A Nonqualified Deferral
Plan (NQDP) is implemented primarily to defer
taxation on discretionary compensation. One major roadblock to achieving
this result is to avoid constructive receipt .
Under the constructive receipt doctrine, an amount may become
currently taxable to a cash basis taxpayer before it is actually received.
The tax code states that cash basis taxpayers include amounts as income
when they are actually or constructively received . The result
is similar to the tax effect to accrual-basis tax payer, who is taxed
on income when earned, as opposed to when received. The amount will be
- it is currently credited to the employee's account.
- set aside for the employee.
- otherwise made available to the employee.
Once income is unconditionally subject
to the taxpayer's demand, that income must be reported even if
the employee chooses not to currently accept the income. In
other words, once an employee has the right to receive compensation,
even if they choose not to receive it, it will be subject
to current taxation.
An employee is credited with a year end bonus and it is available now
or upon demand by the employee at any time. That bonus would be taxable
to the employee when credited, since he is in total control as to when
to receive it.
Criteria to Avoid Constructive Receipt
payments to an executive
who is a cash
basis taxpayer will be currently taxable as soon
as the money is made available to
the taxpayer, and there are no restrictions on the right
to be paid.
Efforts to preserve the tax advantages of establishing an
NQDP constrain the flexibility allowed participants, in
particular with respect to timing of contribution elections
and the ability to revise the distribution elections.
Three key criteria must be met to avoid constructive receipt with respect
to an NQDP:
- The election to defer must be made before the compensation is earned.
- There must be a substantial limitation or restriction over the receipt.
- The plan must remain unfunded (see below).
Income will not be constructively received if the employee's control
over the receipt is subject to a substantial limitation or restriction.
A common substantial limitation is the passage of time, i.e., the employee
cannot receive the money until retirement, termination, disability, death
- an event beyond the employee's control.
To successfully avoid constructive
receipt in an NQDP, the plan must remain unfunded. A plan is
unfunded when there are no formal assets set aside in trust to
pay plan benefits. Any informal assets associated with the
plan must be subject to the corporation's general creditors.
If the plan is unfunded, constructive receipt will be avoided,
even if the employee is 100% vested in his benefits (i.e., the
benefits are non-forfeitable except for the employer's refusal
or inability to pay). The employee, in essence, has an
unsecured promise of the employer to pay the benefits, and is
put in the position of a general creditor. There are
techniques that allow companies to dedicate assets to the plan
(in particular utilizing a Rabbi
can improve the
security level for the participating executives, without incurring immediate taxation.
The above does not prevent the employer from establishing informal funding by purchasing mutual funds,
life insurance, etc. as a reserve fund to cover their liability, as long
as the fund remains a general asset of the corporation.
IRS Positions on Constructive Receipt
When an executive
participates in a NQDP, he is usually given the choices of
allocating his deferral across a choice of preferred
investments, similar to a qualified 401(k) plan. If the
executive is given too much control, the constructive receipt
issue will arise.
The IRS has issued a number of Revenue
procedures which specifically deal with guidelines to avoid
constructive receipt - Rev. Proc.
71-19 and Rev. Proc. 92-65.
Basically, the IRS requires that the participant cannot take
benefit distributions except under plan provisions, and the
plan must remain a mere promise of payment by the
corporation. The IRS has stated that they will not issue favorable
rulings on plans that do not satisfy the guidelines contained in these
two Revenue Procedures.
Excerpts from these Revenue Procedures appear below:
- The deferral contributions must remain the property of the employer.
- The election to defer must be made before the beginning of the period
of service for which the compensation is payable, except in the case
of a new plan or newly eligible to participate. This is usually the
calendar year, so that a election to defer year 2001 compensation must
be made in year 2000.
- When a new plan is implemented, a
participant may elect to defer future compensation within 30
days after the effective date of the plan.
- A newly eligible participant may electto defer future
compensation within 30 days of becoming eligible.
- If an election, other than the initial election of a deferral amount,
is made subsequent to the beginning of the period of service, the plan
must set forth substantial forfeiture provisions that remain in effect
throughout the entire period of deferral. This is often taken to
mean that payout elections must be made at the time of the deferral
election and cannot be subsequently modified. Although the courts have
ruled against the IRS on this matter, the IRS maintains its current
position, and will not issue advance rulings on a plan without this
- The plan must define the time and method of payment for each event (such as
termination, death, retirement or disability).
- Any investments of deferrals made by the employer must remain the
sole property of the employer.
401(k) Mirror Plans and Constructive Receipt
A popular plan design today is to allow the executive to allocate his
deferrals into the same funds as available in his 401(k) plan. The executive
may transfer money from one fund to another, re-allocate account balances,
change fund elections for future deferrals, etc. The question of too much
executive control arises in these types of plans, therefore triggering
concerns regarding constructive receipt.
The IRS has issued a number of Private Letter Rulings which deal with
this issue. In general, they state that the employee may express a preference
for investments, but the employer cannot be obligated to invest according
to the employee's preferences. In other words, the employee suggests
an investment preference. Although the participants' accounts will accumulate
as if their contributions were invested in those preferences, the employer
must be free to invest the deferrals as it sees fit.