article is reprinted with permission from the
July 30, 1990
New York Law Journal.
© 1990 NLP IP Company.
By Joseph E. Bachelder.
THIS COLUMN WILL DISCUSS the current federal income tax status of methods of securing vested nonqualified deferred compensation by third-party guarantees, including surety bonds and letters of credit.
Ordinarily nonqualified deferred compensation arrangements, if secured, are secured by a trust fund or an annuity. Assuming the deferred compensation is vested, care must be taken that the funding vehicle does not accelerate taxation of the deferred compensation. Deferred compensation also may be secured by guarantees in one form or another by some party other than the employer. Such guarantees, rather than funding, are appropriate in a number of situations, such as the following:
1. The need may be a temporary one -- for example, a deferral for a short period.
2. The protection sought may by only with regard to specific events such as unfriendly change in control or the occurence of an adverse financial condition of the employer.
3. An employer may want to secure a promise to pay but not have the current resources to fund the commitment.
4. The guarantee of a surety company or an affluent stockholder may be considered more secure than an irrevocable trust for the benefit of the employee, the assets of which must be subject to the claims of creditors of the employer in order to avoid taxation to the employee with a vested entitlement thereto.
Unfortunately, however, security agreements entered into in connection with deferred compensation arrangements face an uncertain future with the IRS. The IRS has suspended for some period ruling on these security agreements. In 1986, a tax publication reported that "the Service has indicated informally that . . . employer backing of the surety would be tantamount to either an economic benefit or constructive receipt of the nonqualified deferred compensation." Tax Management Compensation Planning Journal, May 2, 1986, at 131. In 1989 the IRS apparently gave notice to some taxpayers who had ruling requests pending regarding third-party guarantees that the IRS position was "tentatively adverse" to the ruling requests. 1 The remainder of this column will concern examples of third-party guarantees and their relative vulnerability in light of existing cases and rulings.
A recent Daily Tax Report clarified that, in the thinking of Mr. Thomas Brisendine, an IRS branch chief, surety bonds acquired by rabbi trusts would not destroy the tax-favored position of rabbi trusts provided that the proceeds of the surety bonds remain subject to claims of creditors of the employer. BNA Daily Tax Rep., G-8 (June 29, 1990) (correcting a June 28 report that had stated that the "IRS would restrict the use of surety bonds and letters of credit in connection with Rabbi trusts.")
Example 1. Employee Purchases Surety Bond.
In PLR 8406012 the IRS ruled favorably in a situation involving purchase of a surety bond by the employee to protect deferred compensation. In that case, an executive participated in a deferred compensation program that was unfunded. In order to protect his entitlement, the executive proposed to purchase a surety bond from an insurance company independent of the employer. The bond would be renewable every five years and would assure payment of any deferred compensation the employer failed to pay for any reason.
The ruling holds that the purchase of the financial surety bond by the executive to protect future deferred compensation payments would not, by itself, cause the deferred amount to be taxable to the executive, either at the time of purchase of the surety bond or at the time of payment of the premiums.
The result of PLR 8406012 is consistent with the principles of the "economic benefit" theory. Under the theory if an employer confers an economic benefit on an employee the employee is taxable on that benefit even though the benefit is in a form other than money or its equivalent. Smith v. Commissioner, 324 U.S., 177 (1945) (economic benefit associated with stock option exercise); Sproull v. Commissioner, 16 TC 244 (1951) (transfer of funds to an irrevocable trust for benefit of employee).
Where the employee purchases the surety bond, the economic benefit attached to the security is provided by the employee's paying the premium. No economic benefit is conferred by the employer. This assumes the employer does not reimburse the employee for the cost of the premiums (or otherwise benefit the employee in some way such as agreeing with the surety to do something that reduces the cost of the premium to the employ discussion in this regard under Example 2 below).
Section 83 of the Internal Revenue Code of 1986 (the Code), which embodies the economic benefit theory, is consistent with this conclusion. The statute deals with a "transfer of property" in connection with employment, a circumstance not present in a transaction between an employee and a surety company.
Example 2. Employer Purchases Surety Bond.
In PLR 8406012, discussed above, the executive represented to the IRS that the employer was not purchasing the surety bond and would not reimburse him for his payments of the premiums for the bond. The ruling, in dictum, states that payment of premiums by the employer for a surety bond in the circumstances described would result in taxable income in an amount equal to the premiums paid by the employer. There is no suggestion in the ruling that payment by the employer would result, in any circumstance, in taxation of the deferred amounts to the employee prior to their actual receipt by him. The ruling analogizes the situation to the purchase of a life insurance policy. Premiums paid by an employer on life insurance in which the proceeds of the policy are payable to the employee's estate or beneficiary are taxable to the employee (subject to limited exceptions such as provided by Code § 79).
