tion of the constructive receipt and cash equivalent doctrines to nonqualified deferred compensation arrangements. Revenue Ruling 60-31 set forth a number of general principles regarding the constructive receipt and cash equivalent doctrines and then provided five examples of their application to deferred compensation arrangements.

The five examples set forth in the ruling made it clear that the constructive receipt and cash equivalent doctrines would not be applied to certain deferred compensation arrangements between an employee and an employer even though the employee might have obtained an agreement from the employer to make an immediate cash payment following the performance of services. Subsequent published rulings continued to confirm that the constructive receipt and cash equivalent doctrines would not be applied merely because an employee was permitted to elect, before the compensation was earned, to defer the compensation to a later time or receive it currently. In addition, some of these subsequent rulings indicated that a cash method employee would not be considered to have current income even though the employer set aside assets to fund its obligation to pay deferred compensation, as long as the employee did not acquire a present interest in either the amounts deferred or the assets used as the employer's funding medium.

In 1972, the Internal Revenue Service issued the first favorable private letter ruling with respect to an unfunded deferred compensation arrangement where a State or local government unit was the employer. Subsequently, many States and local governments have obtained private rulings with respect to their deferred compensation plans which provide that participating employees who use the cash

'At the same time the Service withdrew its prior nonacquiescence and acquiesced in the decision in James F. Oates, supra. See 1960-1 C.B. 5.

See Revenue Ruling 68-99, 1968-1 C.B. 193, where the employer purchased an insurance policy on the life of the employee to insure that funds would be available to meet its obligation to make deferred compensation payments. The ruling held that the employee did not receive a present economic benefit when the employer purchased the insurance contract since all rights to any benefits under the contract were solely the property of the employer and the proceeds of the contract were payable by the insurance company only to the employer.

See also Revenue Ruling 72-25, 1972-1 C.B. 127, where the employer funded its deferred compensation obligation with the purchase of an annuity contract. "These deferred compensation plans typically involve an agreement, between the employee and the State or local government, under which the employer agrees to defer an amount of compensation not yet earned. Frequently, these plans permit the employee to specify how the deferred compensation is to be invested by choosing among various investment alternatives provided by the plan. (However, the employer must be the owner and beneficiary of all such investments and the employee or his beneficiary cannot have a vested, secured, or preferred interest in any of the employer's assets.) Benefits under these plans (including gains and losses and investment income on investments made with the deferred compensation) typically are paid to the employees upon retirement or separation from service with the employer, or, in the case of the death of an employee, to the designated beneficiary. Typically, these plans provide also for the payment of benefits in case of an emergency beyond the employee's control, Many plans also provide for optional modes of distributing benefits (e.g., lumpsum payment or installments over 10 years) upon the occurrence of the event which causes benefits to be paid.

Where an unfunded plan is maintained by a governmental unit or a church, the plan can cover all or any part of an employer's work force. Under Title I of the Employee Retirement Income Security Act of 1974 (ERISA), other employers (including tax-exempt cooperatives) can maintain such plans only for benefits in excess of those permitted under qualified plans, or a group of employees consisting primarily of highly compensated or management employees.

method will include in income benefits payable under the deferred compensation plan only in the taxable year in which such benefits are received or otherwise made available.

Because these plans are not designed to be qualified for special treatment under the tax law, they need not comply with Internal Revenue Code rules prohibiting benefits or contributions which discriminate in favor of employees who are officers, shareholders, or highly compensated. Also, nonqualified plans are not subject to the limitations on contributions or benefits which apply to qualified plans. An active participant in a qualified plan, government plan, or tax-sheltered annuity program is not allowed to make deductible contributions to an individual retirement account. This restriction does not apply to participants in un funded, nonqualified plans.

In April 1977, the Internal Revenue Service stopped issuing private rulings dealing with the income tax treatment of individuals under certain nonqualified deferred compensation plans, the type of unfunded deferred compensation plans typically established by State and local governments, and began advising applicants for rulings that their applications would be delayed pending study. The plans involved permitted individuals to elect to defer a portion of salary that would otherwise be payable. Later, the Service publicly announced the suspension pending a review of the area.

After completion of its review of this area, the Internal Revenue Service issued proposed regulations 10 which provide generally that, if under a plan or arrangement (other than a qualified retirement plan), payment of an amount of a taxpayer's fixed basic or regular compensation is deferred at the taxpayer's individual election to a taxable year later than that in which the amount would have been payable but for the election, the deferred amount would be treated as received in the earlier taxable year. These proposed regulations would apply to plans maintained by States and local governments and tax-exempt organizations as well as plans maintained by taxable employers.

