article is reprinted with permission from the
April 07, 1994
New York Law Journal.
© 1994 NLP IP Company.
By Joseph E. Bachelder.
This column discusses developments in deferred compensation, including examination of two current objectives of deferred compensation. It also discusses developments involving rabbi trusts and the decision of the U.S. Court of Appeals for the Ninth Circuit in Albertson's v. C.I.R.
Among the reasons for the current interest in deferring compensation are the following:
* an expectation that, with the current marginal federal income tax rate at 39.6 percent, which becomes 41.05 percent if Medicare tax is included, the after-tax return on amounts deferred will exceed the after-tax return that would be realized if amounts were paid out currently and then invested on an after-tax basis; and
* in the case of some public corporations, with one or more key executives earning over $1 million per year, the hope that by deferral of the payment of some of the compensation until after these executives retire, the employer will avoid loss of a deduction under §162(m) of the Internal Revenue Code of 1986 on "non-exempt" compensation of these executives.
After-tax returns. If an executive who is resident in New York City is paid a bonus in 1994 in the amount of $100,000 and invests the after-tax proceeds at a pre-tax total return of 12 percent, assuming a 3 percent dividend rate and a 9 percent capital appreciation rate, the $100,000 bonus will yield approximately $76,000 after texas at the end of the five years. 1 If, instead, the executives deferred the $100,000, the amounts deferred yielded 12 percent pre-tax, assuming, for example, they are deemed invested in employer stock, and the aggregate amount were paid out at the end of the fifth year, the executive would have approximately $92,000 after taxes, or $16,000 more than if he received payment today, as in the first alternative.
No Change in Rates
This comparison assumes no change in the tax rates between 1994 and 1999. If tax rates remained the same as they are today until the fifth year when the federal income tax rates increased, the "break-even point" 2 in 1999, assuming the 12 percent pre-tax returns as described above, would be a combined tax rate of approximately 56.77 percent, assuming an increase in the effective federal rate on ordinary income from 41.05 percent to 51.1 percent and no increase in the federal capital gains rate or in state and local tax rates. Under the same assumptions except that the pre-tax total return, including a 3 percent dividend rate, is 8 percent or 15 percent, the "break-even point" would be approximately 54.76 percent and 58 percent, respectively. Each case assumes change in the federal income tax rate on ordinary income only.
Thus, executives contemplating elective deferral arrangements should consider carefully the risk that tax rates may go up so as to eliminate the hoped-for benefit. In addition, an executive should consider the risk that the employer may become unwilling or unable to meet its obligation at the future date, or dates, when the deferred payment becomes due.
Code §162(m). Some publicly owned employers are using deferral as a technique to protect deductions for amounts in excess of $1 million due certain key officers. Code §162(m) limits the deductions on certain types of compensation in excess of $1 million paid to "covered employees." 3 Under current tax rules, an employer does not receive a deduction for non-qualified deferred compensation until that compensation is taxed to the employee. If the employee has retired when the compensation is received, §162(m) ordinarily should not apply to limit the deductibility of the deferred amounts.
On the other hand, there can be no assurance that Congress will not change the rule in the future so as to apply the $1 million limitation to the payment of deferred compensation if, at the time the deferred amounts were earned, the executives was an officer covered by §162(m).
Increasing interest in deferred compensation has led to increasing interest in rabbi trusts. A rabbi trust, which has been a frequent subject of this column, 4 is a funding vehicle for deferred compensation. It is an irrevocable trust established by an employer for the benefit of one or more of its employee, remain subject to the claims of the employer's creditors. On this basis, and assuming certain other conditions are met, the Internal Revenue Service is willing to defer taxability to the employee of the funds in the trust until they are paid out to the employee.
Rabbi trusts are being included in the array of arrangements that financial institutions are marketing to encourage employers and employees to use their services. At least one such institution in Manhattan provides a rabbi trust "kit" with a ready-to-go deferred compensation plan, rabbi trust and administrative forms. At the beginning of the booklet describing the kit, the institution advises that it is prepared to work with participants to establish investment guidelines consistent with participants' goals and objectives. The booklet indicates that participants may choose among mutual funds, common and preferred stocks, taxable and tax-exempt money market funds and corporate bonds.
