Deferred Compensation under Tax Law
Deferred Compensation under Tax Law
What is Deferred Compensation?
Deferred compensation refers to an arrangement in which an employee earns wages or benefits in one period but receives payment at a later date, often upon retirement, termination, or after a specified event. This can include pensions, bonuses, stock options, and other benefits where payment is postponed.
Deferred compensation plans are used as incentives or retirement benefits, allowing employees to defer income tax on compensation until they actually receive the payment.
Types of Deferred Compensation
Qualified Deferred Compensation Plans: Such as 401(k)s and pensions, which meet requirements under the Internal Revenue Code (IRC) Section 401(a), offering tax benefits and protections.
Nonqualified Deferred Compensation (NQDC) Plans: These plans do not meet IRC qualification standards and typically offer more flexibility but fewer tax advantages. They are often used for highly compensated employees or executives.
Tax Treatment of Deferred Compensation
The key tax principle governing deferred compensation is the timing of income recognition.
Under IRC Section 61, all income is taxable when constructively received or when it is no longer subject to a substantial risk of forfeiture.
Deferred compensation is generally not taxed when earned but when paid or made available to the employee, unless the plan violates specific rules.
Key Tax Rules Governing Deferred Compensation
Constructive Receipt Doctrine:
Income is taxable when it is credited to the taxpayer's account, set apart, or otherwise made available so the taxpayer can draw upon it at any time.
Substantial Risk of Forfeiture:
If the employee’s right to the compensation is conditioned on future performance or events, and the compensation can be forfeited, it is not taxed until the risk lapses.
Section 409A (Nonqualified Deferred Compensation):
Enacted to regulate NQDC plans, Section 409A imposes strict rules on deferral elections and distributions to avoid accelerated taxation and penalties.
Important Case Law on Deferred Compensation and Taxation
Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)
This foundational case broadly defined taxable income as “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” It established the principle that deferred amounts become income when the taxpayer has control over them.
United States v. Sondgras, 386 F.2d 228 (9th Cir. 1967)
The court held that amounts are taxable when there is no substantial risk of forfeiture and the employee has an unconditional right to receive the income.
Helvering v. Horst, 311 U.S. 112 (1940)
This case established the constructive receipt doctrine, ruling that income is taxable when it is made available to the taxpayer without restriction, even if not physically received.
Gregory v. Helvering, 293 U.S. 465 (1935)
While primarily a tax avoidance case, it’s important for its principle that transactions must have economic substance beyond merely avoiding tax, relevant for deferred compensation arrangements designed purely for tax deferral.
Gleason v. Commissioner, 61 T.C. 45 (1973)
The Tax Court held that if deferred compensation is subject to a substantial risk of forfeiture, the employee is not required to include it in income until the risk lapses.
Summary of Tax Implications
Deferred compensation is taxed when the employee receives it or when it becomes available without risk of forfeiture.
Qualified plans provide tax deferral with regulatory protections.
Nonqualified plans must comply with Section 409A rules or face penalties.
Courts consistently apply principles like constructive receipt and substantial risk of forfeiture to determine timing of taxation.
Practical Considerations
Employers and employees should carefully structure deferred compensation agreements to comply with tax rules and optimize tax deferral.
Violations of Section 409A can trigger immediate income inclusion, penalties, and interest.
Proper documentation and timing of payments are critical for tax compliance.
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