COMMENTS. I. Introduction and Summary

Transcription

1 TAX SECTION OF THE PHILADELPHIA BAR ASSOCIATION COMMENTS TO DRAFT PERSONAL INCOME TAX BULLETIN PENNSYLVANIA TAXATION OF CONTRIBUTIONS TO DEFERRED COMPENSATION PLANS AND ELIGIBLE RETIREMENT BENEFIT PLANS I. Introduction and Summary Draft PIT Bulletin (the Draft Bulletin ) sets forth the Pennsylvania Department of Revenue s interpretation of how Pennsylvania constructive receipt principles apply to contributions made under deferred compensation plans and eligible retirement benefit plans. The Tax Section of the Philadelphia Bar Association ( Tax Section ) believes that the constructive receipt analysis in the Draft Bulletin is flawed and contrary to Pennsylvania law. Accordingly, we urge that the Draft Bulletin not be released in its present form. Our primary objections to the Draft Bulletin can be summarized as follows: Treatment of Voluntary or Elective Deferral. The Draft Bulletin adopts a per se position that the constructive receipt rules apply to any compensation deferred by an employee under a voluntary or elective salary reduction arrangement, regardless of whether (i) the deferral arrangement is entered into before services are performed or (ii) the deferred amounts are funded or unfunded. This position is contrary to the Department s regulations on constructive receipt, which are based, verbatim, on the federal constructive receipt regulations. Pennsylvania courts have consistently looked to federal cases and rulings and applied basic federal concepts of constructive receipt. The Draft Bulletin, on the other hand, applies the Pennsylvania constructive receipt regulations in a manner inconsistent with the manner in which the identical federal regulations have been applied in numerous cases and rulings. The Department should not adopt federal tax regulations verbatim, and then interpret those regulations without regard to federal cases and rulings to reach completely different results. Funded vs. Unfunded Arrangements. The Draft Bulletin ignores the critical distinction between funded and unfunded deferred compensation arrangements. In a funded arrangement, deferred compensation is contributed to a trust or account that is established for the benefit of the employee and is immune from the claims of the employer s creditors. In an unfunded arrangement, the employee has merely an unfunded and unsecured promise from his or her employer to pay money at a future date. Under basic constructive receipt and economic benefit principles, an employee should always be taxed on amounts contributed to a funded arrangement, yet the Draft Bulletin suggests this is not always the case. The failure to distinguish between funded and unfunded arrangements has also caused the Department to misconstrue AMP Products

2 Corp. v. Commonwealth. 1 Treatment of Mandatory Contributions. The Draft Bulletin appears to state that mandatory payroll deductions are also subject to current taxation, without regard to whether the arrangement is funded or unfunded. This position is even more extreme than the position that voluntary payroll deductions are taxed currently. The Draft Bulletin suggests that there is a distinction between a mandatory payroll deduction and an employer contribution, but this distinction is not spelled out. Drafting Issues. These comments will concentrate on areas of substantive disagreement. We note, however, that we have numerous comments and suggestions regarding the organization and drafting of the Draft Bulletin. Our most fundamental drafting comment is that if the Department is going to interpret the constructive receipt rules in a manner that is fundamentally inconsistent with long settled and widely understood constructive receipt concepts, these fundamental differences should be highlighted and emphasized. The Draft Bulletin gives the impression that Pennsylvania follows federal constructive receipt concepts because much of the language parallels the federal rules, and very little attention is drawn to the fact that the Department is interpreting these rules in a manner quite different from the way the federal rules have been interpreted. Once substantive issues have been resolved, we will be happy to provide specific drafting comments and suggestions. II. Summary of Applicable Pennsylvania Law The fundamental tax issue raised by the Draft Bulletin is when should compensation earned under a deferred compensation arrangement be treated as received by the employee. As discussed below, the Pennsylvania Personal Income Tax Regulations (the PIT Regulations ) have adopted basic, long established and well understood federal tax concepts of actual and constructive receipt of income. The PIT Regulations dealing with the constructive receipt of income are identical to the federal regulations, and Pennsylvania courts have uniformly looked to federal cases and rulings to interpret the Pennsylvania constructive receipt regulations. Nonetheless, the Draft Bulletin interprets Pennsylvania s constructive receipt rules in a manner that is inconsistent with well understood and long settled federal constructive receipt rules. The Draft Bulletin is thus contrary to Pennsylvania law. A. Statutory Definition of Compensation The Pennsylvania personal income tax ( PIT ) is imposed on enumerated classes of income, including compensation. Section 301(d) of the Tax Reform Code of 1971 (the TRC ) defines compensation as follows: Compensation means and shall include salaries, wages, commissions, bonuses and incentive payments whether based on profits or otherwise, fees, tips and Pa. Commw. 346, 593 A.2d 1 (1991), aff d per curiam 530 Pa. 249, 608 A.2d 25 (1991). 2

