Page 98 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

84 The Complete Guide to Executive Compensation

is made. They cite Revenue Ruling 69-650, which indicates that a decision by December 31
is required in connection with compensation to be earned during the following year. This is
the year-before-the-year principle. It is further reinforced by Section 409A of the IRC, which
requires the election to be made prior to the end of the preceding taxable year, except for new
eligibles and performance-based plans. The law permits eligibility within 30 days after first
becoming eligible; and for performance-based plans of at least 12 months, the election can
be made within 6 months prior to the end of the performance period.
It is possible to do a deferral on a deferral. For example, if an executive has deferred a
$100,000 bonus for five years, he or she might decide (early enough to avoid constructive
receipt) to further defer the amount, perhaps paid out in annual installments of $50,000 until
the deferral is exhausted, beginning seven years after the initial deferral. This gives the exec-
utive flexibility to meet children’s college or other expenses. Section 409A of the IRC states
that changes in time and form of payment can be made if not less than 12 months before the
first scheduled date and if the election is deferred for a period of not less than five years from
the date of such payment.
Companies must also be careful in permitting earlier payout after the amount has been
deferred. The earlier-described American Jobs Creation Act of 2004 has specific require-
ments regarding changes in time and form of payment that if not met result in significant tax
penalties. Prior to this law, many companies adopted a haircut provision for early withdrawals,
either by forfeiting a portion of the account balance or by denying eligibility for further
deferrals for a period of time, or both. Such provisions can still be adopted if they are in
addition to the law, but not in place of it.

Economic Benefit
Another tax principle closely allied with the doctrine of constructive receipt is the theory of
economic benefit. Here the IRS interprets an action by the employer as resulting in something
of value being bestowed upon the employee. For example, the mere promise by the compa-
ny to pay in the future (rather than currently) has no economic value even though the trust
is irrevocable and not accessible to present or future management. This is the earlier iden-
tified rabbi trust. This nonqualified trust may or may not be funded. If funded, it must be
available to creditors in case of bankruptcy. It is taxable to the recipient at time of receipt of
funds, not when the organization makes a contribution. A variation is a dry rabbi trust,
which becomes funded at time of a change of contract typically to protect the executive and,
therefore, is subject to taxation.
Another variation was a grantor trust with a call provision that permitted the recipient to
require early payment by the grantor. This typically would be because the executive feared
pending company bankruptcy and therefore an inability by the company to make full pay-
ment. Section 409A of the IRC does not permit this preemptive action; however, payment
upon time of change in ownership or effective control is permitted. Section 409A of the IRC
still applies as to when the decision on form of payment must be made, however.
Similarly, if the employer sets up a trust to which the employee has nonforfeitable rights,
then the amount of annual contribution will be construed to be an economic benefit, and the
employee will be taxed that year on the value of that contribution. This is a secular trust. Note
that this is not an issue of constructive receipt because the trust specified when in the future
the executive will receive payments. However, if there were a substantial risk of forfeiture
associated with these payments, then the economic benefit theory would not apply. One