Nonqualified Deferred Compensation Plans: a Review and Critique," William Mitchell Law Review: Vol
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William Mitchell Law Review Volume 17 | Issue 1 Article 13 1991 Nonqualified efeD rred Compensation Plans: A Review and Critique Carter G. Bishop Marian McMahon Durkin Follow this and additional works at: http://open.mitchellhamline.edu/wmlr Recommended Citation Bishop, Carter G. and Durkin, Marian McMahon (1991) "Nonqualified Deferred Compensation Plans: A Review and Critique," William Mitchell Law Review: Vol. 17: Iss. 1, Article 13. Available at: http://open.mitchellhamline.edu/wmlr/vol17/iss1/13 This Article is brought to you for free and open access by the Law Reviews and Journals at Mitchell Hamline Open Access. It has been accepted for inclusion in William Mitchell Law Review by an authorized administrator of Mitchell Hamline Open Access. For more information, please contact [email protected]. © Mitchell Hamline School of Law Bishop and Durkin: Nonqualified Deferred Compensation Plans: A Review and Critique NONQUALIFIED DEFERRED COMPENSATION PLANS: A REVIEW AND CRITIQUE CARTER G. BISHOPt MARIAN MCMAHON DURKINtt We live in the great world as well as in the little. We belong to groups that extend beyond particular places and we speak a language ... that aspires to universality. If it is to perform its expressive function, our theory must help us grasp this transcendent aspect of our experience.' The tax treatment of nonqualfied deferred compensation plans (NQDCPs) encourages the deferral of the payment of personal service income beyond the economic performance of the services, the natural mar- ket datefor payment. The current use of such plans is premised upon an exemption from a complex series of Department of Labor unfunded plan rules (ERISA2 funding, anti-discrimination and reporting standards) and avoidance of the common law income tax doctrines of constructive receipt and economic benefit. Even where the employee receives a cur- rently taxable economic benefit from the compensation, taxation may be further postponed through the imposition of a substantial risk of forfei- ture under IRC § 83.3 The breadth, complexity and interrelationshipof the labor and tax regulatory regimes confine the understanding of the conditions of the deferral to sophisticated tax planners. This article re- views both sets of rules to enable nonspecialist compensationplanners to t Professor of Law and Director of the Graduate Tax Program, William Mitch- ell College of Law. B.S., Ball State University, 1971; M.B.A., Drake University, 1973; J.D. (With Honors), Drake University, 1975; LL.M. (Taxation), New York University, 1977. tt Associate in the Minneapolis office of Briggs & Morgan, Professional Associ- ation. B.A., Manhattanville College, 1976; J.D. (Magna Cum Laude), William Mitch- ell College of Law, 1984; LL.M. (Taxation) (Magna Cum Laude), William Mitchell College of Law, 1988. 1. D. KENNEDY, LEGAL EDUCATION AND THE REPRODUCTION OF HIERARCHY: A POLEMIC AGAINST THE SYSTEM (1983), quoted in T. SHAFFER, FAITH AND THE PROFES- SIONS 229 (1987). 2. Employee Retirement Income Security Act of 1974, §§ 1-514, 29 U.S.C. §§ 1001-1461 (1988). 3. I.R.C. § 83 (1990) (dealing with property transferred in connection with serv- ices). Reference to sections of the Internal Revenue Code in the text will hereinafter be designated by "IRC." Published by Mitchell Hamline Open Access, 1991 1 William Mitchell Law Review, Vol. 17, Iss. 1 [1991], Art. 13 WILLIAM MITCHELL LAW REVIEW [Vol. 17 understand and implement nonqualified deferred compensation arrange- ments. In addition, the article critiques both the tax and nontax advan- tages that such arrangements enjoy under current law and recommends an alternativeregulatory and tax structure. The article explores the eco- nomic rationality of such arrangementscompared to qualifiedplans and discusses the economic and social policy costs to our tax system of the current method of taxing and regulating nonqualifiedplans. The article concludes that nonqualified deferred compensation plans receive unwar- ranted regulatory and tax subsidies compared to qualified plans and that these subsidies should be reduced, in part, by expanded ERISA regulatory control, by requiringsuch plans to be 'funded" and/or by modification of the constructive receipt doctrine to require taxation of the compensation to the employee at the time of the economic performance of the services. If ERISA coverage is expanded to require the funding of such arrange- ments, the employee may nevertheless defer taxation of compensation be- yond the economic performance of the services under IRC § 83 if the employee is willing to accept a risk of forfeiture of the compensation. However, the "risk " of the employee not receiving thefunds in the future is within the employee's control and is not related to the employer'sfinan- cial stability. At a minimum, the article concludes that ERISA coverage should not discourage currentfunding of such plans by over-regulating 'funded" plans to require satisfaction with the other ERISA standards, such as the anti-discriminationrules. INTRODUCTION ........................................... 