3 similar remuneration received for services rendered, whether directly or through an agent, and whether in cash or in property. The term compensation shall not mean or include: (iii) payments commonly recognized as old age or retirement benefits paid to persons retired from service after reaching a specific age or after a stated period of employment; or (vi) payments made by employers or labor unions, including payments made pursuant to a cafeteria plan qualifying under section 125 of the internal revenue code of 1986 (public law , 26 u.s.c. Section 125), for employee benefit programs covering hospitalization, sickness, disability or death, supplemental unemployment benefits or strike benefits: provided, that the program does not discriminate in favor of highly compensated individuals as to eligibility to participate, payments or program benefits; or (ix) payments made by employers or labor unions for employe benefit programs covering social security or retirement. The definition of compensation is thus very broad. Unlike federal law, however, which generally taxes retirement benefits when they are received, the PIT exempts old age and retirement benefits. B. PIT Regulations On Constructive Receipt and Economic Benefit PIT Regulations 101.7(a) adopts the fundamental federal tax concept that [u]nder the cash receipts and disbursements method of accounting, such an amount [compensation] shall be includable in gross income when actually or constructively received. The concept of constructive receipt is described as follows in PIT Regulation 101.7(c): (c) Constructive Receipt of Income. Income although not actually reduced to possession shall be constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time. However, income shall not be constructively received if the control by the taxpayer of its receipt is subject to substantial limitations or restrictions. Therefore, if a corporation credits its employes with bonus stock, but the stock is not available to such employes until some future date, the mere crediting on the books of the corporation does not constitute receipt. This language was taken verbatim from Treasury Regulation (a), the federal regulation dealing with constructive receipt of income. 2 The federal regulation on constructive receipt has a long established and well understood interpretation, which is summarized in Appendix 1 to these comments. 2 The only difference in wording is that the federal regulation starts as follows: Income although not actually reduced to a taxpayer s possession is constructively received by him (emphasis added). The words a taxpayer s were dropped in the PIT regulation. The PIT regulations also spell employee with only one e at the end. 3

4 Pennsylvania also appears to have adopted the federal economic benefit doctrine. PIT Regulation 101.7(e) provide as follows: (e) Present Economic Benefit. An amount paid as a contribution shall be considered as received if an employe receives rights, such as coverage under a plan that are the following: (1) Of a value which can in no even fall materially below the amount of the contribution. (2) Presently belonging to the employe. (3) Unequivocally provided for the ultimate benefit of the employee under whatever contingency and whatever circumstance the occasion for the benefit should arise. C. PIT Regulations Defining Compensation and Retirement Benefits The enumeration of different types of compensation subject to tax is expanded in section 101.6(a) of the PIT Regulations, which includes amounts received under employee benefit plans and deferred compensation arrangements within the items subject to tax. Section 101.6(c) of the PIT Regulations contains rules applicable to contributions to and distributions from Individual Retirement plans (IRA), Simplified Employee Pension Plans (SEP), Keogh plans, Federally qualified employe pension plans, and similar old age or retirement benefit plans (hereinafter referred to a eligible retirement plans ). Distributions from eligible retirement plans are excluded from income if either (i) the distribution is made upon or after retirement from service after reaching a specific age or after a stated period of employment or (ii) the distribution is transferred into another plan, where the transferred amounts are not included in income for federal income tax purposes. Section 101.6(c)(ii) provides that contributions to an eligible retirement plan made by employers or labor unions on behalf of an employee are excludable from the employe s income except as otherwise provided. In contrast, [c]ontributions to a plan made by an employee or other individual directly or indirectly, whether through payroll deduction, a salary reduction agreement or otherwise, are not excludable from his income. Under this provision, a contribution to an eligible retirement plan by an employee is not excludable from income. D. Pennsylvania Cases Gosewisch and AMP Products In view of the fact that Pennsylvania s constructive receipt regulations mirror the federal regulations, Pennsylvania courts have appropriately looked to federal cases and rulings for guidance in this area. 4

