By Gary J. Gunnett, Esq.
In today’s health care industry, more and more physicians are becoming eligible to participate in nonqualified deferred compensation plans. Unfortunately, nonqualified plans are subject to a unique set of rules rarely communicated in a clear fashion. However, any physician faced with an opportunity to participate in a nonqualified should have a basic understanding of the tension between the taxation of nonqualified benefits and the security of such benefits.
Federal Income Taxation
The fundamental goal of any deferred compensation plan (qualified or nonqualified) is the deferral of tax. The taxation of nonqualified plans is perhaps best understood through a comparison with qualified plans.
A qualified plan is one which meets certain requirements imposed by the Internal Revenue Code (the Code). These requirements include minimum coverage and nondiscrimination requirements prohibiting an employer from providing benefits for physicians (or other “highly-compensated employees”) to the exclusion of other employees, and limitations on the amount of benefits that can be provided. In exchange for compliance with these requirements, certain favorable tax treatment is afforded. Specifically, the employer is entitled to a tax deduction for amounts contributed to the plan, benefits within the plan grow on a tax-deferred basis, and plan participants are not taxed on the benefits until they are actually paid from the plan. Further, distributions from qualified plans are generally eligible for rollover to an IRA or other qualified plan, thereby permitting further tax deferral.
A nonqualified plan is not subject to the same minimum coverage and nondiscrimination requirements. Therefore, a nonqualified plan can be designed to cover a limited group of employees (e.g., physicians). Also, a nonqualified plan can provide benefits in excess of those permitted under the qualified plan limits. Since the strict qualified plan rules do not apply to nonqualified benefits, however, the tax treatment of a nonqualified plan is not as favorable.
First, an employer is not entitled to a tax deduction until such time as the benefits are actually paid to the employee. Second, under the tax doctrine of constructive receipt, nonqualified benefits are taxable to the employee at such time as the employee has the right to receive the benefits (without regard to when the benefits are actually paid), unless the employer’s obligation to pay the benefits remains merely an “unfunded and unsecured” promise to pay.
Generally, the amount of a nonqualified benefit is limited by an employer because of the relationship between the benefit payment and the timing of the employer’s tax deduction. However, since tax-exempt employers (e.g., hospitals) are not concerned with tax deductions, the Code imposes special rules on nonqualified benefits paid by tax-exempt entities. Nonqualified benefits paid by tax-exempt entities will be taxed when paid (as opposed to the time of deferral) only if the plan meets the requirements of Code Section 457, including an annual contribution limit of $8,000 (as indexed for cost-of-living increases). Benefits under plans providing deferred compensation in excess of $8,000 per year become taxable when they are no longer subject to a “substantial risk of forfeiture” (e.g., a requirement that an employee remain in the employ of the employer for a fixed number of years).
Social Security Taxes
Employers and employees should also be aware of the special timing rule which applies for purposes of Social Security (FICA) taxes. Although an amount deferred under a nonqualified plan may not be subject to income tax until actually paid, the amount is subject to FICA tax when it is no longer subject to a substantial risk of forfeiture. This result is both good and bad.
The old-age portion of the FICA tax (6.2 percent on the employer plus 6.2 percent on the employee) is subject to a taxable wage base ($76,200 in 2000). Therefore, if an employee has current compensation in excess of $76,200, the accrual of a deferred compensation benefit does not increase the 6.2 percent tax. On the other hand, the Medicare portion of the FICA tax (1.45 percent on the employer plus 1.45 percent on the employee) is not subject to any wage base. Therefore, the full deferred compensation obligation can be subject to Medicare tax prior to actual payment of the benefit.
Another area in which nonqualified plans differ significantly from qualified plans is the area of benefit security. Federal laws governing qualified plans require that all qualified plan contributions be set aside in trust, beyond the reach of creditors of the employer as well as creditors of the employee. Therefore, a vested participant in a qualified plan can take comfort in the fact that his or her benefits will eventually be available for their intended purpose.
