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Constructive Receipt Doctrine

Overview

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 taxable if:

  • 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.

Example:
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
Corporate 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 Trusts) that 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 provision.
  • 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.

 

 

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