Deducting interest in deferred compensation arrangements.
In a recent Ninth Circuit case (Albertson's, Inc., 12/30/93, rev'g 95 TC 415 (1990)), the court held that interest accrued on deferred compensation was deductible in the year incurred. The Ninth Circuit reversed the Tax Court, which had held that the interest was additional deferred compensation and therefore not deductible until the year paid to the participant under Sec. 404.
The Albertson's case
Albertson's Inc. had deferred compensation arrangements for eight executives and an outside director. The agreements provided deferred compensation for the participants plus an "additional amount" calculated by a predetermined formula. The deferred compensation and the additional amount vested immediately and were payable on retirement or termination of employment. The executives' agreements equated the additional amount to interest accrued at a rate approximating the company's borrowing rate. Similarly, the additional amount in the outside director's contract was directly related to interest rates on certificates of deposit as published in The Wall Street Journal. If elected by the participant, payment of the total amount due could be deferred an additional 15 years beyond the date of retirement or termination, and the additional amount would continue to accrue until payout.
In response to a request for a change in accounting method, the IRS initially permitted Albertson's to deduct the additional amount in the year accrued. Subsequently, the Service changed its position, determining that the additional amount was compensation and, therefore, not deductible under Sec. 404 until paid to the participants. The IRS assessed Albertson's for the amount due, and the Tax Court ruled in favor of the Service. The Ninth Circuit, however, held for Albertson's, stating that the additional amount in these deferred compensation agreements constituted interest and, as such, was deductible under Sec. 163, not Sec. 404.
Vested plans: In Albertson's the deferred compensation was fully vested. When the deferred compensation is not fully vested, the interest element may be considered to be compensation. This is analogous to the treatment of dividends paid on restricted stock during the period in which the restrictions apply, as compensation under Sec. 83. What constitutes interest? In Albertson's, the interest accrued on the deferred compensation was clearly unrelated to the additional performance of services and continued to be accrued and payable even if the participant deferred the time of payout for an additional 15 years. The Ninth Circuit determined that participants were not required to perform any "specific" additional services for the interest accrual to continue beyond the termination of employment or retirement date (at the same rate), even though the agreements called for the participants to provide "advisory and consulting services" for as long as the payment was deferred. However, if interest had been conditioned on performance of additional services, it might have been considered compensation and therefore not deductible under Sec. 163.
Although the case does not directly discuss this issue, a footnote indicates that the interest accrued must be "... subject to a rule of reason." therefore, interest accruing at unreasonable rates may be considered compensation.
The case does not address the question of whether an interest element may exist in the absence of an explicit provision or characterization of it as interest in the plan. Accounting method change: If a company is not currently deducting interest as it accrues with respect to existing deferred compensation agreements that fit the profile in this case, the company most likely will have to request a change of accounting method from the IRS for current and new plans. Unless the Service acquiesces in the Ninth Circuit decision (which appears unlikely), it will not consent to this accounting method change. If the IRS does not consent to the change, a company may have to defend the validity of the deduction in court. And there is no guarantee that any circuit other than the Ninth would hold favorably.
Of course, with similar facts, a company in the Ninth Circuit would be able to go to the Tax Court, which would then follow Albertson's
For clients that have offered deferred compensation plans without an interest element, the client's implementation of new deferred compensation agreements containing an interest element would not necessitate the Service's advance consent, since no change in accounting method occurs. Taxation of the participant: How are the participants taxed on the interest? Are they taxable on the interest in the year accrued or only in the year paid? Is the interest considered to be original issue discount (OID) on indebtedness?
The Ninth Circuit found that there was "indebtedness" with respect to the deferred compensation. Assuming that this applies to the participant as well, the question is how the interest should be treated. The OID rules under Secs. 1272 through 1275 apply to debt instruments, including notes, certificates or "some evidence of indebtedness." Under the proposed regulations, this also includes any "...contractual arrangement that constitutes indebtedness under general principles of Federal income tax law."
Under Sec. 1273, OID is the excess of the stated redemption price at maturity less the issue price of the indebtedness. When the indebtedness is issued for cash, which is not treated as property, the issue price is considered to be the cash amount borrowed; OID results if the amount to be paid (other than interest payable currently) exceeds the cash borrowed. If there is OID, the participant would be required to include in income the interest accrued each year at the stated rate in the plan.
When the indebtedness is not publicly traded and is issued for services, the issue price equals the stated redemption price at maturity, with no OID.
Therefore, it may be possible to argue that the indebtedness is issued for the services provided by the participant; as a result, the interest income is not OID and is not required to be included in a cash basis taxpayer's income until paid. However, it is also possible that the IRS might take the position that the debt was deemed to be issued for cash, which would result in annual taxable interest income to the participants without cash payments from which to pay the taxes and withholding. Withholding and reporting: Presumably, interest income is reported in the year paid, assuming no OID, on Form 1099-INT, Interest Income, and no FICA tax withholding or Federal income tax withholding (other than backup withholding) is required. Therefore, if the amount is treated as interest, it would be reported on Form 1099-INT. If the interest incurred is considered to be OID, the amounts would presumably be reported on Form 1099-OID, Original Issue Discount.
For employees, there should be no FICA tax, regardless of how the additional amount is characterized. If deferred compensation is always vested (as in Alberton's), it is immediately subject to FICA tax; subsequent earnings, including interest, are not subject to FICA.
For independent contractors, such as directors, if the additional amount is characterized as interest, it should not be subject to self-employment tax. If the additional amount is considered to be compensation, it would be subject to self-employment tax. Amending plans: Employers should carefully consider the consequences of modifying existing deferred compensation plans to obtain current rather than deferred deductions for interest accruing on the compensation. For example, it may be appropriate to not change plans currently grandfathered under Secs. 280G or 162(m); the company risks losing deductions altogether if such plans are modified so they are no longer grandfathered.
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|Publication:||The Tax Adviser|
|Date:||Mar 1, 1994|
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