David I. Walker ABSTRACT

THEPRACTICEANDTAXCONSEQUENCESOFNONQUALIFIEDDEFERREDCOMPENSATION

DavidI.Walker*

ABSTRACT

Although nonqualified deferred compensation plans lack explicit taxpreferences afforded qualified plans, it is well understood that nonqualifieddeferredcompensationresultsinajointtaxadvantagewhenemployersearnahigherafter-taxreturnondeferredsumsthanemployeescouldachieveontheirown. Several commentators have proposed tax reformaimed at leveling theplayingfieldbetweencashandnonqualifieddeferredcompensation,butreformisnoteasilyachieved.ThisArticleexaminesthestakes.Itinvestigatesprivatesectornonqualifieddeferredcompensationpracticesand shows that joint taxminimization often takes a backseat to accounting priorities and participantdiversificationconcerns. Inpractice,thelargestsourceofjointtaxadvantagelikely stems from use of corporate owned life insurance (COLI) to informallyfund nonqualified deferred compensation liabilities, suggesting that narrowreform aimed at COLI use might be a more attractive policy response thanfundamentalreformofthetaxationofnonqualifieddeferredcompensation.

*Professor of Law andMaurice Poch FacultyResearch Scholar, BostonUniversity School of Law.Acknowledgmentstofollow.DraftofSept.1,2017.Pleasedonotcitewithoutauthor’spermission.

TableofContentsIntroduction................................................................................................................................................................2I.DeferredCompensationOverview................................................................................................................6A.QualifiedDeferredCompensationPlansandTaxation..................................................................6B.NonqualifiedDeferredCompensationArrangements....................................................................8C.NonqualifiedDeferredCompensationTaxation.............................................................................10D.NonqualifiedDeferredCompensationAccounting.......................................................................13E.EfficientAssetAllocationandOtherFeaturesofNonqualifiedDeferredCompensation...................................................................................................................................................................................15

II.ApproachandMethodology.........................................................................................................................17III.NonqualifiedDeferredCompensationinPractice............................................................................21A.ParticipationandSourceofFunds.......................................................................................................21B.ParticipantNotionalInvestment...........................................................................................................22C.InformalFundingByPlanSponsors....................................................................................................26D.JointTaxConsequencesofNonqualifiedPlansinPractice........................................................321.DefinedContributionPlans.................................................................................................................342.DefinedBenefitPlans............................................................................................................................36

IV.Discussion...........................................................................................................................................................38A.IsThereaJointTaxAdvantageIssuetoWorryAbout,and,IfSo,WhatIsIt?...................38B.WhatAretheDistributionalConsequencesofDeferredCompensation?...........................44C.WhatRoleDoTaxesPlayintheAdoptionorOperationofNonqualifiedDeferredCompensationArrangements?....................................................................................................................46D.Why(Else)DoFirmsOfferNonqualifiedDeferredCompensation?......................................48E.AFinalMystery?RelativeUseofOwn-CompanyStockinQualifiedandNonqualifiedDeferredCompensationPlans.....................................................................................................................50

V.Conclusion............................................................................................................................................................52Appendix....................................................................................................................................................................53

Nonqualified Deferred Compensation

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Introduction

Executives and other high-level corporate employees often receivecompensation relating to current services that is payable in future years. Thisdeferredcompensationmightconsistof “long-term” incentivecompensation(bothequity and non-equity based arrangements) that generally pays out several yearsaftergrant. Compensationalsomaybedeferredthroughqualifiedplans,explicitlytax-preferred arrangements that include traditional, qualified defined-benefitpension plans and qualified defined-contribution plans, such as 401(k)s.1 Thisarticlefocusesonathirdclassofdeferredcompensationwritlarge,thenonqualifiedanalogs of qualified plans, generally referred to as nonqualified deferredcompensation.2