Any implication that participates in deferred compensation arrangements, including those with rabbi trusts, m ay actually direct investments may be dangerous advice. In a 1990 private letter ruling, the IRS addressed a deferred compensation plan in which a participant could "select from time to time the investments in which his bookkeeping account will be deemed to be invested." PLR 9101011, Oct. 5, 1990. The ruling goes on to state that "[the company] is under no obligation to acquire or provide any of the investments designated by a participant." It holds that "a Plan participant's right to choose from time to time the designated investments in which his deferrals and matching contributions are deemed to be invested under the Plan will not cause those amounts to be includible in his gross income until the taxable year in which those amounts are actually paid or made available for payment to him."
If, in contrast to the circumstances described in PLR 9101011, the participant could direct actual investments, the result might very well have been different. Published rulings acknowledging deferral of taxability in circumstances in which investments by the employer are involved make it clear that employee had no discretion over the investments. 5 In a number of private letter rulings covering circumstances in which the employee is allowed the discretion to make "deemed" investments, the consequence of the "deemed" investment is a credit to a bookkeeping account. 6 No asset of the employer is required to be in a particular investment at the direction of the employee.
In 1992, the IRS issued a model trust ruling setting forth provisions necessary to qualify a trust for treatment as a rabbi trust. Rev. Proc. 92-64, 1992-2 C.B. 422. The first provision under §5(a) of the model rabbi trust dealing with investment authority states that "all rights associated with assets of the Trust shall be exercised by Trustee or the person designated by Trustee, and shall in no event be exercisable by or rest with Plan participants." No other provision of the ruling modifies this provision as to its requirement that plan participants have no investment authority with respect to trust assets.
Thus, while a participant might provide suggestions to the trustee, the trustee could not, within the guidelines of Revenue Procedure 92-64, be required to follow directions of a participant.
Interesting us of a rabbi trust. According to its 1993 proxy statement, AMR Corporation, the parent of American Airlines, has a program under which executives are awarded, on a deferred basis, shares of stock. The deferred awards generally vest and, it appears, are distributed upon or after the executive's retirement.
Thus, while an award of deferred stock economically is very much the same as an award of restricted stock, the award remains a mere "promise to pay" until the actual distribution of the shares, for example, at retirement. In the case of AMR's chief executive officer, Robert Crandall, the deferred stock award, as originally granted, was subject to a vesting schedule with distribution of the shares at the earlier of Jan. 1, 1996 to his termination of employment.
According to the 1993 proxy statement, Mr. Crandall entered into an agreement whereby he surrendered the vested portion of his deferred stock award, and AMR established a trust in which it deposited a number of shares equal to the number of deferred shares as to which Mr. Crandall surrendered his rights. Moreover, as other deferred shares vest, they are transferred to the trust. Thus, the trustee rather than Mr. Crandall becomes entitled to the distribution of shares. 7
A consequence of the arrangement just described is that the transfer of shares of stock to the trustee of the rabbi trust will occur without tax to Mr. Crandall at that time. Thus, value of the investment can build up on a pre-tax basis until distributed to Mr. Crandall.
Following are further observations on such an arrangement, not because they are necessarily applicable to the AMR situation, but because they might be relevant to other situations -- if a distribution could occur to a "covered employee" in circumstances in which a deduction might be jeopardized under §162(m), the deferral of the distribution, through rabbi trust or otherwise, until after such employee's retirement should avoid the applicability of §162(m), and assuming such arrangement carries over into retirement, it could provide a continuing, post-retirement, tax-free buildup of earnings and gains.
On Dec. 30, 1993, in Albertson's, the Ninth Circuit ruled that interest accrued with respect to a deferred compensation account is interest within the meaning of §163 and is deductible by the employer in the year of accrual. This reversed a U.S. Tax Court decision that held such interest was not deductible until paid to the employee, because it was not deductible as interest under §163 but as compensation under §4048.
The IRS had indicated that it will seek to overturn the Ninth Circuit's decision. 9
According to A. Thomas Brisedine, branch chief in the IRS Office of the Associate Chief Counsel, Employee Benefits and Exempt Organizations Division, the decision could result in the government's losing $1 billion in revenue. The Justice Department has petitioned the Ninth Circuit for a rehearing. 10
Also Senator David Pryor (D-Ark.) introduced legislation in Congress on Feb. 28, 1994 that would effectively overrule the Albertson's decision. 11
Accordingly, the issue as to whether interest with respect to deferred compensation accounts may be deducted as it accrues may be decided, ultimately, by the U.S. Supreme Court or Congress.