5 Gosewisch v. Commonwealth, 40 Pa. Commw. 565, 397 A.2d 1288 (1979), involved the issue of whether any portion of a distribution received by a taxpayer in 1973 from his former employer s profit sharing plan should be treated as having been constructively received by the taxpayer prior to the June 1, 1971 effective date of the PIT. The Commonwealth Court cited the constructive receipt language currently found in PIT Regulation section 101.7(c), noted that it was taken verbatim from the federal constructive receipt regulation and stated that the court would seek guidance from federal authorities: Department Regulation 301(q)-2 [now 101.7(c)] was taken verbatim from Treas. Reg (a) promulgated under the United States Internal Revenue Code, and we therefore seek guidance from treasury department rulings and federal case law interpreting the application of the constructive receipt doctrine to payments from profit sharing trusts. Gosewisch v. Commonwealth, 397 A.2d 1288, 1293 (Pa. Cmwlth. 1979). The court went on to cite federal authority, including Rev. Rul (which remains a leading federal authority on constructive receipt), and held that the taxpayer did not constructively receive any amounts prior to the year of payment. The Department appears to take the position that Gosewisch effectively was overruled by the later case of AMP Products Corporation v. Commonwealth, 140 Pa. Commw. 346, 593 A.2d 1 (1991), aff d per curiam, 530 Pa. 249, 608 A.2d 25 (1992). 3 AMP involved a qualified pension plan that had a cash or deferred arrangement pursuant to section 401(k) of the Internal Revenue Code of 1986 (the Code ). The issue in AMP was whether the employer had to withhold PIT with respect to elective deferrals made under the cash or deferred arrangement. The court held that elective deferrals under a qualified 401(k) arrangement were taxable to the employees, and thus subject to withholding. It is important to note that the holding in AMP is entirely consistent with basic federal tax principles of constructive receipt and economic benefit. As explained in more detail in Appendix 1, under these basic federal tax principles, an employee is taxed currently when his employer contributes amounts to a fund or trust which is established for the benefit of the employee and which is not subject to the claims of the employer s creditors. 4 In order to prevent employees from having to pay tax on amounts they elect to defer under a section 401(k) cash or 3 4 For example, in Pennsylvania Personal Income Tax Opinion issued 05/22/2001, the Department discussed Gosewisch and AMP at length and stated that the Commonwealth Court of Pennsylvania has made inconsistent declarations in relation to whether the Department s constructive receipt regulation must be interpreted with reference to federal tax principles. We vigorously dispute this statement, and the Department s analysis of the AMP case. The Department s analysis in this ruling incorrectly focuses on whether deferrals were elective or nonelective, and ignores the important distinction, which is whether the deferred compensation arrangement is funded or unfunded. In addition, the IRS generally argues that to avoid constructive receipt an employee must elect to defer compensation prior to the year in which the services are performed. Elections under a 401(k) cash or deferred arrangement can be made in the year the services are performed. 5

6 deferred arrangement, Congress explicitly overruled the normal rules of constructive receipt and economic benefit by providing special rules in section 402 of the Code. In the absence of the special rules in section 402 of the Code, an employee would be taxed currently on amounts he or she elects to defer under a 401(k) arrangement. Pennsylvania has no special rule comparable to section 402 of the Code that would override the normal rules of constructive receipt and economic benefit and permit the exclusion from income of voluntary contributions to a 401(k) plan. To the contrary, the PIT Regulations provide the reverse, that voluntary contributions under a qualified cash or deferred arrangement are not excludable from income. See PIT Regulation 101.6(c)(8)(ii)(B), quoted above. The court in AMP expressly noted that although the contributions under the cash or deferred arrangement were not taxable for federal purposes, the PIT had no analog to 401(k) or 402 of the Internal Revenue Code and that the PIT regulations provide a contrary rule: Although the Federal government does not tax contributions to a retirement benefit plan when those contributions are made, the Federal scheme is inapplicable to Pennsylvania. As a sovereign, the Commonwealth can impose its own scheme of taxation and has chosen to tax such contributions at the time they are made. AMP s argument that the deferred compensation is not constructively received by the participating employee is inapposite. Pursuant to 61 Pa. Code 101.6(c)(8)(ii)(B), contributions are not excludable from the employee s income. The decision in AMP is a straight-forward application of PIT Regulation 101.6(c)(8)(ii)(B), which states that [c]ontributions to [an eligible retirement plan] made by an employee or other individual directly or indirectly, whether through payroll deduction, a salary reduction agreement or otherwise, are not excludable from his income. This regulation, and the AMP decision, are entirely consistent with basic federal tax rules of constructive receipt and economic benefit. The AMP decision never addresses the application of Pennsylvania constructive receipt principles, but instead declared that these principles were inapposite to the case at hand. AMP does not cite or discuss, much less overrule, Gosewisch, or make any statements about whether the Pennsylvania constructive receipt rules differ from federal constructive receipt rules. The decision in AMP correctly focuses on the issue of whether there was a contribution to a fund and not on whether the deferral was elective or nonelective. In contrast, the Department s analysis incorrectly focuses on whether deferrals are elective or nonelective, and ignores the important issue, which is whether the arrangement is funded or unfunded. III. Treatment of Elective Deferrals A. Position Taken in Draft Bulletin Draft Bulletin takes the position that an employee will be taxable currently on any amount of normal compensation that the employee elects to defer under a voluntary or elective 6