NonqualifieddeferredcompensationplanshavealonghistoryintheU.S.and

they remain popular today.3 These plans take a variety of forms, including bothdefined-benefit and defined-contribution arrangements. Often these planssupplementorextendthebenefitsprovidedtoqualifiedplanparticipants,butthisisnot always the case. Perhaps most familiar are elective deferred compensationplans,which allow participants to defer a portion of their salary, bonus, or othercompensation, and defer the tax on that compensation, until a future date, oftenuntilretirement.41As discussed infra Part I.A., participants in defined benefit plans are promised specifiedbenefits at retirement, e.g., an annuity equal to a percentage of pre-retirement wages;defined contribution plans specify annual contributions that yield benefits at retirementthatdependontheinvestmentchoicesoftheparties.2Thereisnoauthoritativedefinitionofnonqualifieddeferredcompensation. I.R.C.§409Adefinesanonqualifieddeferredcompensationplanasanyplanprovidingforthedeferralofcompensationotherthanaqualifiedplan.I.R.C.§409A(d)(1)(2012).Underthisdefinition,stock options and other long-term equity-based pay would be considered nonqualifieddeferredcompensation. ThepresentArticle,however,generallyexcludesequity incentivepay from the definition of nonqualified deferred compensation, in keeping with morestandardindustryterminology.3 Approximately three quarters of large companies offer nonqualified deferredcompensation programs currently. DOUG FREDERICK & AARON PEDOWITZ, MERCER, MARKETLANDSCAPEOFEXECUTIVEBENEFITPROGRAMS2(Feb.26,2016)(reportingthat73%ofFortune500companiesofferednonqualifiedsavingsplansin2015);THENEWPORTGROUP,EXECUTIVEBENEFITS:ASURVEYOFCURRENTTRENDS13(2014/2015Edition)[hereinafterNewportGroupSurvey](72%ofFortune1000companiesofferedanonqualifiedsavingsplanin2013).Some governmental entities and other tax-exempt organizations also offer nonqualifiedsavings opportunities. The use of nonqualified deferred compensation by theseorganizationsisnotafocusofthisArticle.4Taxation isdeferredonly if the termsof thedeferredcompensationarrangementdonotrunafouloftheconstructivereceipt,cashequivalence,andeconomicbenefitdoctrines,and,since2004,therequirementsofI.R.C.§409A.Seeinfratextaccompanyingnotes40-47.


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Although nonqualified deferred compensation plans lack explicit tax

preferences afforded qualified plans,5it is well understood that nonqualifieddeferred compensation can be tax advantaged in some circumstances. Thecomparison that is generally made is between 1) a payment of current cashcompensationthatistaxedtotheemployeeanddeductedbytheemployer,followedby employee investment of the after-tax amount until some future date and 2)deferral of current compensation, investment by the employer, and payout at afuturedateresultingatthattimeintaxationoftheemployeeandadeductionfortheemployer. Ignoringpotentialchangesintaxratesovertime,nonqualifieddeferredcompensation results in a joint (sometimes called “global”) tax advantage to anemployee and employer if the employer is able to earn a higher after-tax rate ofreturnthantheemployeeisabletoearnonherown.6Thiscircumstancecanariseanytimethattheemployer’staxrateonaninvestmentislessthantheemployee’srate on the same investment (assuming both can access the investment), but isparticularly pronounced when the investment under consideration is in theemployer’sownstock.Inthatcase,anemployeewouldbetaxedwithrespecttoheroutside investment in her own company’s stock at the regular rates applied todividendsandcapitalgains,butafirmfacesnotaxongainsorlossesonholdingsofitsownstockunderaparticularruleofthefederalincometaxcode,IRC§1032.7

Participants in defined contribution nonqualified deferred compensation

plans generally are permitted to control the notional investment of their accountbalances,similartothewayinwhichparticipantsmanage401(k)investments,butthese notional investments and the actual investments of deferred amounts byemployersponsors,ifany,arenotdisclosedtoinvestors.8Financetheorysuggeststhat poorly diversified executives shouldnot voluntarily tie nonqualifieddeferredcompensation account balances to their own companies’ stock prices.9 However,recent scholarship suggests that they oftendo so10and that employers commonlyinvest deferred amounts in their own stock, as well.11 If so, and given §1032,5QualifiedplantaxationisdiscussedinfraPartI(A).6InfraPartI(C).7InfraPartI(C).Thejointtaxadvantageisalsolargeincasesinwhichtheplansponsoristaxexemptoreffectivelytaxexempt.However,employeesofgovernmentalandnon-profitentitieshaveonlylimitedaccesstotaxdeferredsavingsopportunities. Infranote180andaccompanyingtext.8The term “notional investment” refers to the fact that nonqualified plan participants donot direct the investment of any actual assets but instead select a benchmark orbenchmarks for the determination of the amounts contractually due to them at payout.InfraPartI(B).9Infratextaccompanyingnotes71-72.10Robert J. Jackson& ColleenHonigsberg,TheHiddenNatureofExecutiveRetirementPay,100VA.L.REV.479,492(2014).11Michael Doran, The Puzzle of Non-Qualified Retirement Pay: Optimal Contracting,Managerial Power, and Taxes 28 (Univ. of Va. Sch. of Law Pub. Law and Legal TheoryResearchPaperSeries2016-13,WorkingPaper,Feb.1,2016).


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nonqualifieddeferred compensation arrangements couldbe generating significantjointtaxbenefitsforparticipantsandemployers,andthesejointtaxbenefitsmightjustify a change in the taxation of nonqualified deferred compensation, as severalcommentatorshaveproposed.12

But there are obstacles to reforming the taxation of nonqualified deferred

compensation,13and,againstthatbackdrop,thisArticleinvestigatesthestrengthofthe driving force behind tax reform. It asks whether private sector nonqualifieddeferredcompensationplansarebeingoperatedinsuchawayastogeneratejointtax advantages, subsidizing the compensation of high-income individuals, andpotentiallydistortingexecutivepayarrangements.

