William Byrnes' Tax, Wealth, and Risk Intelligence

In order for a deferred compensation trust to the “qualified,” it must comply with all of §401s specific requirements.  Complete compliance creates tax-deferred status.  §501 states (emphasis mine), “An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.”

One of 401’s most important requirements is that funds can only be used for the benefit of the employees.  §401(a)(2) states in relevant part,

“(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…”

To borrow language from contract law, this section contains a condition precedent, which is, “…  an event which must take place before a party to a contract must perform or do their part.”  The following hypothetical illustrates: Company A owes a significant amount of money and also has a large, well-funded retirement plan.  401(a)(2) prevents the company from raiding the retirement fund until every possible obligation of the trust is paid.

The Treasury Regulations add additional color:

(2) As used in section 401(a)(2), the phrase “if under the trust instrument it is impossible” means that the trust instrument must definitely and affirmatively make it impossible for the nonexempt diversion or use to occur, whether by operation or natural termination of the trust, by power of revocation or amendment, by the happening of a contingency, by collateral arrangement, or by any other means. Although it is not essential that the employer relinquish all power to modify or terminate the rights of certain employees covered by the trust, it must be impossible for the trust funds to be used or diverted for purposes other than for the exclusive benefit of his employees or their beneficiaries.

The phrasing is unambiguous, providing no legal “wiggle-room.”

In my introductory post on the topic, I specifically noted this code section uses trust language, placing a fiduciary duty and obligation on the sponsoring company.  This section furthers that observation.

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.