7 payroll deduction arrangement, regardless of whether the plan in question is qualified or nonqualified for federal tax purposes and regardless of whether it is funded or unfunded. This statement is contrary to Pennsylvania law to the extent it applies to deferrals under unfunded nonqualified plans. 5 Pennsylvania has adopted the basic federal concepts of constructive receipt and economic benefit, yet under federal tax concepts of constructive receipt and economic benefit, an employee is generally not currently taxed on amounts voluntarily deferred under a nonqualified deferred compensation arrangement. B. Proper Application of Constructive Receipt Rules to Elective Deferrals 1. Pennsylvania Constructive Receipt Rules are Consistent with Federal Rules As discussed above, PIT Regulation 101.7(c) restates verbatim the federal constructive receipt regulations, and Gosewisch confirms that federal cases and rulings are to be applied in interpreting Pennsylvania s doctrine of constructive receipt. AMP did not address the application of Pennsylvania constructive receipt principles, and did not cite or discuss, much less overrule, Gosewisch. Moreover, the result in AMP (that the employee is taxable currently when elective deferrals are contributed to a trust that is immune from the employer s creditors) is fully consistent with the basic federal constructive receipt and economic benefit rules. 2. The Draft Bulletin is Inconsistent with Federal Constructive Receipt Rules As discussed in more detail in Appendix 1, the basic federal rules of constructive receipt and economic benefit have long been settled and are well understood by taxpayers. In general, as long as an employee elects to defer compensation prior to the time the services are performed and the deferred compensation arrangement is unfunded, 6 the employee will not be treated as constructively receiving amounts the amounts the employee could have received if no election had been made. The IRS blessed elective deferrals of income in Revenue Rulings and and has set forth bright line rules for purposes of obtaining a private letter ruling on nonqualified deferred compensation arrangements. 7 See Revenue Procedure We agree with the statement in Draft Bulletin that the same constructive receipt rules apply to all plans, whether they are qualified or nonqualified for federal tax purposes, and whether or not they are considered eligible retirement plans for PIT purposes. This does not mean, however, that the treatment of an elective deferral arrangement will be the same in all types of plans, however. The Draft Bulletin overlooks the critical significance of the issue of whether the plan is funded or unfunded (i.e., whether deferred amounts are held in a trust that is immune from the claims of the employer s creditors). In this context, unfunded means that the deferred amounts are not placed in a trust established for the employee s benefit that is immune from the claims of the employer s creditors. These rules merely establish the criteria for obtaining a favorable letter ruling, and do not purport to establish the outer boundary of the constructive receipt and economic benefit rules. Various court decisions have gone beyond the IRS ruling guidelines. See, e.g., Veit v. Commissioner, 8 T.C. 809 (1947) acq C.B. 4, where the agreement to defer the payment of compensation was made after the services were performed, but prior to the time the compensation was payable. 7

8 In practice, employers tailor their nonqualified deferred compensation arrangements to comply with federal constructive receipt rules. As explained in more detail in Appendix 2, the essential feature of a nonqualified plan is that they are unfunded. More precisely, in nonqualified plans the employee is relying on the employer s unfunded and unsecured promise to pay compensation in the future. This is in contrast to qualified plans, where federal law generally requires that amounts put into the plan be held in a trust established for the benefit of the employee that is secure from the claims of the employer s creditors. When discussing federal law, it is important to distinguish between the normal or basic rules of constructive receipt and economic benefit (both of which are incorporated into Pennsylvania law) and federal statutory exceptions to the normal rules (either restricting or enlarging the normal rules), which will not apply for PIT purposes unless the PIT statute contains a comparable exception. For example, under normal constructive receipt principles, an employee would be currently taxed on amounts voluntarily deferred under a 401(k) arrangement (because this arrangement is funded), but special rules in section 402 of the Code override this result. Similarly, since an eligible deferred compensation plan established by a governmental employer is fully funded, these amounts would be taxable currently to government employees under the normal constructive receipt rules, but this result is overridden by a special rule in section 457(g) which reverses the normal rules. Congress also sometimes overrides the normal constructive receipt rules by currently taxing amounts that would not be treated as constructively received under normal rules. An example of this is section 457(f), which generally provides that if a government or exempt employer establishes an ineligible deferred compensation plan, then employees are taxed in the year in which there is no substantial risk of forfeiture of the deferred compensation. Due to this special rule, governmental and exempt employees are taxed currently on deferred income, even though the deferred compensation arrangement is not funded. The important point is that rules such as this are exceptions to the normal rules of constructive receipt and should not apply for PIT purposes in the absence of a similar exception in Pennsylvania law. 3. Regulation Section 101.6(c)(ii)(B) Does Not Apply Because There Is No Contribution In the Case Of A Voluntary Deferral Under An Unfunded Arrangement. As noted above, Section 101.6(c)(ii)(B) of the PIT regulations provides that [c]ontributions to a plan made by an employe or other individual directly or indirectly, whether through payroll deduction, a salary reduction agreement or otherwise, are not excludable from his income. This regulation was the critical regulation involved in the AMP decision. This regulation will not apply, however, to an unfunded, nonqualified deferred compensation arrangement because in such a case there is no contribution to any sort of plan. The essence of an unfunded, nonqualified plan is that the employer has merely an unfunded and unsecured obligation to pay amounts in the future, and no funds are ever contributed by either the employer or the employee to any sort of fund or trust (other than a rabbi trust, in which case the funds remain subject to the claims of the employer s creditors and are still treated as belonging to the employer for all income tax purposes). 8

