William Byrnes' Tax, Wealth, and Risk Intelligence

In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors.    

It’s doubtful that anybody in the Financial Services industry is unaware of qualified retirement plans such as 401(k)s and IRAs.  Knowledge of them is required to pass licensing exams and every firm includes them in sales literature.  Non-qualified plans (NQDC), however, are less well-known, largely because they are more complex and appeal to a far smaller group of potential buyers.  Although their application is narrower, in the right circumstances they can provide clients with tremendous advantages.

This post begins a series on NQDC.  We will be spending a large amount of time with the tax code and accompanying treasury regulations; this is necessary due to NQDC’s complexity and numerous regulations.  But before delving into the code, let’s use basic statutory analysis and analyze the “plain meaning” of the words, beginning with “non-qualified.”  The primary difference between NQDC and qualified plans is that the former don’t comply with §401’s safe harbors – especially the rules relating to “highly compensated individuals”[1] and the plan funds not being subject to the plan sponsor’s general creditors.[2]  In fact, the treasury regulations define NQDC as much by what it isn’t[3] as what it is.  Moving onto the other words, the Merriam Webster online dictionary defines the word “deferred” as “withheld for or until a stated time”[4] and “compensation” as “payment.”[5]  Combining these two definitions, we get: payment for services that is withheld until specifically enumerated events.

A properly implemented NQDC plan requires that the client does not formally receive income before certain events[6] or else he will become liable for the accompanying taxes at inopportune times (along with penalties).  Therefore, we need to know when a taxpayer recognizes income to avoid attribution from these events.  This naturally leads to a discussion of the two accounting methods.  The cash method stipulates that “all items which constitute gross income … are to be included for the taxable year in which actually or constructively received.”[7]  The most obvious example occurs when the taxpayer’s account increases by a specific amount of money.  The accrual method is the second system.  It has two factors: all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.[8]  For example, once the taxpayer has done the agreed upon work and sent an invoice, he can book the income under the accrual method.

The client must also avoid constructively receiving income, which is defined in §1.451-2(a):

Income although not actually reduced to a taxpayer’s possession is 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, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

The service provider cannot reach, attach, pledge, or be credited with all or any portion of the money set aside under the plan.  This requires that all funds in the NQDC plan be subject to a substantial risk of forfeiture, which is discussed in treasury regulation §1.83-3(a).

a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.

The most commonly used situations in NQDC contracts are continued performance by the service provider or the occurrence of a major corporate event such as a merger or acquisition, specific sales goals, going public, and the like.    

            This post only covers the surface of several key NDQC components.  However, it should provide the reader with a basic overview of these key elements.

Next, we’ll dig deeper into the definition of an NQDC plan.

[1] 26 U.S.C. 401(a)(4)

[2] See 26 U.S.S. 401(a)(2)

[3] The Treasury regulations define NQDC by what it isn’t.  See generally Treas. Reg. §1.409A-1(a)(2)(i) through Treas. Reg. §1-409A-1(2)(ix)

[4] https://www.merriam-webster.com/dictionary/deferred

[5] https://www.merriam-webster.com/dictionary/compensation

[6] 26 U.S.C. 409(A)(2)(A)(i)-(vi)

[7] Treas. Reg. §1.446-1(c)(i)

[8] Treas. Reg. §1.446-1(c)(ii)