This Article investigates notional participant investment of nonqualified

deferredcompensationbalances,actualemployerinvestmentofdeferredamounts,andotherfactsonthegroundthatallowonetoassessthejointtaxconsequencesofnonqualified deferred compensation arrangements as they currently function.14Insightsarederivedfromseveralindustrysurveysandproxystatementdisclosures,aswellasinterviewswithanumberofindividualswithextensiveexperienceinthedesign and administration of nonqualified deferred compensation plans. Keyfindings,andimplications,includethefollowing:15

• Notional investment by nonqualified deferred compensation plan

participantsinthestockoftheirowncompaniesappearstobemodest,andemployerinformalfundingofnonqualifieddeferredcompensationliabilitieswith own-company stock even more so. As a result, §1032 apparentlyprovides little joint tax advantage for nonqualified deferred compensationarrangements.

• Corporateownedlifeinsurance(COLI)productsareusedtoinformallyfund

aquarterormoreofaggregatenonqualifieddeferredcompensationaccountbalances. COLI use can result in a large joint tax advantage, but the taxadvantage is offset to some degree by the cost of insurance andadministrativecosts.

12SeeMichael Doran, Executive Compensation Reform and the Limits of Tax Policy, THEURBAN-BROOKINGSTAXPOLICYCTR.,Nov. 2004, at 14;Daniel I.Halperin, InterestinDisguise:Taxing the “Time Value ofMoney”, 95 YALE L.J. 506, 539 (1986); Ethan Yale & Gregg D.Polsky,ReformingtheTaxationofDeferredCompensation, 85N.C.L.REV. 571, 574 (2007);Daniel I. Halperin& Ethan Yale,DeferredCompensationRevisited114 TAXNOTES 939, 941(Mar.5,2007).13InfraPartII.14One might argue that potential joint tax consequences are also important or moreimportantthanactualtaxconsequences.InfraPartIV(A).15InfraPartIII.


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• Othernonqualifiedplanliabilitiesarefundedusingtaxablesecurities(oftenheld in rabbi trusts) or remain unfunded liabilities with the deferredamountsbeingusedinthebusinessortoreduceborrowing. Ineithercase,andsettingasideemployersfacingloweffectivemarginaltaxrates,thejointtaxconsequencesrangefrommodestadvantagetomodestdisadvantageandarelikelytoberoughlyneutralinaggregate.The joint tax consequences of nonqualified deferred compensation do not

appeartobeoffirstorderimportanceinthedecisiontoadopttheseplans,andwhilecertaintaxconsiderationsclearlymatterinoperation(e.g.,avoidingtaxpenaltiesonnon-complyingdeferredcompensationplansunderIRC§409A),16participantsandplan sponsors do not appear to be making investment decisions with a view tominimizing their joint tax burden.17 As a result, it is not clear that fundamentalreform of nonqualified deferred compensation is required. A more surgicalapproachtargetingtheuseofCOLImightbeabetterresponse.18

Whydon’t firmsandemployeesmake tax-minimizing investmentdecisions

within nonqualified deferred compensation programs? It appears that financialaccounting and participant diversification concerns often trump joint tax-minimization.19 In elective defined contribution plans, participants tend to selectdiversified equity and debt funds that create volatile liabilities on corporatefinancial statements. To the extent that they informally fund their obligationswithin these plans, sponsors tend to mirror the aggregate notional investmentchoices of participants in order to hedge their economic exposure, as well asfinancialstatementvolatility,evenwhenthe joint taxconsequencesareneutralordisadvantageous. Notional participant investment in own-company stock, bycontrast, undermines participant diversification needs and also creates liabilitiesthat cannot be perfectly hedged from an income statement perspective. Thecombinedeffectappearstodiscouragetheuseofown-companystockinsuchplans.

But what about firms that face a low effective marginal rate because ofaccumulated losses? These firms could invest deferred participant dollars inessentiallyanymannerandcreatea joint taxadvantage. Despite thepotential taxsavings, preliminary evidence suggests that nonqualified deferred compensationparticipationat these firms isanorderofmagnitude less thanat firms facinghigheffective rates. Perhaps the risk associatedwith anunsecuredpromise todeliverdeferred compensation outweighs the potential tax savings at these firms.

16InfraPartI(C).17As discussed infra Part IV.A.2, extensive use of COLI to informally fund nonqualifieddeferredcompensationisinitselfevidencethatthepartiesoftendonotminimizejointtaxcosts through investmentdecisions. If firmsandparticipantsminimized joint taxthroughuseofown-companystock,forexample,therewouldbenoneedtoacquireexpensiveCOLIproducts.18InfraPartIV(A).19InfraPartIII.


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Whatever the explanation, low effective rate firms do not appear to be fullyexploitingthenonqualifieddeferredcompensationopportunity.

This Article also considers the distributional consequences of nonqualified

deferredcompensation.20Despitethelackofaclearjointtaxadvantageathightaxfirms, this Article argues that the after-tax returns achieved by nonqualifieddeferred compensation participants substantially exceed those available onequivalent outside investments, and that it is unlikely that these effective above-market returns are shifted back to firms through other adjustments tocompensation. Shareholders, in otherwords, likely bear the cost of these above-marketreturns,notthepublicfisc.