9 It should also be noted that Regulation 101.6(c)(ii)(B) only applies to eligible retirement plans (payments from which are exempt from PIT if paid after retirement), and does not apply to a deferred compensation arrangement which is not considered an eligible retirement plan. This point is of secondary importance, however, due to the more fundamental point that in an unfunded, nonqualified deferred compensation arrangement there is never any sort of contribution to a plan. 4. Other Positions Taken in Draft Bulletin The Draft Bulletin suggests that the Department s position on constructive receipt is not limited to those situations where an employer adopts a cash or deferred arrangement that gives employees an election to receive compensation currently or to defer it. Parts of the draft seem to suggest that the Department will argue that constructive receipt rules apply whenever the deferral of compensation was voluntary or unilaterally established by the employee. There is no indication, however, of when the Department will treat a deferral as voluntary or unilaterally established by the employee. This inevitably will involve a very messy inquiry into subjective issues such as when the employer would have been willing to pay compensation and whether the deferral arrangement was instigated by the employer or the employee. We strongly urge the Department not to go down this road. In the federal tax area, the issue of whether a deferral was voluntary or involuntary is essentially irrelevant. The key considerations are when the deferral agreement was entered into and whether the arrangement is funded or not. It is impractical to base taxation on whose idea it was to defer income. Parts of the Draft Bulletin also appear to suggest that mandatory payroll deductions are not excludible or deductible from compensation and that any amount lawfully deducted and withheld from remuneration and accounted for as a part of the employee s total remuneration and as a contribution to a deferred compensation or retirement benefit plan must be treated as compensation at the time the compensation is paid. This is potentially misleading. The critical issues in such cases are whether the deferred benefits are funded and whether there has been a contribution by the employee. If compensation is deferred on a mandatory, nonelective basis in the context of an unfunded, nonqualified plan the constructive receipt and economic benefit principles do not apply. In contrast, if the mandatory reductions actually are contributed to a trust for the employee s benefit that is immune from the claims of the employer s creditors, then the economic benefit rules apply. Similarly, if an amount is involuntarily deducted for the employee s benefit (e.g., income tax withholding) then the employee is subject to tax on the withheld amount. The discussion of secular trusts in the Draft Bulletin is extremely confusing. First, no definition of rabbi trust and secular trust is provided, although we presume that these terms are to be given their generally understood meanings. Second, the statement that a secular trust will defer the receipt of income is puzzling, since this is contrary to federal concepts (which dictate that amounts put into a secular trust are taxed currently). See Appendix 2 Overview of Deferred Compensation Arrangements. Finally, the statement that the grantor trust rules are not applicable is extremely puzzling. How does the Department believe secular trusts are treated? 9

10 5. Uniformity The Department has taken the position from time to time that it would violate the Uniformity Clause of the Pennsylvania Constitution to treat contributions made under a nonqualified deferred compensation arrangement differently than contributions made under a qualified retirement plan. The Department s position ignores the important distinction that in the case of a qualified plan, there is an actual contribution to a trust that is established for the benefit of the employees and is immune from the claims of the employer s creditors. In this case, the employer has fully performed its obligations, and has no future obligation. In contrast, in an unfunded, nonqualified arrangement there is no contribution or payment of the deferred amounts and the employees are relying on the employer s unfunded and unsecured promise to pay money in the future. In view of these critical differences, uniformity does not require that taxpayers be treated the same in both cases. 6. Policy considerations Our primary objection to Draft Bulletin is that it is inconsistent with the Pennsylvania statute and regulations, as interpreted by Pennsylvania courts. Every official position taken by the Department should be consistent with the law. Aside from this, we also have a number of policy concerns about Draft Bulletin Draft Bulletin will cause unnecessary and incorrect differences between the Pennsylvania and federal tax treatment of nonqualified deferred compensation arrangements. Of course, where there is a legal distinction between the Pennsylvania and federal tax systems, this distinction must be implemented. If there is not such a requirement, it generally is a bad idea to create additional differences between Pennsylvania and federal tax rules. Such differences are burdensome for employers and employees, are often ignored, and are difficult to enforce. The Commonwealth is better served by promulgating a tax policy that is congruent with federal rules to the extent legally permissible. In the case of unfunded deferred compensation plans, there is no legal requirement to deviate from the federal rules. Indeed, the applicable Pennsylvania regulations were taken directly from the federal constructive receipt regulations and the Commonwealth Court has confirmed that the federal doctrine should, therefore, serve as a guide in applying Pennsylvania s constructive receipt doctrine. 10

