IRS proposes revoking deferred compensation ruling.

The IRS has "tentatively concluded" that the part of Letter Ruling 9235006 that held that a parent company would be treated as the sole owner and grantor of a trust it established to provide nonqualified deferred compensation benefits to its own executives and those of its affiliates was incorrect. As a result, the Service has proposed revoking that holding, as well as its conclusions that (1) dividends paid on the parent's stock held by the trust will not be includible in the parent's gross income and (2) the parent will not recognize any gain or loss on the trustee's receipt of money or other property in exchange for the parent's stock.

Company X is the parent of an affiliated group. A few years ago, X requested a ruling on the income tax consequences of establishing a trust to assist X in providing nonqualified deferred compensation under a plan for certain executives of X and its affiliates. Although the purpose of the trust was to pay X's and the affiliates' benefit obligations to participating executives, the trustee was obligated to hold the trust assets and income for the benefit of X's and the affiliates' general creditors in the event X or the affiliates became insolvent. The trust agreement further provided that plan participants had no beneficial ownership in, or preferred claim on, the trust assets. Thus, although the assets were held in trust, in the event of X's or the affiliates' insolvency, the assets were within the reach of X's or the affiliates' general creditors. Under the terms of the trust, trust assets were to be invested in X stock.

In Letter Ruling 9235006, the IRS ruled that:

1. X would be treated as the trust's owner under Sec. 675(4), relating to grantor trusts; therefore, under Sec. 671, all the trust's items of income, deductions and credits would be included in computing X's taxable income and credits.

2. Because X was treated as the owner of the entire trust, it was treated under Rev. Rul. 85-13 as the owner of the trust's assets for Federal income tax purposes.

3. Provided X remained the owner of the trust, (1) dividends paid on X stock held by the trust would not be includible in X's income (since X would, in effect, be paying itself a dividend) and (2) under Sec. 1032, X would not recognize gain or loss on the trustee's receipt of money or other property in exchange for X stock (since X would, in effect, be receiving payment in exchange for its own stock).

Owner of trust

In Letter Ruling 9404008, the Service stated that it had tentatively concluded that its rulings in #1 and 2 were incorrect. And because those rulings were incorrect, its conclusions in #3 were also incorrect. Apparently, the IRS now believes that the trust would have more than one grantor, in which case Sec. 1032 would not shield dispositions of X stock by the affiliates (although, under Rev. Rul. 80-76, there might still be no gain or loss).

Tax treatment of benefits

The Service also concluded in the earlier ruling that:

4. X's establishment of the trust and the contribution of assets to it would not constitute a transfer of property under Sec. 83.

5. Cash basis participants would include plan benefits in income in the tax year in which the benefits were paid or made available, and neither the creation of the trust nor the contribution of assets to the trust would cause a participant to recognize income in an earlier year under the constructive receipt doctrine or the economic benefit doctrine.

6. Under Sec. 404(a)(5), either X or the affiliates would be entitled to deduct the benefits paid under the plan in the tax year in which the benefits were included in the participants' income.

In Letter Ruling 9404008, the IRS stated that it was proposing to revoke each of these rulings as well, unless the trust was amended by adding certain language to address the Service's concerns regarding creditors' rights in trust assets. An IRS official has indicated separately that the trust assets were reachable by the creditors of some, but not all, of the affiliates whose executives were covered by the plan--a fact not apparent from the text of Letter Ruling 9235006.