Deducting deferred bonuses

Editor: Albert B. Ellentuck, Esq.

A current deduction for accrued bonuses is allowed only if a bonus is actually received (not merely constructively received) by the employee within 2½ months of year end (Sec. 404(a)(11)). Any payments made after this 2½-month period are deductible by an accrual-basis corporation in the tax year in which the payments are included in income by the recipient.

Controlling shareholder

An accrual-basis C corporation is allowed a deduction for accrued bonuses payable to a cash-basis controlling shareholder as of the day the compensation is received (actually or constructively) by the shareholder (Sec. 267(a)(2)). In a C corporation, a controlling shareholder is one who owns (directly or indirectly) more than 50% of the value of the corporation's stock (Sec. 267(b)(2)). Thus, an accrual-basis C corporation is placed on the cash basis for deducting compensation accrued, but not yet paid, to a controlling shareholder.

Example 1. Accrued bonus payable to a related C corporation owner: A owns 60% of T Inc., an accrual-basis C corporation with a Dec. 31 year end. The corporation accrues a $10,000 bonus for A on Dec. 31, year 1, and pays it on Jan. 5, year 2. Since A owns more than 50% of the stock, T cannot deduct the accrued bonus until the year A recognizes the income, which is year 2.

Observation: The IRS ruled that a taxpayer constructively received his accrued salary on the last day of the corporation's year because the salary was authorized for that year by the corporation he controlled, and it was financially able to pay the salary. Furthermore, the employee kept the corporate books and had the power to draw the salary. The corporation was allowed a deduction in the year of the accrual, but the shareholder had to recognize the salary as income in the year before actual receipt (Rev. Rul. 72-317; IRS Letter Ruling 8630059).

Personal service corporation

An accrual-basis personal service corporation (PSC) cannot deduct salaries and bonuses owed to any cash-basis shareholder (or someone related to a shareholder) until the payment is included in the payee's income (Sec. 267(a)(2)).

Restriction on retention bonuses

The IRS stated that bonuses subject to a contingency cannot be accrued in year 1 to be paid in year 2 even if paid within 2½ months of year end (Chief Counsel Advice (CCA) 200949040). Therefore, if employees cannot receive their deferred bonuses for performance in year 1 unless they are still employed on the year 2 bonus payment date, the company's liability for the bonus is subject to a contingency and cannot be accrued in year 1. In this fact pattern the economic performance piece of the all-events test is not passed as of the end of year 1.

Similarly, the IRS held that bonuses were not fixed in the year of service when the amount of individual awards were finalized but reverted back to the company if an employee left before receiving the bonus, even though the forfeited amounts could be considered insignificant (CCA 201246029).

However, Rev. Rul. 2011-29 provides that an employer can establish the "fact of the liability" under the first prong of the all-events test (Sec. 461) for retention bonuses payable to a group of employees even though the employer does not know the identity of any particular bonus recipient, or the amount payable to that recipient, until after the end of the tax year. As a result, the employer could deduct the amount in the year the liability was incurred. Under the program analyzed in Rev. Rul. 2011-29, bonuses were paid to employees for services performed during the tax year. The amount of bonuses payable under the program was determinable through a formula that was fixed prior to the end of the year, or through other corporate action that fixed the amount payable to the employees as a group. Any bonus amount allocable to an employee who was not employed on the date on which bonuses were paid was reallocated among the other eligible employees.

Incurring accumulated earnings tax on capital for deferred compensation funding

When deferred compensation plans are used by closely held corporations and are maintained for a long time, resulting in large accumulations of capital by the corporation to fund the plan, it is possible the IRS may try to impose the accumulated earnings tax. However, in the Scripps Newspapers case, the Tax Court held that the accumulation of earnings to fund a nonqualified plan is a valid business purpose (John P. Scripps Newspapers, 44 T.C. 453 (1965)). Note, however, that the employees in that case were not major shareholders.