11 Appendix 1 Federal Constructive Receipt and Economic Benefit Principles 1. Interpretation of Treas. Reg (a) There is an extensive body of case law and IRS rulings interpreting the constructive receipt rules found in Treas. Reg (a) (which is identical to PIT Regulation 101.7(c)). In a number of early cases, the IRS made the exact argument that the Department is making in the Draft Bulletin, namely, that there must be some sort of determination of whether an employer would have been willing to pay compensation currently, and that if it appears that the employee voluntarily turned his back on compensation and either asked or agreed that the compensation be deferred, the employee should be treated as being in constructive receipt of income. This argument was uniformly rejected by the courts. See Commissioner v. Oates, 207 F.2d 711 (7 th Cir. 1953); Veit v. Commissioner, 8 T.C.M. 919 (1949); Veit v. Commissioner, 8 T.C. 809 (1947) acq C.B. 4. In Rev. Rul , C.B. 174, the IRS addressed the application of the constructive receipt rules to five different situations where an employee or independent contractor entered into an agreement that provided for the deferred payment of compensation. The IRS stated in this ruling that [a] mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method. The IRS also stated that the statute cannot be administered by speculating whether the payor would have been willing to agree to an earlier payment. Thus, the fact that employees agreed to the deferral (and, indeed, may have instigated the deferral) was viewed as an irrelevant factor. It is impractical to try to determine whether an employer would have been willing to pay compensation currently, or whether the deferral arrangement was instigated by the employer or the employee. In Rev. Rul , C.B. 106, the IRS addressed the application of the constructive receipt rules to a typical nonqualified elective deferred compensation ruling. Under the plan considered in this ruling, certain employees were given the right to irrevocably elect, prior to the end of each year, to defer receipt of a portion of their scheduled salary for the following taxable year. The employer established a deferred compensation account for each employee who elected to defer compensation, but the deferred payments were to be satisfied from the general corporate funds and were subject to the claims of creditors. The IRS ruled that, under constructive receipt principles, the salary voluntarily deferred under the plan was not includible in income in the year earned, but would be taxable in the later taxable year(s) in which it is actually received by or otherwise made available to the taxpayer. The IRS set forth the conditions under which it will issue a favorable private letter ruling on an unfunded deferred compensation arrangement in Rev. Proc Under this revenue procedure, the IRS will issue a private letter ruling if the deferred compensation arrangement satisfies the following requirements: A1-1

12 If the plan is elective, the election must be made before the beginning of the period of service for which the compensation is payable. Normally, the election must be made before the year in which services are to be performed, but special rules apply in the year the plan is first implemented and the first year an employee becomes eligible to participate in the plan. The plan must define the time and method for payment of deferred compensation or each event (such as termination of employment, regular retirement, disability retirement or death) that entitles a participant to receive benefits. The plan may provide for payment of benefits in the case of an unforeseeable emergency (i.e., an unanticipated emergency that is caused by an event beyond the control of the participant and would result in severe financial hardship if early withdrawal were not permitted). The plan must provide that participants have the status of general unsecured creditors of the employer and that the plan constitutes a mere promise by the employer to make benefit payments in the future. If the plan provides for a rabbi trust, the trust must conform to the terms of the model trust described in Rev. Proc The plan must provide that a participant s rights to benefit payments under the plan are not subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant or the participant s beneficiary. It should be noted that Rev. Proc merely sets forth the requirements imposed by the IRS to obtain a favorable private letter ruling. These requirements are more restrictive in some respects than what the courts have permitted. For example, in Veit v. Commissioner, 8 T.C. 809 (1947), acq C.B. 4, the agreement to defer compensation was made after the services were performed, but before payment was originally due. The IRS acquiesced to this holding. 2. Economic Benefit Doctrine A close relative of the constructive receipt doctrine is the economic benefit doctrine. The economic benefit doctrine focuses on whether the obligation to make deferred payments is funded or unfunded. The essential difference between the two doctrines is that the constructive receipt doctrine determines whether an employee received money or other property, whereas the economic benefit doctrine determines whether the employee received a benefit because someone else received money or property. For example, in one of the five examples in Rev. Rul , the full amount of deferred compensation was paid by the employer to a bank, as escrow agent. Under the escrow agreement, the account was in the employee s name, and payments were to be made only to the employee or his estate in the event of death (i.e., the account was not subject to the claims of the employer s creditors). In this case, the IRS ruled that the employee received an A1-2