Reasons for change

The committee believes that the regulations concerning nonqualified deferred compensation plans involving an individual election to defer compensation proposed by the Internal Revenue Service on February 3, 1978, if adopted in final form, would seriously impact upon the employees of many States and localities. If adopted, the regulations

7

An employer who makes contributions to a qualified plan generally is allowed a deduction for his contributions at the time they are made; deductions for contributions to a nonqualified plan for employees are generally deferred until benefits under the plan are taxable to the employee. Also lump sum distributions from qualified plans are accorded special 10-year income averaging and annuity distributions from qualified plans are accorded estate and gift tax exclusions. The lumpsum distribution rules and the estate and gift tax exclusions apply to certain tax sheltered annuity programs and individual retirement accounts but do not apply to nonqualified plans.

8

Generally, an employee's benefits under a qualified plan are limited to 100 percent of average pay (3 years) or $75,000 (adjusted for increases in inflation since 1974). Contributions for an employee are limited to 25 percent of pay or $25,000 (adjusted for inflation since 1974).

10

IR-1881 (9/7/77).

Prop. Regs. § 1.61–16, published in the Federal Register for February 3, 1978. (43 F.R. 4638).

would prohibit employees of States and local governments and employees of tax-exempt rural electric cooperatives and their tax-exempt affiliates from participating in salary-reduction deferred compensation plans as a means of providing retirement income.

The committee believes that limitations should be imposed on the amounts of compensation that can be deferred under these arrangements and allowed to accumulate on a tax-deferred basis. The committee realizes that the denial of a compensation deduction to a nontaxable entity until an amount is includible in the income of the person providing services does not act as a restraint on the amounts that nontaxable entities are willing to let employees defer as it does when a taxable entity is involved. Accordingly, the committee believes that a percentage-of-compensation limit on amounts that can be deferred, as well as an absolute dollar limitation to prevent excessive deferrals by highly-compensated employees, is necessary.

Explanation of provisions

The committee's bill adds a new provision to the Code (sec. 457) to provide certainty with respect to unfunded deferred compensation plans maintained by States and local governments and tax-exempt rural electric cooperatives and their tax-exempt affiliates. Thus, under this provision, employees and independent contractors who provide services for one of these entities that maintains an eligible deferred compensation plan will be able to defer compensation as long as such deferral does not exceed the prescribed annual limitations.

In general

Amounts of compensation deferred by a participant in an eligible State deferred compensation plan, plus any income attributable to the investment of such deferred amounts, will be includible in the income of the participant or his beneficiary only when it is paid or otherwise made available. For this purpose, the fair market value of any property (including an annuity contract or a life insurance policy) distributed to the participant from the plan will be includible in income. Amounts will not be considered "made available" merely because the plan allows the participant to choose among various options that the employer may provide for the investment of deferred amounts or to elect, prior to the earliest distribution date provided under the plan, the manner in which deferred amounts are to be paid. Of course, if a participant assigns or alienates his benefit under a plan, the benefit is considered made available to him. If life insurance is purchased with some, or all, of the amounts deferred under the plan, the cost of current life insurance protection will not be considered made available as long as the State or local government (1) retains all of the incidents of ownership of the policy, (2) is the sole beneficiary under the policy, and (3) is under no obligation to transfer the policy or to pass through the proceeds of the policy as such to the participant or a beneficiary of the participant. However, if the plan provides a death benefit, whether or not funded by the employer through the purchase of life insurance on the participant, any such death benefit will not qualify for exclusion from gross income as life insurance proceeds under section 101 (a) of the Code. Instead, the committee intends that any death benefit will be treated under the deferred compensation rules by the recipient.

Plan requirements

To qualify as an eligible State deferred compensation plan, the plan must be maintained by (1) a State, a political subdivision of a State, an agency or instrumentality of a State or one of its political subdivisions, or (2) a rural electric cooperative exempt under section 501 (c) (12) of the Code, and any affiliates which are exempt under section 501 (c) (6). In addition, the plan by its terms must not allow the deferral of more than $7,500, or 3313 percent of the participant's includible compensation for the taxable year, whichever is less. For this purpose, includible compensation is determined before any reduction for amounts deferred under a tax-sheltered annuity described in section 403(b) of the Code.