As stated above, in order to meet the goal of tax deferral, nonqualified plans must remain “unfunded and unsecured.” This means that all assets used to fund nonqualified benefits must remain assets of the employer, subject to claims of the employer’s general creditors. Thus, nonqualified plan participants must face the very real possibility that they might never receive the amounts deferred under a nonqualified plan. This holds true for voluntary salary deferrals elected by the individual as well as contributions made by the employer.
Situations Other Than Bankruptcy of the Employer
There are two types of settings in which the security of a nonqualified benefit becomes an issue: (1) situations other than bankruptcy of the employer and (2) the bankruptcy of the employer.
One common non-bankruptcy situation is a change in control. New management is not always inclined to honor deferred compensation obligations adopted by prior management. Another common situation is a simple lack of cash flow. If an employer is short of bankruptcy but does not have enough cash to pay all of its obligations, it may be inclined to pay those parties critical to continuation of its business, at the expense of nonqualified plan participants. Because an employee has a contractual right to nonqualified benefits, the employee can always sue the employer to recover what is due under the terms of the plan. However, litigation is an expensive, time consuming and inconvenient alternative.
The Rabbi Trust
Because of the concern over security, employers have, subject to IRS approval, developed several ways to provide a greater level of comfort to employees. One of the most popular is the rabbi trust. (The rabbi trust derived its name from an early IRS ruling holding that deferred compensation payable to a rabbi was not taxable prior to the rabbi’s actual receipt of the compensation, in spite of the placement of the compensation in trust.) Under a rabbi trust, funds used to pay deferred compensation are transferred to a third-party trustee (usually a bank or trust company). The terms of the trust arrangement require the trustee to pay nonqualified benefits as they become due under the terms of the plan, without regard to the whims of the employer. Thus, the rabbi trust protects the individual in the event of non-bankruptcy events.
Bankruptcy of the Employer
The bankruptcy of the employer is a different situation. Since amounts deferred under a nonqualified plan remain subject to claims of the employer’s general creditors, secured creditors will first be paid in full, and plan participants are merely among the unsecured creditors waiting in line for any amounts that may be left over. Therefore, when the sponsor of a nonqualified plan goes into bankruptcy, the plan participants typically receive only pennies on each dollar owed. In some cases, they receive nothing. This rule applies to amounts voluntarily deferred by the employee out of his salary as well as any employer money that may have been contributed.
Importantly, assets in a rabbi trust must remain subject to the claims of the employer’s creditors. Under the terms of a rabbi trust agreement, the employer is obligated to notify the trustee in the event of its insolvency, inability to pay debts as they become due, or pending bankruptcy. Once this notification is received, the trustee must stop making payments to plan participants and hold all plan assets for the benefit of creditors of the employer. Therefore, a rabbi trust offers no security to nonqualified plan participants in the event of the bankruptcy of the employer.
An alternative to the rabbi trust is the secular trust. Secular trusts protect the interest of the individual in bankruptcy situations as well as non-bankruptcy situations, but the price for this protection is current taxation on the deferred amounts. More sophisticated planners seeking the best of both worlds have developed a hybrid, the “rabbicular trust,” under which a rabbi trust converts to a secular trust (and becomes taxable) upon the occurrence of an event signaling financial difficulty for the employer. However, a rabbicular trust must be designed very carefully to ensure that it accomplishes the desired tax deferral without compromising the security of the benefit.
Weighing the Options
In today’s market, more physicians are employed by institutional employers, as opposed to practices owned and controlled by the physicians themselves. Accordingly, fewer physicians are covered by generous qualified plans. Instead, they are faced with a decision of whether to participate in a nonqualified arrangement. This decision should be made only after a careful consideration of the tax benefits of participation, weighed against the risk of insecure benefits. With the uncertain financial future of many health care institutions, the decision is often difficult. However, an understanding of the basic nonqualified plan rules goes a long way toward successful planning.
Gary J. Gunnett, Esq., a shareholder in the Pittsburgh law firm of Houston Harbaugh, P.C., focuses his practice on matters involving employee benefit plans for health care practitioners and other clients.