Before 1982, Albertson's, Inc. had entered into deferred compensation arrangements with eight of its top executives and one outside director. The arrangements allowed the executives to defer their salaries and/or bonuses and, in the case of the outside director, his director's fees, for a specified period of time.
The amounts deferred by the executives would earn interest at a rate equal to the weighed average of the long-term borrowing rate of Albertson's for each of the fiscal years during the period of deferral. The amounts deferred by the outside director, according to the Tax Court's opinion, would earn interest at a rate based on rates for new certificates of deposit of $1 million or more offered by major banks, as published in The Wall Street Journal.
Tax Court Decision
In 1987, the IRS sought a deficiency based on the interest amounts previously deducted. 12 In 1990, the Tax Court found for the IRS in a decision in which nine judges ruled that the interest was not §163 interest, and nine judges ruled that it was. 12
Of the nine who ruled the interest was §163 interest, four concurred in the result on the ground that §404 generally allows a deduction for deferred compensation only when paid, which in this case would include the accrued interest, and that §404 overrides §163 as to the timing of the deduction.
On appeal, the Ninth Circuit held that the interest accruing on the deferred compensation arrangements was deductible as it accrued. The court stated that denial of a deduction because there was no interest element in the transaction would be to "stand history on its head."
In reaching its holding, the court held, among other things, that these amounts were interest because they were for the use or forbearance of money and did not depend in any way upon the amount or type of services performed by the participants.
In addition, the court held that the timing restrictions under §404 did not apply because that section affects §§162 (business deductions, including compensation) and 212 (other deductions attributable to the production of income), and not §163 (interest deductions). 13
In view of reactions to Albertson's in government agencies and Congress, the likelihood of the result of this holding surviving for long, even within the Ninth Circuit, is questionable. It seems impractical at this time for an employer to change a practice of deferring deductions for interest, or interest equivalents, under deferred compensation arrangements. To accomplish this, an employer might be required to follow IRS procedures for changing a method of accounting.
On the other hand, some employers may wish to consider filing protective refund claims as to taxable years still open just in case Albertson's becomes the prevailing law on the deductibility of interest accruing on deferred compensation.
1 The assumptions underlying the calculations of the 12% total return rate are as follows: (1) initial amount deferred -- $100,000; (2) capital appreciation rate -- 9 percent; (3) dividend rate (pre-tax) -- 3 percent; (4) combined individual tax rate (federal, state and local, including federal surcharge and Medicare) -- 47.86 percent; and (5) combined individual tax rate on long-term capital gains (federal, state and local -- 34.81 percent.
2 "Breakeven point" for this purpose means that tax rate above which the after-tax return on a bonus deferred for the five-year period becomes less than the after-tax return if, instead, the bonus is paid today, with the after-tax proceeds invested for five years.
3 A "covered employee" includes the company's chief executive officer, of the individual acting in such a capacity, at the close of the taxable year and the four highest compensated officers for the taxable year, other than the chief executive officer, as determined by Item 402(a)(3)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Internal Revenue Code, §162(m)(3).
4 See this column, New York Law Journal, Aug. 31, 1992; Aug. 29, 1988; June 29, 1987, Sept. 30, 1985;l and April 29, 1985.
5 Rev. Rul. 72-25, 1972-1 C.B. 127; Rev. Rul. 68-99, 1968-1 C.B. 193.
6 PLR 8804057 (Nov. 4, 1987); PLR 8804023 (Oct. 30, 1987); PLR 8507028 (Nov. 20 1984); PLR 8411022 (Dec. 8, 1983).
7 Mr. Crandall's employment agreement and the amendment providing for the transfer of deferred stock entitlements to the rabbi trust are exhibits to AMR's Forms 10-K (1988 and 1992, respectively).
8 95 TC 415 (1990).
9 24 Daily Tax Report (BNA) G-1 (Feb. 7, 1994).
10 39 Daily Tax Reports (BNA) G-6 (March 1, 1994).
11 S. 1877, 103d Cong., 2d Sess. (Feb. 28, 1994).
12 An interesting feature of this case is that the IRS apparently approved a change in the method of accounting by Albertson's several years previously in which it has shifted to deducting interest on deferred compensation as it accrued. 95 TC at 418. No explanation is given in the Tax Court opinion as to the basis on which the IRS originally approved the change in the accounting method.
13 The Ninth Circuit remarked that [permitting] the deduction of interest may simply have resulted from a glitch in the Code. Even if that is the case, however, Code changes are for Congress to make -- not the courts." 12 F3d at 1539.