Deferred Compensation Agreements. Journal of Accountancy, Vol.180, pp.35, 41