The remainder of the Article is organized as follows. Part I provides an

overview of qualified and nonqualified deferred compensation. Part II brieflydescribes the approach andmethodologyof thepresentArticle. Part III providessurvey and interview evidence concerning nonqualified deferred compensationpracticesandusesthatevidencetoestimatetheaggregatejointtaxconsequencesofnonqualifiedplansathighratefirmsinpractice.PartIVdiscussestheimplicationsof these findings for high effective rate firms, investigates use of nonqualifieddeferred compensation by low rate firms, addresses distributional consequences,and considers non-joint tax minimization explanations for the persistence ofnonqualified deferred compensation, including path dependence and stealthcompensationforexecutives.PartVconcludeswithacallforreassessmentofCOLIuse and taxation and for enhanced disclosure of effectively above-marketnonqualifieddeferredcompensationreturns.

I.DeferredCompensationOverview ThisPartbeginswithabriefdescriptionofqualifiedplansbeforemovingonto description and overview of the tax, accounting, and governance features ofnonqualifiedplans. ThisPartalsohighlightspriorresearchthataddresses the taxconsequencesofnonqualifieddeferredcompensation.

A.QualifiedDeferredCompensationPlansandTaxation

Congress has provided preferential tax treatment for qualified deferredcompensationplans inorder toencouragecompanies tocreate theseplansandtoencourage employees to save for retirement. Qualified plans are intended to bebroadly based and are subject to nondiscrimination requirements21and limits on

20InfraPartIV.B.21I.R.C.§§401(a)(4),410(b).Theserequirementsaredesignedtoensurethatplansdonotdiscriminate in favor of highly compensated employees. See EMPLOYEEBENEFITRESEARCHINSTITUTE, FUNDAMENTALS OF EMPLOYEE BENEFIT PROGRAMS 46 (6th ed. 2009) [hereinafter,EBRI).


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contributions,benefits,andtheamountofanemployee’scompensationthatmaybetakenintoaccountforpurposesofaqualifiedplan.22

Qualifiedplansmaybe structuredasdefinedbenefit (DB)plansordefinedcontribution (DC) plans. DB plans promise participants specified benefits atretirement. Often the benefit is structured as an annuity and represents somefraction of a participant’s pre-retirement wage rate.23 The plan sponsor (theemployer) makes contributions to a pension trust and directs the investment oftrust assets to satisfy plan obligations.24 Participants are essentially passivebeneficiaries. Definedcontributionplans,suchas401(k)plans,alsoinvolvecontributionsto a trust, but participants generally direct the investment of their own accountswithin the trust based on a menu of investment options provided by the plansponsor and administrator. 25 Both participants and employers may makecontributions to DC accounts. Employer contributions often are structured asmatching contributions. Benefits ultimately are a function of the amountscontributedandtheinvestmentchoicesmadebyparticipants.

While qualified DB planswere once very common in the U.S. – and henceconstitutewhatmanyolderAmericansthinkofascorporatepensions–manyfirmshavephasedoutDBplans,generallyreplacingthemwithDCplans.26Attheendof2015, assets in private qualified DB plans totaled $3.1 trillion, while privatequalifiedDCassetstotaled$5.4trillion.27

22See I.R.C. §402(g) (2012) (limiting themaximumsalarydeferral for eligible employeesusing tax qualified plans to $18,000); I.R.C. § 414(v) (2012) (allowing for an additional$6,000 “catch-up” contribution for eligible employees over age 50); I.R.C. 401(a)(17)(limitingtheannualamountofeligiblesalarytobeconsideredunderatax-advantagedplanto $265,000); EBRI, supranote 21, at 50. Most, but not all, of these restrictions wereimposedbytheEmployeeRetirementIncomeSecurityActof1974(ERISA).23EBRI,supranote21,at44.24Management of trust investments is subject to a general prudent man fiduciary dutystandard;however,ERISAlimitsinvestmentinplansponsorstockto10%oftotalDBtrustassets.29U.S.C.§1107(a)(2012).25401(k) and the nonprofit analog 403(b) plans are perhapsmost familiar, but DC plansalsoincludeotherprofit-sharingplans,employeestockownershipplans(ESOPs),andotherarrangements.EBRI,supranote21,at45.26DOUG FREDERICK & AARON PEDOWITZ, MERCER, MARKET LANDSCAPE OF EXECUTIVE BENEFITPROGRAMS2(Feb.26,2016)(providingdataindicatingthat22%ofFortune500companiescurrently maintain a qualified DB plan that is open to new employees, while 99% offerqualifiedDCsavingsopportunities).27FED.RESERVE,STATISTICALRELEASE,FINANCIALACCOUNTSOFTHEUNITEDSTATES,4THQUARTER201593(releasedMar.10,2016).DBplanshavebeenmorepersistentinthepublicsector.See JohnG.Kilgour,Section457DeferredCompensationPlans,45COMP.&BENEFITSREV.176,176(2013)(notingthat87%ofstateand83%oflocalgovernmentemployeeshadaccesstoatraditionalDBpensionplanin2010).