An eligible State deferred compensation plan may provide a limited "catch-up" provision for any, or all, of the last three taxable years of a participant ending before the normal retirement age specified by the plan (or if no normal retirement age is specified by the plan, then either the later of the normal retirement age specified in any other retirement plan maintained by the sponsoring entity for age 65.) Under the catch-up provision, in addition to the amount that may be deferred under the usual $7,500 and 333-percent-of-includible-compensation limitations, a participant may defer an additional amount equal to any deferral limitations not utilized for prior taxable years in which the participant was eligible to participate in the plan (even if nothing was deferred) and was subject to the deferral limitations imposed by the bill. The maximum that can be deferred in any taxable year through the utilization of both the normal deferral limitation and the catch-up provision is $15,000. (Of course, the deferred amount also cannot exceed the amount of the participant's compensation from the State, etc.). For example, a 62-year old participant in a plan with a normal retirement age of 65 who is scheduled to receive a salary of $20,000 during the next taxable year, could elect to defer $15,000 of that compensation if prior year's deferral limitations have been underutilized by at least $10,000. (The regular limitation is $5,000 ($20,000-$5,000) + 3=$5,000; the catch-up amount is $10,000 ($15,000-$5,000).)

The underutilized deferral limitation for a taxable year is the difference between compensation actually includible in income for that year and compensation that would have been includible in income if the maximum deferral limitation had been utilized. For example, an individual with a salary of $20,000 who did not elect to defer any compensation would have an underutilized deferral limitation of $5,000 ($20,000-$15,000 (includible compensation if the 333 percent deferral limitation had been utilized)). In calculating the underutilized deferral limitation, the participant must use the actual plan limitations if they are less than the limitations provided by this bill.

In addition to providing limitations on amounts of compensation that can be deferred, the bill provides that the plan must not permit participants to defer compensation for a taxable year unless an agreement providing for such deferral has been entered into before the

beginning of the plan year (or the calendar year if no plan year is provided). In the case of (1) persons first performing services for the sponsoring entity, and (2) newly implemented deferred compensation plans, employees or independent contractors would have a reasonable period of time from the date participation in the plan is offered to them to effect an election to defer. In such case, the election to defer compensation would become effective for pay periods beginning after the date the participation agreement is filed with the sponsoring entity or the plan administrator. If a plan is amended to provide for participation by a group of employees or independent contractors not previously permitted to participate, or in the case of individuals first meeting any eligibility requirements provided under the plan, it is intended that a reasonable period of time will be allowed for affected individuals to elect to participate as if this were a newly implemented plan or as if these were new employees.

An eligible State deferred compensation plan cannot make benefits available to participants before the earlier of (1) separation from service with the sponsoring entity, (2) retirement in accordance with the terms of any retirement plan maintained by the sponsoring entity, (3) death, or (4) the occurrence of an unforeseeable emergency. While the Secretary of the Treasury is to prescribe regulations defining what constitutes an unforeseeable emergency, it is not intended that such term would include the purchase of a home or the need for funds to send children to college. In addition, it is expected that plans will permit the withdrawal of only the amount of funds reasonably needed to satisfy the emergency needs.

Finally, for the deferred compensation plan to be eligible under the bill, all amounts of compensation deferred under the plan, all property or rights to property (including rights as a beneficiary of life insurance protection) purchased with the amounts deferred, and any income earned on property purchased with amounts deferred must remain assets of the plan sponsor subject to the claims of its general creditors. Thus, while plan participants may select among any optional methods provided under the plan for investing amounts of deferred compensation, they cannot have any secured interest in the assets purchased with their deferred compensation and the assets may not be segregated for their benefit in any manner which would put them beyond the reach of the general creditors of the sponsoring entity.

Any plan which is not administered in accordance with the bill's requirements for eligible State deferred compensation plans will lose its eligible status on the first day of the first plan year beginning more than 180 days after notification by the Secretary of the Treasury that such requirements are not being met, unless satisfactory corrective action is taken by the first day of such plan year. If a plan loses its status as an eligible State deferred compensation plan, amounts subsequently deferred by participants will be includible in income when deferred (unless the amounts are subject to a substantial risk of forfeiture when deferred). However, it is intended that amounts preentity) he must designate how the $7,500 limitation will be allocated in income until paid or otherwise made available.