In a recent ruling, PLR 8923020, the IRS considered a situation analogous to the case of an employer purchasing a surety bond to protect an employee's deferred compensation. In that case, the operator of a sweepstakes contest purchased a surety bond in order to guarantee payment of prizes, which were paid over a period of years. The annual premiums amounted to approximately 0.5 percent of the present value of the prize. The operator of the sweepstakes contest agreed to indemnify the surety company if the company had to make payments under the bond. State law required the operator of the sweepstakes contest to secure the deferred prizes by either putting the amounts involved in a trust fund or by purchasing a surety bond.
The good news for the sweepstakes winners was the holding of the ruling that there would be no taxable income attributable to the purchase of the surety bond by the sweepstakes operator. The sweepstakes prizes would be taxable only as received, and there would be no tax to the prize winners in respect of the premium payments to the surety company. In reaching this holding, the ruling comments as follows:
In this case, the sweepstakes winner has no choice as to the manner of payment and will not be in constructive receipt of the sweepstakes winnings. Moreover, because X will not set aside any amounts in a fund or trust, it has not conferred any economic or financial benefit on the sweepstakes winner.
The bad news for executives is the distinction drawn by the ruling regarding the consequences of a surety bond in an employment context:
The ruling stated above applies only to the use of a surety bond in a non-employment context. No inference should be drawn as to the tax consequences under § 83 of a promise to pay compensation which is secured by a surety bond. The definition of property under § 1.83-3(e) of the Income Tax Regulations encompasses a promise to pay which is either funded or secured (emphasis added) and does not require that assets be set aside in a fund or trust.
The rationale of the ruling is difficult to understand.
1. It is difficult to see how a surety bond does not confer an economic benefit on a sweepstakes winner under the circumstances noted but does confer an economic benefit on an executive under a deferred compensation arrangement. Assume that the executive, like the sweepstakes winner, has no choice over when payment is to be made. The security involved in each case is the same. The rules under Code § 83 embody the same economic benefit theory applicable in the nonemployment context. True, there is only a limited nexus between a sweepstakes winner and a sweepstakes operator and the provision of the surety bond met a requirement of state law. Nonetheless, the economic benefit conferred would seem to be the same in each case: the greater assurance of payment that is provided by a surety bond.
2. The sentence in Treasury Regulation 1.83-3(e), referred to in the above quotation, reads as follows:
"(e) Property. For purposes of § 83 and the regulations thereunder, the term "property" includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future."
Transfer of Property
The sentence in the Regulation admittedly is a confusing one. In its suggestion that a mere promise to pay constitutes property, the sentence in the regulation is wrong. It is likely the draftsman of the Regulation wanted to emphasize that a mere promise to pay does not constitute property but instead expressed it as if it were property (but excluded by the regulation from being treated as property). The jump from the grammatical uncertainty in Treasury Regulation 1.83-3(e) to the conclusion reached in PLR 8923020 evidences that old adage that two wrongs do not make a right.
The statute and the regulations under § 83 are concerned with a transfer of property. If the employer transfer a premium to a surety company, the transfer of property, or the economic benefit, that has occurred is the transfer of money to purchase the surety bond. It is the premium that should be taxable where the employer pays the surety bond premium (as stated in PLR 8406012), not the deferred compensation that it is paid to secure.
PLR 8923020 raises the question as to what the IRS would suggest be taxed under various types of surety and other security arrangements. It seems inconceivable that the payment of one year's premium would trigger taxation of the entire deferred amount it is securing.
There is no comparability between a transfer of $1 million to a trust to found a deferred compensation benefit for an executive and the transfer of $5,000 to $10,000 to a surety company as one year's premiums for protection regarding payments that run substantially beyond that year. What if an employer makes the first payment of premium and then defaults? What if the surety retains a right to cancel under certain circumstances and exercises it?
A third-party guarantee is just another promise that the obligor's promise will be carried out. Again, it is not a transfer of property under Code § 83. In the Sproull case, noted above, the economic benefit principle was applied to the transfer of funds to a trust for the benefit of an executive, which trust became the obligor to pay the benefit. A surety company, however, originally is only a secondary obligor. Nor does it hold funds as a fiduciary for the obligee. Thus, if the surety becomes insolvent, the obligee would be a general creditor with no rights against any specific funds.
There are, indeed, circumstances in which an employer's payment of premiums may not reflect the full value of the guarantee. For example, the employer may transfer funds to the guarantor as collateral (but not as escrow or trust funds), thereby reducing the premium required. This would have to be taken into account in valuing the economic benefit of the guarantee. It does not suggest an acceleration of the deferred compensation.
Example 3. Affiliate of the Employer Guarantees Payment.