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The taxation of qualified DC and DB plans is the same. In a nutshell,participants can contribute pre-tax dollars to a qualified plan trust.28 Employercontributionsonbehalfofparticipantsare immediatelydeductibleandexcludablebytheparticipants.29Trustassetsgrowtax-free.30Participantsgenerallyaretaxedatordinaryrateswhen theyreceivebenefits.31AsProfessorsDanielHalperinandAlvinWarrenhavedescribed, thekey to the joint taxbenefitofqualifieddeferredcompensationistheexemptionfromtaxoftheincomeandgainsthataccruetothetrustbetweencontributionandwithdrawal.32Thedeferralof income inclusionbyparticipants actually has no impact on the joint tax advantage, assuming that taxratesareunchangedovertime.33

B.NonqualifiedDeferredCompensationArrangements

Modestly compensated rank and file employees may be able to secureadequate retirement income streams through social security and participation inqualified plans alone, but given the income-based limitations on qualified planparticipation,thisisunlikelytobethecaseformorehighlycompensatedemployeesandexecutives.Inordertosecureanadequateretirementincome,theseindividualsmust invest additional after-tax dollars on their own account or participate incompanysponsoredsavingsplansthatlacktheexplicittaxpreferencesofqualifiedplans,i.e.,nonqualifieddeferredcompensation.

Nonqualified deferred compensation plans come in the same two basicflavors as qualified plans: defined benefit and defined contribution plans. Anonqualified DB plan may supplement a qualified DB plan, providing benefitsbeyond the limits imposed on qualified plans under the tax code (often called asupplemental executive retirement plan), or a nonqualified DB plan may exist

28BORISBITTKER&LAWRENCELOKKEN,FEDERALTAXATIONOFEMPLOYEECOMPENSATION ¶ 3.14(2016),availableatThomsonReutersCheckpoint(citingI.R.C.§402(a)(2012)).Thisparagraphdescribesthetaxationof“conventional”DCplans,suchasIRAsand401k’s.Under theRoth alternative, participants contribute after-tax dollars, but payouts are freefrom tax. It iswidely understood that if tax rates are consistent, conventional and Rothaccountsyieldequivalentresults.SeeHalperin&Warren,supranote32,at325(alsonotingthateffectivecontributionlimitsdifferbetweenRothandconventionalDCplans).29BITTKER&LOKKEN,supranote28,at¶3.14(citingI.R.C.§402(a)(2012)).30BITTKER&LOKKEN,supranote28,at¶3.16(citingI.R.C.§§401(a),501(a)).31I.R.C.§§402(a),72(a)(1);EBRI,supranote21,at43. There isanexception toordinaryincometaxtreatmentthatapplieswhenparticipantsreceivecompanystockinkind. Infranote223.32Halperin, supranote 12, at 539; Daniel I. Halperin & Alvin C. Warren, UnderstandingIncomeTaxDeferral,67TAXL.REV.317,324(2014).33ThiscounterintuitiveresultreflectsthesamemechanismthatleadstotheequivalenceofRothand conventional IRAs, under standardassumptions.Halperin&Warren, supranote32,at325.


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independently of any qualified plan. Like qualified DB plan participants,nonqualifiedDBparticipantsarelargelypassivebeneficiaries.34

Similarly,anonqualifiedDCplanmaysupplementacompany’s401(k)plan,or it might exist independently of any qualified plan. Nonqualified DC plansfrequently provide for elective deferrals by executives, but companies may alsomatch these contributions to some extent or make independent contributions tononqualified DC accounts.35 Account balances – the amounts promised toparticipants–riseorfalleachyearbasedonthenotional“investment”decisionsofparticipants. These account balances are paid out to participants at a pre-determinedtimeoronapre-determinedschedule.

To be clear, unlike the owner of a 401(k) account, a nonqualified DC plan

participantdoesnotdirecttheinvestmentofactualassets.ThenotionalinvestmentdecisionsofnonqualifiedDCparticipants simplydetermine theamounts thatplansponsorsarecontractuallyobligatedtodeliveratpayout.Also,unlikequalifiedplancontributions,thereisnolegalrequirementthatsponsorsofnonqualifiedDBorDCplanssetasideassetsorinvesttheminanyparticularfashion.

Asdetailedbelow,nonqualifiedplanslackthetaxadvantagesassociatedwith

qualifiedplans.Nonetheless,itiscommonforfirmstopromiseparticipantssimilaroridenticalbenefits.36Again,thisissimplyacontractbetweenparticipantandfirm.For example, participants in a nonqualified401(k)matchplanmaybe allowed tonotionally invest their deferred compensation dollars and any companycontributions in thesame funds thatareavailable to401(k) investorsandreceivereturns on their notional investments that are undiminished by tax during thedeferral period; i.e., tax-free growth. The only limitations on the amount orpercentage of income thatmay be deferred by nonqualified plan participants arecontractual.