Deducting interest accrued on deferred compensation

Another issue involves deductibility of amounts accrued annually on deferred compensation. In Albertson's, Inc., 42 F.3d 537 (9th Cir. 1994), the Ninth Circuit held that employers that enter into deferred compensation agreements with top executives under a nonqualified plan are not allowed to deduct the interest when it is accrued. The court stated that the Sec. 404(a)(5) restrictions apply. These restrictions defer the employer's deduction until the time the employee recognizes the income.

Nonqualified profit sharing with a partial deferral of benefits

When a plan has a partial deferral of benefits, the portion currently paid to an employee is taxable (Sec. 61(a)). The deferred portion of the bonus paid under the plan is taxable to the employee only if he or she has constructive receipt of the income (Sec. 451(a); Regs. Secs. 1.451-1 and 1.451-2(a)). A tax deduction is allowed to the corporation only when the bonus is paid to the employee (assuming no prior constructive receipt of the bonus amounts) (Sec. 404(a)(5)).

Because this compensation plan is not a qualified plan under Sec. 401, it may discriminate among the employees regarding coverage, vesting, etc.

Caution: A nonqualified deferred profit sharing plan is not exempt from Sec. 409A unless the employee actually or constructively receives income within 2½ months after the year that a substantial risk of forfeiture lapses. Steps should be taken to ensure that the plan meets the Sec. 409A requirements if the plan is not exempt from Sec. 409A.

Rabbi trusts

Taxation of rabbi trustsA rabbi trust is an unfunded plan that provides some security for the employee because the employer does not have access to the trust assets. However, because the assets can be reached by the employer's creditors, the funding of the trust does not trigger taxable income for the employee. The rabbi trust does remove some of the risk for the employee because a solvent employer is prevented by the provisions of the trust from defaulting on its obligation to the employee.

The IRS has designed a model rabbi trust agreement that can be adopted by employers. The model contains alternative provisions that can be used to tailor the trust to an individual employee's needs. An employer and employee that adopt the model trust are assured that the tax results of the arrangement are those described previously. The model trust is in Rev. Proc. 92-64. The assurance does not, however, extend to the underlying deferred compensation arrangement unless an IRS ruling is secured. However, the IRS will not ordinarily issue advance rulings or determination letters regarding the tax consequences of a nonqualified deferred compensation arrangement using a grantor trust where the trust fails to meet the requirements of Rev. Proc. 92-64 (Rev. Proc. 2018-3, §4.01(34)).

Caution: A common problem with rabbi trusts is that employees consider themselves owners of the funds and wish to direct the investments. The employee can express an opinion on investments but cannot direct the investments (i.e., he or she cannot call the broker or receive statements). The trustee must oversee the investment of the funds so that the arrangement is a valid trust and not an agency relationship.

Offshore rabbi trusts: Under Sec. 409A(b) rules, assets that are set aside in an offshore (established outside the United States) rabbi trust will be considered as part of a funded arrangement and will not result in the deferral of income. Typically, offshore rabbi trusts have been used to shield assets contributed to the trust from creditors.

The purpose of this provision is to prevent employers from placing assets intended to satisfy deferred compensation arrangements in foreign trusts, making it difficult for creditors to reach the assets and effectively protecting the assets from the creditors. The rule does not apply to assets located in a foreign jurisdiction if substantially all of the services to which the deferred compensation relates are performed in that jurisdiction. This provision also limits the use of rabbi trusts in instances where assets are transferred to a rabbi trust upon a change in the employer's financial health. For example, if a nonqualified deferred compensation plan provides that upon a change in the employer's financial health the deferred assets will be put in a rabbi trust for the employee, all the assets set aside are taxable to the employee when they are set aside.

Planning tip: Rabbi trusts that are not offshore trusts remain a valid planning tool, but they must never be set up so that they come into existence because of a financial trigger provision. It appears, however, that a plan can provide that a rabbi trust either exists from the plan's inception or is created if the company comes under new ownership or control.

Taxation of secular trusts

Secular trusts are usually designed as grantor trusts to avoid double taxation. Generally, they are created as either employee-grantor trusts or employer-grantor trusts. The IRS released four letter rulings that provide adverse tax consequences to employer-grantor trust arrangements (IRS Letter Rulings 9206009; 9207010; 9212019; and 9212024). In light of these rulings and because these types of trusts are subject to the requirements of the Employee Retirement Income Security Act (ERISA), caution is required when working in this area.

