Category: Employee Benefits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com The taxpayer is a corporation. The founder died in 1981 and his wife took over as president. In 1991, taxpayer established a deferred compensation plan to pay benefits to the wife in connection with the founder's past services. The taxpayer deducted such payments either as "pension benefits" or as "other employee benefits". On examination, the IRS agent proposes denying the pension deduction based on what the agent cites as 1.404(a)(4)(b). This is really a mis-citation. The proper citation is regulation 1.404(a)-1(b). Regulation 1.404(a)-1(b) provides in pertinent part as follows. A contribution under a plan which is primarily for the benefit of shareholders of the employer is not deductible. Such a contribution may constitute a dividend within the meaning of Section 316. See also Sections 1.162-6 and 1.162-8. Discussion: Deductibility of Deferred Compensation The agent apparently feels that this regulation represents a rule that deferred compensation benefits paid to shareholders are per se nondeductible. This is an erroneous conclusion. The fact is any corporate payment which is primarily for the benefit of shareholders is nondeductible and may constitute a dividend. A corporate expenditure must meet the ordinary and necessary test of Section 162 in order to be deductible. The two things are mutually exclusive: an expenditure cannot be both an ordinary and necessary expense of the business and primarily for the benefit of shareholders. It is a question of fact to determine how an expenditure must be characterized. It does not follow from Regulation Section 1.404(a)-1(b) that any deferred compensation benefit paid to or on behalf of a shareholder is primarily for the benefit of the shareholder. The deferred compensation amount must be evaluated: does it represent reasonable payment for services performed or is this amount just a means of taking money out of the corporation in an ostensibly deductible manner? This is no different from the analysis necessary with respect to payment of current compensation amounts to shareholders. The case of Yeomans Distributing Company v. U.S., 607 F. Supp. 42, 85-1 USTC ¶9260, 56 AFTR 2d 85-5345, is exactly on point. In this case we can see almost exactly the same fact pattern as present in this matter. The whole point of the case is a factual determination is necessary. Is the deferred compensation payment reasonable payment for prior services or is the amount primarily for the benefit of the shareholder? Note that the Yeomans decision does nothing for the present taxpayer except 1) negate the agent's apparent assertion of a per se rule with respect to deferred compensation paid to shareholders; and 2) open the door to the relevant factual inquiry about what the payment actually represents. The taxpayer still has to bear the burden of proving that this payment is for prior services of the founder. I assume you have the means to do that. I stand ready to assist you if needed. Discussion: Withholding of Income Tax, FICA, and FUTA Ordinarily, deferred compensation is subject to withholding of income tax, FICA, and FUTA at the later of 1) the time the deferred compensation amounts are no longer to substantial risk of forfeiture; or 2) the time the services are performed. In this case, the services were performed prior to the existence of the plan of deferred compensation; accordingly, withholdingif any is necessary under these provisionswould be required at the time of payment. See Sections 3121(v) and 3306(r)(2). There are interpretive regulation in effect under these Sections, but the effective date of the regulations is after the date at issue in this matter. In this matter, the amounts in question were paid to the widow of the founder in respect to the founder's past services. The payments were made long after the founder's death. Section 3121(a)(14) and 3306(a)(15) exempt from FICA and FUTA, respectively, payments made by an employer to an employee's survivor or estate after the calendar year in which the employee died. These rules, in my opinion, clearly exempt the payments in question from FICA and FUTA in this matter. Apparently, there is no similar provision for income tax withholding. While the taxpayer in this matter should be able to escape liability for the amount of income taxes that should have been withheld by showing that the recipient included the deferred compensation amounts in income, this relief does not have the effect of shielding the taxpayer from imposition of penalties for failure to withhold and pay over such amounts. See Regulation 31.3401(d)-1. |