Asinthequalifiedplanworld,firmsareshiftingfromnonqualifiedDBplans

tononqualifiedDCplans.Thesetrendsarerelated.Acompanythatdiscontinuesitsqualifiedpensionplan is less likely tomaintain anonqualified supplementalplan.Onesourceindicatesthatonly25%ofFortune500companiesallowednewhirestoparticipate innonqualifiedDBplans in2015,downfrom38%thatdidso just fiveyearsearlier.37Meanwhile,64%oftheFortune500offeredanonqualifiedDCplan

34ROBERTA.MILLER,EXECUTIVECOMPENSATION215-16(YaleD.Tauber&DonaldR.Levyeds.,2002).35MILLER,supranote34,at215-16.36MILLER,supranote34,at215-16.37Mercer,supranote26,at2. SeealsoTHENEWPORTGROUP,EXECUTIVEBENEFITS:ASURVEYOFCURRENT TRENDS 41 (2014/2015 Edition) [hereinafter Newport Group Survey] (30% ofsurveyrespondentsreportanactiveDBsupplementalplanin2013;20%ofFortune1000reportanactiveDBsupplementalplan).


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in 2015.38 However, given grandfathering, almost half of Fortune 500 executivescontinuedtoaccruebenefitsinanonqualifiedDBplanin2015.39

C.NonqualifiedDeferredCompensationTaxation

When properly designed, a nonqualified deferred compensationarrangementresultsindeferralofparticipantinclusion(andemployerdeduction)ofdeferredpaymentsuntil thepayments are received. In the interim, the employerwill pay tax at its regular rate on any incomearising from its use of thedeferredfunds. Severaldoctrines, includingconstructivereceipt, cashequivalence,and theeconomicbenefitrule,mightbeinvokedtorequireemployeeinclusionintheyearofdeferral, or at some point between deferral and payout, if access to deferredamountsisnotsufficientlylimitedorifthearrangementtoocloselyresemblescashcompensation.40

In order to achieve tax deferral, a nonqualified deferred compensation

obligationmustrepresentonlyan“unfundedandunsecuredpromisetopaymoneyor property in the future,” 41 and participants must be “general unsecuredcreditors”42of the employer. In the wake of the Enron fiasco and several otherperceivedabusesofnonqualifieddeferredcompensationarrangements,43Congressenactedlegislationin2004totightentherulesandputinplaceseverepenaltiesfornoncompliance. That legislation, codified as IRC §409A, constrains the timing ofelective deferrals, how assets are held, and payout decisions. To comply with§409A,deferralelectionsgenerallymustbemadepriortothebeginningofthetax

38Mercer,supranote26,at2.SeealsoNewportGroupSurvey,supranote37,at13(78%ofsurveyrespondentsand72%ofFortune1000offeredanonqualifiedDCplanin2013).39Mercer, supranote 26, at 2. Use of nonqualified DB plans is not random. One sourcesuggested utilities, for example, are more likely to maintain DB plans than other firms.TelephoneInterviewwithExecutiveBenefitsConsultantswithanInternationalFirm(Feb.17, 2016). Jackson and Honigsberg found that DB obligations constituted 56% of totalpublic company top 5 executive nonqualified deferred compensation benefits. Robert J.Jackson & Colleen Honigsberg, TheHiddenNatureofExecutiveRetirementPay, 100VA.L.REV.479,492(2014).40Miller, supranote 34, at 259-66; Gregg D. Polsky, Fixing Section 409A: Legislative andAdministrative Options, 57 VILL. L. REV. 635, 638 (2012) (to avoid application of theconstructivereceiptdoctrinedeferralelectionsmustoccurbefore therelatedservicesareperformedandmustbeirrevocable;toavoidapplicationoftheeconomicbenefitdoctrine,theparticipantmustremaininthepositionofageneralunsecuredcreditor).41Treas.Reg.§1.83-3(e)(2014)(excludingsuchpromisesfromthedefinitionofproperty,thetransferofwhichwouldbeimmediatelytaxableunderI.R.C.§83).42This is oneof several requirements thatmustbe satisfied to achieveanadvance rulingfromtheIRSthatanonqualifieddeferredcompensationarrangementwillnotrunafouloftheconstructivereceiptdoctrine.Rev.Proc.92-65,1992-2C.B.428.43See Polsky, supranote 40,at 641 for a discussion of purported abuses of nonqualifieddeferredcompensationatEnron.