46 A. Article Paradigm ................................ 46 B. Importance of Nonqualfied Plans ................. 55 C. General Rules and Areas of Concern ............... 59 I. ERISA COMPLIANCE STANDARDS .................... 63 A. Introduction and Historical Context ................ 63 B. IRC § 401 Qualified Plan Limitations ............ 65 1. Annual Benefit and Contribution Limitations .... 67 a. Defined Benefit Plans ..................... 67 b. Defined Contribution Plans ................ 68 c. Combined Plan Limitations ................ 69 2. Participationand Coverage Requirements ....... 69 a. Minimum Coverage Rules ................. 70 b. Minimum ParticipationRules .............. 71 C. General Applicability of ERISA ................... 72 1. ERISA Exemptions .......................... 72 2. Funding Requirements ........................ 73 a. Qualified Plans .......................... 74 http://open.mitchellhamline.edu/wmlr/vol17/iss1/13 2 Bishop and Durkin: Nonqualified Deferred Compensation Plans: A Review and Critique 1991] DEFERRED COMPENSATION PLANS b. Nonqualified Plans ....................... 74 1) DOL View of "Funded" Plans ......... 74 2) Judicial View of "Funded" Plans ....... 75 c. Highly Compensated Employees ............. 78 3. Reporting Standards ......................... 79 D. Roadmap to Create an "Unfunded" Plan .......... 80 E. Critique and Proposal............................ 82 II. INCOME TAX ANALYSIS OF "UNFUNDED" PLANS ...... 86 A. Introduction .................................... 86 B. Model I (Non- § 83) ............................ 88 1. General Analysis ............................. 88 2. Constructive Receipt Doctrine ................. 91 a. HistoricalDevelopment .................... 91 b. Past Services ............................. 95 c. Future Services ........................... 95 1) IRS Position ......................... 95 2) Case Law ............................ 98 3) Policy Analysis ....................... 102 3. Economic Benefit Doctrine .................... 103 a. HistoricalDevelopments ................... 103 1) Cash Equivalency Doctrine............. 104 a) Property Transactions............. 104 b) Service Transactions .............. 105 b. "Mere Promise to Pay" Paradigm .......... 109 c. The Role of Valuation, Cash Equivalency and Economic Benefit ......................... 113 d. Maximizing Employee Economic Security .... 118 1) Surety Bond Security .................. 118 2) Separate Employer "Rabbi" Trusts ..... 121 3) Payment Acceleration Provisions ........ 124 4) Policy Considerations.................. 126 4. Employer Deduction .......................... 127 C. Model I (§ 83) ................................ 129 1. General Analysis ............................. .129 a. Restricted Property "Owner" .............. 130 2. IRC § 83(b) Election ........................ 131 a. Gambler's Choice-DisappearingBasis ....... 131 1) Deferral and Conversion Risk .......... 132 2) DisappearingBasis ................... 133 b. Election Rationale ........................ 134 1) Employer Perspective .................. 136 2) Future Changes in the Law ............ 137 Published by Mitchell Hamline Open Access, 1991 3 William Mitchell Law Review, Vol. 17, Iss. 1 [1991], Art. 13 WILLIAM MITCHELL LAW REVIEW [Vol. 17 3) $ection 16(b) Issues .................. 138 3. Transfer and ForfritureProvisions ............. 138 a. General Analysis ......................... 138 b. "Transferability" Defined .................. 139 c. "Substantial Risk of Forfeiture" Defined .... 140 d. Future Service Requirements ............... 141 1) "Best Efforts" Underwriter ............ 141 2) Employer Earnings Condition .......... 141 3) Employer Dischargefor Cause .......... 142 4) Covenants Not to Compete ............. 142 5) Post-Retirement Consulting ............ 142 e. Employer Enforcement ..................... 142 4. Property Transfers Governed by IRC § 83 ...... 143 a. Current vs. Future Money Transfers ........ 144 b. IRC § 83(b) Election ..................... 145 c. Employer's Perspective ..................... 146 5. Legislative History of IRC § 83 ............... 146 6. Taxation of Options .......................... 147 a. Compensation vs. Capital Gain ............ 147 7. Shared Appreciation Rights ................... 148 8. Employer Deduction .......................... 152 III. ECONOMIC RATIONALITY ANALYSIS .................. 153 A. General Analysis ................................ 153 1. Model I Case (Non-