Page 97 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 3. Current versus Deferred Compensation 83

8. Nonfunded, nonqualified, nonforfeitable plan. This is even more attractive to the
executive than number 6, since the benefit is 100 percent vested. This is an example of
the earlier-described rabbi trust. Although this situation was covered in Revenue Ruling
60-31, for years companies included some degree of forfeiture to minimize any possible
claim by the IRS of constructive receipt. Revenue Rulings 64-279 and 70-435 reaffirmed,
as did the Revenue Act of 1978, that a mere promise to pay does not trigger an income
tax liability as long as the recipient is not put ahead of the general creditors of the com-
pany. From the employer’s point of view, it is a little less attractive than number 6 since
ability to retain the executive is lost with the full vesting. As with other nonqualified
plans, the company has no tax deduction until the executive receives payment. Intent on
providing a safe harbor from constructive receipt and economic benefit issues, the IRS
set up a model rabbi trust in Revenue Procedure 92-64. Anyone creating such a trust
would be well advised to examine this procedure very carefully.

TAX PRINCIPLES

The individual pays taxes on the benefit when received (actual or constructive) in addition to
any economic benefit that may have been received. These two principles, constructive receipt and
economic benefit, will be described subsequently, as well as the definition and treatment of
restricted property. The company has a tax deduction when paid to the individual (nonqualified
deferral) or put into a trust (qualified deferral).

Constructive Receipt
Some bonus plans may call for payments in several annual installments, usually no more than
five. The rationale for such an approach on timing is as follows: (1) it cushions the effect of
one low-bonus year, (2) it helps to retain executives since the payment of deferred awards is
often contingent upon continued employment with the company, and (3) it spreads the tax
bite. Concerning this last point, it is imperative that any deferred payments be viewed in light
of the IRS doctrine of constructive receipt in order to avoid taxation to the recipient in the
year in which granted. This was defined in Revenue Ruling 60-31, which said, “Under the
doctrine of constructive receipt, a taxpayer may not deliberately turn his back upon income
and thereby select the year for which he will report it.”
The doctrine of constructive receipt is defined in Section 1.451-2(a) of the Treasury
Regulations. It states: “Income, although not actually reduced to a taxpayer’s possession, is
constructively received by him in the taxable year during which it is credited to his account,
set apart for him, or otherwise made available so that he may draw upon it at any time, or so
that he could have drawn upon it during the taxable year if notice of intention to withdraw
had been given. However, income is not constructively received if the taxpayer’s control of its
receipt is subject to substantial limitations or restrictions.” In other words, if the executive
could reach out and take the money (regardless of whether or not he or she did), it would
considered taxable income. This could lead to the disastrous situation where the person is
taxed on income not yet received!
The chances of such an interpretation being made is minimized if the individual makes
a determination before the amount is earned; some interpret this as before January 1 of the
year on which the bonus is calculated, not simply a couple of months before the calculation