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year in which the amounts are earned.44 Payout options are limited to death,disability,separationfromservice,changeincontrol,unforeseeableemergency,oradateorscheduledeterminedatthetimeofdeferral.45While§409Aalsoaddressesfunding,46forourpurposes, it issufficienttorememberthatnonqualifieddeferredcompensationmayrepresentonlyanunsecuredpromisetopayandthatanyfundsbackingupsuchapromisemustalsobeavailabletoacompany’sgeneralcreditors.Participants in plans that run afoul of §409A are subject to taxation of deferredamounts when they vest and an additional 20% penalty tax on the value of thedeferredcompensation.47

While §409A is daunting in some respects, the law had no impact on the

underlyingeconomicsofnonqualifieddeferredcompensation.48ProfessorHalperindrew attention to the potential joint tax advantage of the nonqualified deferredcompensationtaxregimethirtyyearsagoinhisseminalYaleLawJournalarticleontaxation and the time value ofmoney.49 As he demonstrated, the deferral of theemployer’s deduction tomatch the timing of employee inclusion is insufficient toeliminate the joint taxadvantageofnonqualifieddeferredcompensation. Theneteffect of the nonqualified deferred compensation taxation regime (assuming nochange in taxrates50) is to tax investmentreturnsduring theperiodofdeferralattheemployer’srateratherthanattheemployee’srate.51AsProfessorsHalperinandWarrenput it ina recentsuccinctanalysis,nonqualifieddeferredcompensation istax advantaged under normal assumptions “if the employer earns an after-tax44I.R.C. §409A(a)(4) (2012). There is an exception for newly hired employees. I.R.C.§409A(a)(4)(B)(ii). Ingeneralthisrequirement isnotachangefromprior law. Rev.Rul.60-31,1960-1C.B.174;seealsoRev.Proc.92-65,1992-2C.B.428.45I.R.C.§409A(a)(2)(A).AsPolskynotes,thesedistributionrulesensurethatdeferralsareessentiallyirrevocable.SeePolsky,supranote40,at643.46I.R.C.§409A(b).47I.R.C.§409A(a)(1).48EricD.Chason,DeferredCompensationReform:TaxingtheFruitoftheTreeinitsProperSeason,67OHIOST.L.J.347,349(2006);Polsky,supranote40,at643.49SeeHalperin,supranote12,at540.50Although generally difficult to predict, changes in tax rates affect the attractiveness ofnonqualified deferred compensation. Specifically, nonqualified deferred compensationtends to be preferred over cash from a joint tax perspective if the employee’s tax rate isexpectedtobeloweratpayoutthanatdeferral(eitherbecauseofachangeinthebracketsor one’s positionwithin thebrackets) and/or if the employer’s tax rate is expected to behigheratpayout thanatdeferral. MYRONS.SCHOLESETAL.,TAXESANDBUSINESSSTRATEGY:APLANNINGAPPROACH183(2nded.2001). Thus,whileareduction in thecorporate taxratefrom35%to,say,25%wouldgenerallyincreasetheattractivenessofnonqualifieddeferredcompensationinsteadystate,theprospectofsuchareductioninthefuturemightdampenappetites for deferred compensation plans today. Executives who expect to have lessincome and to face a lower marginal rate in retirement would tend to prefer deferredcompensation,allelsebeingequal.51SeeHalperin,supranote12,at539-41.SeealsoAlvinC.Warren,Jr.,TheTimingofTaxes,39NAT’LTAXJ.499(1986)(generalizingtheunderlyingprincipleanddiscussinganumberofapplications).


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return on the deferred compensation that is higher than that available to theemployee,”52andthisviewiswellaccepted.53

As Halperin noted back in 1986, nonqualified deferred compensationarrangements will be tax advantaged if a plan sponsor is effectively tax exemptbecause of excess tax losses.54 He noted further that other nonqualified deferredcompensationplan sponsors could invest individendpaying stocksandexcludealargefractionofdividendincomeorcouldinvestintheirownstockandavoidtaxonappreciation on those shares per §1032.55 Viewing these arrangements asproviding an unintended and unwarranted subsidy for high-income taxpayers,Halperin proposed the adoption of a special tax, payable by employers, on theinvestment income generated by nonqualified deferred compensationarrangements,ataxthatwouldreplicatetheeconomicimpactofaccrualtaxation56