Cases and rulings dealing with guarantees of deferred compensation by affiliates of the employer consistently have held that the guarantee does not result in current taxation of the amounts deferred. In Berry v. United States, 593 F.Supp. 80 (MDNC 1984), owners of a corporation that operated a basketball team guaranteed payments of $1 million over 10 years to a basketball player. The court expressed itself in a way directly contradictory to the suggestion in PLR 8923020 that a guarantee of a promise to pay may somehow convert the promise into property. The court said:
The plaintiff asserts that the descriptive phrase "not * * * secured in any way" set out above [a reference to Revenue Ruling 60-31, 1960-1 C.B. 174, at 177] confers some benefit upon him by way of converse implication. The theory is that if a naked promise to pay -- not secured in any way -- is not a receipt of income, then a promise secured in some way would be such a receipt. As the theory runs, the promise by Southern Sports to pay Caldwell was secured in some way, becaue the club's principals (Munchak and Gorham) guaranteed the salary. The court cannot agree. The guarantee itself is a mere promise to pay. No funds were set aside for Caldwell's benefit. No escrow or trust fund was established, nor was any lien or security interest established to assure his position. Caldwell had no control or command of funds or property, so the rule of constructive receipt does not apply. 593 F.Supp. at 85. 2
In 1988 a private letter ruling held that a parent corporation's guarantee of an employer's obligations to make deferred compensation payments did not result in accelerating taxability. PLR 8808032. 3
In view of the cases and rulings in the area of owner guarantees of employer obligations to make deferred compensation payments, it would seem unlikely the IRS would seek to change this established rule by requiring acceleration of the deferred payments solely because of a guarantee by the affiliate. Such guarantees are an important part of United States business, involving not only employees but cash-basis contractors as well.
Example 4. Bank Issues Letter of Credit.
In Korstad v. Commissioner, 45 TCM (CCH) 1032 (1983), a seller of real estate required the buyer to secure the installment obligations due under the contract by obtaining a letter of credit from a bank. The taxpayer elected to report on the installment sale basis under Code § 453. The IRS argued that the letter of credit, which was transferable, was a cash equivalent and thus the taxpayer was not eligible to elect installment treatment under § 453. The court rejected the IRS position, stating that the letter of credit was securing the obligation of the buyer, not replacing it. 4
Code § 453(f) (3), in defining a payment for purposes of the installment sales provisions, excludes evidences of indebtedness of a buyer "whether or not payment of such indebtedness is guaranteed by another person." The regulations under § 453 contain an example of a "stand-by" letter of credit that does not accelerate the payment it secures. 5 It would seem anomalous that letters of credit, provided they meet the requirements of the regulations under Code § 453, would not constitute payment under the installment sales provisions of Code § 453 but could be deemed a transfer of property under Code § 83.
The economic benefit to the employee of the letter of credit is the value of the assurance it provides -- not the value of the payment it is securing. Again, a guarantee, itself, is only another promise. It should not be treated like a transfer of property in trust to fund the deferred amount.
Ultimately, it is hoped, the IRS will consider the question as simply one of valuation of the security obtained by the letter of credit, as discussed in connection with the surety bond examples. Thus, if an employer not only pays a fee for a letter of credit but provides other consideration to the bank (such as an increase in its compensating balance), the value of the letter of credit may be found to be greater than the actual premiums paid.
1 Moore & Tilton, "Non-qualified Deferred Compensation: The Quest for Benefit Security," Non-Qualified Deferred Compensation Plans 1989 (Practising Law Institute 1989) 205, at pp. 320-21.
2 See also Robinson v.Commissioner, 44 TC 20 (1965), acq., Rev. Rul. 70-435, 1970-2 C.B. 100.
3 See also PLR 8752037. In a 1955 published ruling the IRS held that transfer of funds to a trust or to purchase an annuity for an employee would result in tax to the employer. This funding relieved two guarantors of the employer's obligation of their guarantee responsibilities. There is no suggestion in the ruling that the employee was taxable in prior years as a result of the guarantees. Rev. Rul. 55-691, 1955-2 C.B. 21.
4 See also Sprague v. United States, 627 F2d 1044 (10th Cir. 1980), 78-2 USTC (CCH) para. 9650, F.Supp. (W.D. Okla. 1978). The court in Korstad v. Commissioner also distinguished those cases in which the buyer deposited cash or a cash equivalent with the bank in support of the letter of credit. In such cases, according to the court, the bank is merely holding funds -- virtually as an escrowee -- whcih the seller otherwise could have demanded and received. For cases finding that the letter of credit in effect became a substitute obligation, Watson v. Commissioner, 69 TC 544 (1978), aff'd 613 F2d 594 (5th Cir. 1980), and Griffith v. Commissioner, 73 TC 933 (1980).
5 A "stand-by" letter of credit, as defined in the regulations, is a "non-negotiable, nontransferable (except together with the evidence of indebtedness which it secures) letter of credit, issued by a bank or other financial institution, which serves as a guarantee of the evidence of indebtedness which is secured by the letter of credit." Treas. Reg. § 15A.453-1(b)(3)(iii). For examples see Treas. Reg. § 15A.453-1(c)(1), Examples (7) and (8).