The recent IRS publication, Nonqualified Deferred Compensation Audit Technique Guide was created to help IRS examiners during audits. As a result, it also becomes a helpful resource for organizations seeking to ensure their compliance with 409A and other tax code regulations that may impact deferred compensation. The following excerpt from the document provides information on distinctions and requisites of funded vs. unfunded NQDC plans.
Important Nuances Regarding Funded vs. Unfunded NQDC Plans
NQDC plans are either funded or unfunded, though most are intended to be unfunded because of the tax advantages unfunded plans afford participants.
An unfunded arrangement is one where the employee has only the employer’s “mere promise to pay” the deferred compensation benefits in the future, and the promise is not secured in any way. The employer may simply track the benefit in a bookkeeping account, or it may invest in annuities, securities, or insurance arrangements to help fulfill its promise to pay the employee, as long the annuities, securities, or insurance policies are owned by the employer and remain part of the employer’s general assets.
Similarly, the employer may transfer amounts to a trust that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, help keep its promise to the employee. This type of arrangement is commonly called a “rabbi trust.” Rev. Proc. 92-64 includes model provisions for a rabbi trust, including a statement that any assets in the trust are subject to claims of the employer’s general creditors.
To obtain the benefit of income tax deferral, it is essential that the amounts are not set aside from the employer’s creditors for the exclusive benefit of the employee. If amounts are set aside from the employer’s creditors for the exclusive benefit of the employee, the employee may have currently includible compensation.
A funded arrangement generally exists if assets are set aside from the claims of the employer’s creditors, for example in a trust or escrow account. A qualified retirement plan is the classic funded plan. A plan will generally be considered funded if assets are segregated or set aside so that they are identified as a source to which participants can look for the payment of their benefits. For NQDC purposes, it is not relevant whether the assets have been identified as belonging to the employee.
What is relevant is whether the employee has a beneficial interest in the assets, such as having the amounts shielded from the employer’s creditors or the employee has the ability use these amounts as collateral. If the arrangement is funded, the benefit is likely taxable under IRC §§ 83 and 402(b).
It is important to distinguish between a funding arrangement for an unfunded plan (i.e., the way an employer decides to satisfy its deferred compensation obligations) and a funded plan. As discussed above, a funded plan arises when amounts are set aside from the employer’s creditors for the exclusive benefit of the employee. For example, if an employer purchases an annuity in the name of an employee, such that the employee can look to the annuity for the payment of benefits if the employer is unable to pay, the employer has created a funded plan. On the other hand, if the employer purchases an annuity that is owned by the employer and merely earmarked to pay that employee’s benefits in the future, they have created a funding arrangement for an unfunded plan, as long as the annuity is a general asset of the employer.
…While the use of a funding arrangement (such as a rabbi trust) may not create a funded plan for purposes of IRC §§ 83 or 402(b), an unfunded rabbi trust can nevertheless be subject to tax under IRC § 409A(b) under certain circumstances.
From the source document: This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. This guide is current through the revision date. Since changes may have occurred after the revision date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the revision date.
Audit Technique Guide Revision Date: 6/1/2021.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.
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