13 economic or financial benefit in the year the funds were placed in escrow for his benefit, and thus had to include this amount in his taxable income. The IRS position is that the economic benefit doctrine applies when assets are unconditionally and irrevocably paid into a fund or trust to be used for the taxpayer s sole benefit. In Rev. Proc , the IRS stated that under the economic benefit doctrine, a taxpayer using the cash receipts and disbursements method of accounting must include in gross income currently any financial or economic benefit derived from the absolute right to receive property in the future that has been irrevocably and unconditionally set aside for the taxpayer in a trust or fund. Sproull v. Commissioner, 16 T.C. 244 (1951), aff d per curiam, 194 F.2d 541 (6 th Cir. 1952); Pulsifer v. Commissioner, 64 T.C. 245 (1975). The economic benefit doctrine will not apply, however, if the employee is relying on the employer s promise to pay benefits in the future. Similarly, the doctrine does not apply if assets are held in a rabbi trust where the assets of the trust are subject to the claims of the employer s creditors. In contrast, the economic benefit doctrine will result in current taxation if assets are placed in a secular trust (where the assets are not subject to the claims of the employer s creditors). 3. Exceptions to General Federal Rules The Internal Revenue Code of 1986 (the Code ) provides a number of statutory exceptions to the general rules of constructive receipt and economic benefit. Obviously, if the PIT does not provide for analogous exceptions, these exceptions will not apply for PIT purposes. Under normal constructive receipt and economic benefit principles, an amount that an employee elects to contribute under a 401(k) arrangement would be taxable to the employee in the year that the employer contributed amounts to the 401(k) trust. Note that under a 401(k) arrangement, all deferred amounts are held in a trust that is immune from the claims of the employer s creditors. Code 402(e)(3) provides, however, that contributions made by an employer on behalf of an employee to a trust which is a part of a qualified cash or deferred arrangement as defined in Code 401(k)(2) shall not be treated as distributed or made available to the employee nor as contributions made by the employee merely because the employee had an election whether the contribution will be made to the trust or received by the employee in cash. Code 401(a) also provides the general rule that a beneficiary of a trust described in Code 401(a) is only subject to tax when amounts are actually distributed. Another exception to normal constructive receipt rules can be found in Code 125, which provides that a participant in a cafeteria plan is not taxable merely because the participant has an election to choose either cash compensation or nontaxable benefits provided under the plan. In this case, however, the definition of compensation in the PIT statute provides for a similar exemption from normal constructive receipt principles. Another important exception to the normal federal rules of constructive receipt and economic benefit is found in Code 457, dealing with deferred compensation arrangements of state and local governments and tax-exempt organizations. Note that in the case of a private A1-3

14 employer, the employer s willingness to enter into a nonqualified deferred compensation arrangement is significantly constrained by the fact that the employer s deduction is also deferred. This constraint is irrelevant when the employer is a governmental or tax-exempt entity. Accordingly, Congress enacted Code 457 to limit the ability of tax-exempt and governmental employers to enter into deferred compensation arrangements. Under Code 457, the tax treatment of a deferred compensation arrangement set up by an exempt employer depends on whether or not the plan is an eligible deferred compensation plan. If the plan satisfies the requirements of an eligible deferred compensation plan the deferred compensation and income earned thereon is only includible in the income of the participant or beneficiary in the year that amounts are actually paid. The annual amount that can be deferred by a participant under an eligible deferred compensation plan is limited to $12,000 in As originally enacted, amounts deferred under an eligible retirement plan had remain the property of the employer and subject to the claims of the employer s creditors. This rule was changed in 1996 for governmental plans. Under Code 457(g), all assets of a plan maintained by a governmental employer must be held in trust for the exclusive benefit of the participants and their beneficiaries. Since, under normal economic benefit rules, a fully funded deferred compensation arrangement would be taxable immediately to the employees, Code 457(g)(2)(B) provides that amounts in the trust shall be includible in gross income only to the extent provided in Code 457. Without this special rule, the amounts held in trust would be taxed to the governmental employees. If the deferred compensation plan of a governmental or tax-exempt employer is not an eligible arrangement (and is not qualified under other federal tax rules), then the compensation must be included in the gross income of the participant or beneficiary in the first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation. 8 See Code 457(f). In other words, if the deferred compensation arrangement is not eligible or qualified the employees must pay tax when compensation is earned, as long as the right to receive the compensation is fully vested. When the deferred amounts are actually paid, the taxation of the participation is governed by the rules in Code 72 relating to annuities (these rules determine which portion of the payments is a taxfree return of previously taxed income and which portion is additional income). Code 457(f) overrides the normal constructive receipt and economic benefit rules in the case of a governmental or tax-exempt employer. As a result of this provision, these types of employers cannot establish the same sorts of nonqualified deferred compensation arrangements as private employers. The normal constructive receipt and economic benefit rules are also overridden for FICA tax purposes. Under Code 3121(v)(1) the term wages for purposes of FICA taxes is 8 The right to compensation will be deemed subject to a substantial risk of forfeiture if the employee s rights to such compensation are conditioned upon the future performance of substantial services. A1-4