A secular trust provides complete security against both the employer and its creditors. The price paid for this total security is a loss of tax deferral. Therefore, a secular trust makes sense only when security concerns are so great the employee is willing to forfeit the tax benefits of deferral, or the employer provides a gross-up amount sufficient to make the employee whole, and the employee receives an overall benefit substantially approximating what would be received if a rabbi trust arrangement was used.

Requesting tax rulings about deferred compensation plans

In some cases, the taxpayer may wish to request a ruling from the IRS about the tax ramifications of a deferred compensation arrangement. The procedures for such a request are contained in Rev. Proc. 92-65. If deferral of compensation is at the employee's election, the general rule states the employee must make a valid deferral election in the year before the services are rendered in order to obtain a ruling from the IRS. However, an exception to this general rule provides that, in the first year in which the plan is effective (or the employee is eligible to participate), the employee must make the election within 30 days after the date the plan becomes effective (or the employee becomes eligible to participate). In addition, for advance ruling purposes, the subsequent deferrals must be subject to substantial risk of forfeiture. The IRS will not rule on the taxability of deferred compensation plans for controlling shareholders (Rev. Proc. 2018-3).

Meeting ERISA requirements for deferred compensation plans

Deferred compensation arrangements should be reviewed to determine if they are subject to ERISA requirements. If covered by ERISA, the plan will be subject to funding, vesting, and participation requirements similar to those that apply to qualified plans. It will also be subject to the same reporting and disclosure requirements.

In Rev. Proc. 2015-32, the IRS established a program to relieve plan administrators and sponsors of certain single-member plans and foreign plans from penalties under Secs. 6652(e) and 6692 for failing to file Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan, in a timely manner, effective June 3, 2015. The program is not available for any plan to which the IRS has sent a penalty assessment letter. Plans subject to ERISA cannot use the program and should use the Delinquent Filer Voluntary Compliance Program (DFVCP).

Sec. 457A requirements for foreign NQDC plans

Sec. 457A limits the deferral of income attributable to services performed after 2008 for tax-indifferent foreign corporations and partnerships consisting of foreign persons and organizations that are exempt from U.S. income tax. Any compensation that is deferred for longer than 12 months under an NQDC plan of a nonqualified entity is includible in gross income when there is no substantial risk of forfeiture of the rights to the compensation. Any deferred income relating to services performed before Jan. 1, 2009, must be included in the individual's income before 2018 (unless the compensation will not vest until a later year). The provisions of Sec. 457A are in addition to requirements under Sec. 409A and any other rules governing NQDC plans.

Sec. 457A is aimed at curtailing the ability of investment fund managers and others to defer income recognition of management and incentive fees due from offshore entities organized in tax-haven countries. However, it also applies to deferred compensation plans of corporations and partnerships located in tax-haven jurisdictions and may apply to plans organized in jurisdictions that do not have a comprehensive income tax treaty with the United States and use a territorial approach to income taxation.

Notice 2009-8 and Rev. Rul. 2014-18 provide interim guidance for Sec. 457A. The IRS anticipates issuing regulations under Sec. 457A; however, any future guidance that would expand the coverage of Sec. 457A will not apply to a tax year beginning before the issuance of the guidance.

In Rev. Rul. 2014-18, the IRS ruled that neither nonstatutory stock options nor stock-settled stock appreciation rights granted to employees of a U.S.-owned foreign corporation were nonqualified deferred compensation (NQDC) plans subject to tax under Sec. 457A. In this case, the nonstatutory stock options and the stock-settled stock appreciation rights met all the requirements under Sec. 409A for deferral of taxation. As such, their taxation was determined under Sec. 83. The ruling states that a nonstatutory stock option and/or a stock appreciation right that is exempt under Sec. 409A is also exempt from the rules of Sec. 457A. This ruling amplified Notice 2009-8.   

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 30th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).

 

Contributor

Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va. For more information about this column, contact thetaxadviser@aicpa.org.

 

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