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Unfunded deferred compensation plans.

Many country clubs and other exempt organizations provide unfunded deferred compensation plan benefits to key employees from the employer's general assets,

which are accessible by the employer's general creditors. Generally, these plans allow employees to defer part of their current compensation until retirement or termination.


Before 1978, the IRS ruled that an employer's obligation to make future payments to an employee under an unfunded deferred compensation arrangement would not be taxable to the employee or deductible by the employer until the employee had the unrestricted right to payment. In 1978, the Service issued Prop. Regs. Sec. 1.61-16, which states that compensation is includible in taxable income in the year it is earned if the employee has the right to elect to received it in that year. In 1978, in response to public protests, Congress nullifield the regulation's application for taxable entities (Revenue Act of 1978, Section 132).

In addition, Sec. 457 was enacted to allow states and their political subdivisions to offer deferred compensation arrangements--but with sharply limited deferral opportunities for their employees. The Tax Reform Act of 1986 (TRA) extended Sec. 457 to tax-exempt organizations.


Under Sec. 457, amounts deferred in an "eligible" deferred compensation plan are not includible in income until paid or otherwise made available to the employee. As long as the plan in eligible, the proposed regulation is suspended for tax-exempt organizations and states and their political subdivisions. If the plan is not an eligible plan, the amounts deferred are subject to immediate inclusion in the affected employee's gross income in the year of deferral--unless they are subject to a substantial risk of forfeiture.

Substantial risk

of forfeiture

Compensation is subject to a substantial risk of forfeiture if the individual's right to receive it is conditioned on the future performance of substantial services (Sec. 457(f)(3)(B)). The fact that an employer's promise to pay is unfunded and unsecured does not constitute a substantial risk of forfeiture. Generally, exempt organizations provide elective deferred compensation arrangements for certain key employees who are not required to perform future services. Thus, for the amounts to be tax-deferred, the plan must be an "eligible plan."

Eligible plans

An eligible plan must meet the following requirements.

* The plan allows participation only by individuals who perform services for the exempt organization.

* Subject to the catch-up election (discussed later), the maximum amount that may be deferred for any tax year is the lesser of $7,500 or one-third of the participant's includible compensation. Includible compensation excludes amounts deferred under the plan, limiting the deferral to the lesser of $7,500 or, generally, 25% of total current and deferred income.

* The plan must provide that compensation for any calendar month may no be deferred unless a deferral agreement is entered before the first day of that month.

* Generally, the plan cannot provide for distributions until the earliest of the calendar year in which the participant reaches age 70 1/2, separates from service or is faced with an unforeseen emergency.

* The plan must provide that all compensation deferred under the plan, all property and rights purchased with this compensation, and all earnings attributable to such compensation, property or rights, remain solely the property of the exempt employer, subject only to claims of the employer's general creditors. Therefore, the plan must be unfunded. Consequently, any investment income earned on deferred amounts must belong to the exempt organization. For clubs exempt under Sec. 501(c)(7), the investment income is unrelatedbusiness taxable income subject to tax, generally, at corporate rates.

The unfunded requirement

Tax-exempt organization plans, other than governmental and church plans, are not exempt from the Employee Retirement Income Security Act of 1974 (ERISA), Title I, which requires funding. Thus, Sec. 457 plans, which must be unfunded, would be disqualified.

IRS Notice 87-13 (Part G, Q&A 25) stated:

In the case of a deferred compensation plan that is subject to Title I of ERISA, compliance with the exclusive purpose, trust, funding and certain other rules will cause the plan to fail to satisfy section 457(b)(6).

The only alternative for tax-exempt organizations is to use a "top-hat" plan, which is exempt from Title I's funding requirements. A top-hat plan is an unfunded deferred compensation plan for a select group of management or highly compensated employees (ERISA Section 301(a)(3)).

Catch-up election

A catch-up provision can be elected for one or more of the participant's last three tax years ending before the participant reaches normal retirement age under the plan. This election can be made only if the participant did not defer the maximum amount permitted under the plan in previous years. The difference between the deferral limitation and the amount deferred for each year of participation must be computed. This cumulative underdeferral increases the maximum deferral under the plan for the three years before normal retirement--up to the greater of$15,000 or the compensation for the year.


Deferred compensation and any attibutable earnings are included in the participant's gross income in the year that these amounts are paid or otherwise made available to the participant or other beneficiary. Any deferral exceeding the limits is included in income in the first tax year in which there is no substantial risk of forfeiture (Regs. Secs. 1.457-1(b)(2), Example (5), and 1.457-2(e)(3)). Life insurance proceeds or death benefits paid under a Sec. 457 plan are not excludible from the beneficiary's gross income under Sec. 101(a) or (b), respectively (Regs. Sec. 1.457-1(c)).

Lump-sum distributions from a Sec. 457 plan are not eligible for five- or 10-year averaging (under Sec. 402(e)(1) and TRA Section 1122(h)(5)) and cannot be rolled over tax-free to an individual retirement account (IRA). If the distribution consists of an annuity or life insurance contract, the amount included in income is the contract's fair market value.

Distributions are subject to income tax withholding, but not FICA or FUTA taxes. Deferred amounts are subject to FICA and FUTA taxes at the later of the time the services are performed or when there is no substantial risk of forfeiture. (See Sec. 3121 (v)(2) and the Tax Clinic item, "Non-qualified Deferred Compensation and the New Medicare Hospital Insurance Tax," TTA, May 1991, at 300.)

Unforeseeable emergency

Any amount distributed for an unforeseeable emergency is includible in gross income when paid or otherwise made available to the participant. Income tax withholding applies under the general distribution rules, as previously discussed.

An unforeseeable emergency is a severe financial hardship resulting from a sudden and unexpected illness or accident of the participant (or his dependent), loss of the participant's property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the participant's control. Distributions cannot be made to the extent the hardship is relieved through insurance, liquidation of the participant's assets (to the extent the liquidation itself does not cause severe financial hardship), or by cessation of deferrals under the plan.

Note: The need to send a child to college or the desire to by a home is not considered an unforeseeable emergency (Regs. Sec. 1.4572(h)(4)).
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Article Details
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Author:Tonyan, Peter D.
Publication:The Tax Adviser
Date:May 1, 1992
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