15 expanded to include (i) amounts contributed by an employer to a 401(k) plan under a cash or deferred arrangement, 9 and (ii) any amount deferred under a nonqualified deferred compensation plan. 10 The point of these various exceptions is that the issue of when compensation is deemed received by a cash basis taxpayer is governed by normal constructive receipt and economic benefits principles. If an exception to these basic, normal rules is desired, a statutory change is required to override the normal rules. In the absence of a statutory override the normal rules should apply Actually, by saying that Code 402(e)(3) will not apply for this purpose, this section is canceling the exception from the normal constructive receipt rules and causing the normal rules to apply to elective 401(k) contributions. These amounts are to be included in FICA wages as of the later of when the services are performed or when there is no substantial risk of forfeiture of the rights to such amount. A1-5

16 Appendix 2 Overview of Deferred Compensation Arrangements The Draft Bulletin uses a number of terms without defining them and does not clearly describe the types of deferred compensation and retirement arrangements to which it applies. The following is a brief overview of different types of deferred compensation arrangements. Deferred Compensation Arrangement A deferred compensation arrangement is an arrangement that defers the payment of compensation beyond the time that the services are performed and beyond the time that the payment would otherwise have been made. For federal tax purposes, a deferred compensation arrangement may be either a qualified stock bonus, pension or profit-sharing plan, or a nonqualified arrangement. For Pennsylvania tax purposes, a distinction is often made between a deferred compensation arrangement and an eligible retirement plan. This distinction is important in Pennsylvania because payments to an employee after retirement from an eligible retirement plan are exempt from PIT if paid after retirement, whereas payments from a deferred compensation arrangement are taxable (even if, in fact, the payments are made after retirement). Qualified Plans For federal tax purposes it is important to distinguish between qualified and nonqualified deferred compensation arrangements. The term qualified plan generally refers to a qualified pension, profit-sharing or stock bonus plan described in sections 401, 403(b), 408 and 457 of the Code. Qualified plans must satisfy very specific and detailed requirements, restrictions and limitations set forth in the Code. For example, a qualified plan must generally cover a broad class of employees, it cannot discriminate, it must be fully funded, the amounts that can be deferred are limited and the period of deferral is limited. If a plan is a qualified plan the employer and the employee qualify for favorable tax treatment. For example, in the case of a plan that satisfies the requirements of section 401(k), the employee is not taxed on either employer contributions or on elective employee contributions, notwithstanding the requirement that all contributions must be held in a trust for the benefit of the employee and that is protected from the claims of the employer s creditors. This is because Code 401(k) exempts these arrangements from the normal constructive receipt rules. Although the employee is not taxed currently on amounts contributed to a 401(k) plan, the employer is nonetheless able to claim a deduction for amounts contributed to the plan. This is also a departure from normal federal tax rules (which defer an employer s deduction for compensation expense until the year the employee is taxed on the income). Another benefit of qualified plan status is that earnings on the deferred amounts are not subject to tax until they are paid out. A2-1

17 Nonqualified Deferred Compensation Plans Due to the strict restrictions and limitation imposed on qualified plans, taxpayers have developed a number of nonqualified deferred compensation arrangements to defer the recognition of compensation. Nonqualified deferred compensation arrangements are structured to comply with constructive receipt rules (otherwise they would not be effective to defer the recognition of income). One factor that limits the willingness of employers to enter into such arrangements is that, unlike qualified plans, an employer cannot deduct amounts deferred under a nonqualified arrangement until the year in which the employee recognizes income. In addition, the employer is generally taxed on any investment income earned on deferred amounts. The key features of most nonqualified deferred compensation arrangements are that (i) the employee must elect to defer compensation prior to the time that services are provided and (ii) the obligation to pay the deferred amounts is unfunded (as described below). Accordingly, the employee is relying on the employer s promise to pay money in the future. In most cases there is no contribution to any sort of trust or account (other, perhaps, than to a rabbi trust ). Funded vs. Nonfunded Plans As noted above, qualified plans generally are required to be funded, meaning that deferred compensation must be held in a trust established for the employees benefit that is immune from the claims of the employer s creditors. In contrast, to avoid the constructive receipt rules, deferred compensation arrangements generally are unfunded. The key element of an unfunded arrangement is that the deferred amounts remain subject to the claims of the employer s creditors. The classic example of an unfunded deferred compensation arrangement is where the employer makes an unfunded and unsecured promise to pay compensation in the future to employees. In many cases, the deferred amounts may bear interest or otherwise increase in value in accordance with an agreed-upon formula (e.g., the increase in value may be tied to the value of a particular stock or a stock index). Unfunded arrangements may take a number of different forms: In some cases, the deferred amounts are never set aside and remain at all times in the general funds of the employer. The nonqualified deferred compensation arrangement may provide for accounts to be established for each employee, to keep track of the amount of deferred compensation and the income accruing on such amount, but these accounts may be merely notional (i.e., the accounts are used to compute the amount due the employee, but there is no requirement that the employer actually establish and fund accounts). In other cases, an employer either may choose to or may be required to fund segregated accounts and invest them in a particular manner, but the accounts belong to the employer and are subject to the claims of the employer s creditors. There has been no payment or contribution to any sort of fund or trust in such A2-2