52Halperin & Warren (2014), supra note 32, at 329. Halperin & Warren’s example isreproduced in theAppendix. Other examples canbe found inHalperin, supranote12, at519-20;Doran,supranote12,at6-7.53SCHOLESETAL.,supranote50;Doran,supranote12,at1;Yale&Polsky,supranote12,at576-78.ButseeEthanYale,InvestmentRiskandtheTaxBenefitofDeferredCompensation,62TAX L. REV. 377, 377 (2009) (arguing that the conventional analysis fails to account fordifferencesininvestmentriskwithinandwithoutnonqualifiedplans).This approach to analyzing the joint tax consequences of nonqualified deferredcompensation, andconversely, the consequences for thepublic fisc, is essentiallya “pass-through” approach. It assumes that plan sponsors are investing dollars on behalf ofparticipantsandsharingthetaxburdeninsomefashion.Thereareotherframesthatmayhave different implications for the public fisc. For example, one could viewnonqualifieddeferred compensation as a tax-advantaged substitute for equity investment. Normally,profitsthatarepaidoutofacompanyaredoubletaxed–thecorporateleveltaxiscombinedwithataxondividends(withnocorporatedeductionfordividendspaid)–butprofitsthatare paid out as compensation are only taxed once – the corporate tax is combinedwithtaxable(anddeductible)compensation.Thedifficultquestion,whichImustleavetofuturework, is whether or in what circumstances an “equity substitute” approach is moreappropriate than a “pass-through” approach. This Articlewill embrace the pass-throughapproach that generally undergirds the previous work in this area highlighted in thissection. I thankDanHalperin forcallingmyattentionto the“equitysubstitute”approachanddiscussingitwithme.54Halperin, supranote 12, at 540. In 1986, non-governmental tax-exempt entities alsocould provide their employees with unlimited tax advantaged nonqualified deferredcompensation (Halperin, supranote 12, at 540), but that situation is more complicatedtoday.Seeinfranote180.55Halperin,supranote12,at540.Atthetime,corporationscoulddeduct85%ofdividendsreceivedonsmallholdingsofsharesofother firms. Today, thegeneraldividendreceiveddeductionis70%.I.R.C.§243(a)(2012).56Accrual taxation would require assessment and payment of tax on gains and lossesannually,despitetheabsenceofcashflowsprovidingfundstopaythetax.


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and would level the (tax) playing field between current and deferredcompensation.57

Professors Ethan Yale and Gregg Polsky have worked out the details of a

special taxonnonqualifieddeferred compensation investment incomeat length.58Yale and Halperin subsequently described the implementation of such a tax asfeasible, but not easy.59 Professor Michael Doran has proposed application ofaccrualtaxationtononqualifieddeferredcompensation,thatis,taxationintheyearinwhichcompensationisearned,irrespectiveofthetimingofpayout,arguingthatmeasurementandabilitytopayissuesaremanageable.60Allofthesecommentatorsagreethat§409Afailstoaddressthefundamentallackofneutralityinthetaxationofcurrentcompensationandnonqualifieddeferredcompensation.61

In a recent working paper, Doran argues that a combination of tax

advantages explains the motivation of firms to employ nonqualified deferredcompensationatleastaswellascompetingexplanations.Onthespecificquestionofthejointtaxadvantageofretirementbalancesbeinginvestedbyfirmsinsteadofbyexecutives individually, Doran states that it is “commonplace” for companies toinvestnonqualifieddefinedcontributionplandeferralsintheirownstock,andthat“this practice has a solid foundation in tax law,” given the fact that firms are nottaxedongainsontheirownstock.62

D.NonqualifiedDeferredCompensationAccounting

57Halperin, supra note 12, at 544 (suggesting a special tax on nonqualified deferredcompensationinvestmentincomesetatthetopindividualmarginalrate).The joint taxadvantage identifiedbyHalperinassumes thatemployeeoutside investmentreturns are taxed at regular individual rates. As discussed supra note 173 andaccompanying text, individuals can reduce taxes on savings by investing through certaininsurance products. Moreover, as the recent Panama Papers revelations starklydemonstrate, some wealthy U.S. citizens apparently have minimized or avoided tax onoutside investment through the use of anonymous offshore accounts. Eric Lipton& JulieCreswell, Panama Papers Show How Rich United States Clients Had Millions Abroad, N.Y.TIMES (June 5, 2015), http://www.nytimes.com/2016/06/06/us/panama-papers.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news&_r=1.58Yale&Polsky,supranote12,at599.59SeeHalperin&Yale,supranote12,at939.60Doran,supranote12,at15.61SeeDoran,supranote12,at1-2;Halperin&Yale,supranote12,at941;Polsky,supranote40,at639-40;Yale&Polsky,supranote12,at574.62Doran,supranote11,at28.DorancitesJacksonandHonigsbergforthepropositionthatfirm investment of deferred amounts in company stock is commonplace, but Jackson andHonigsbergonly investigatedexecutivenotional investment. Discussionof the taxationofCOLI products, which are often used to informally fund note nonqualified deferredcompensationarrangements,isdeferreduntilPartIII(C).


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Nonqualifieddeferredcompensationobligationsarereflectedasliabilitiesoncorporatebalancesheets,andnetincomeisadjustedineachperiodforincreasesordecreases in these liabilities (a process known as “marking to market”).63 DBliabilitiesmayfluctuatesomewhatwithchangesininterestrates,butarerelativelystable.64DCliabilities,ontheotherhand,canbehighlyvolatileasalargefractionofparticipant balances are notionally invested in equity securities.65 Employerscannotformallyfundtheseobligationswithoutjeopardizingparticipanttaxdeferral,but liabilities can be informally funded by setting aside assets in a rabbi trust, acorporateownedlifeinsurance(COLI)vehicle,orsimplyinasegregatedaccount,aslong as these funds remain available to general creditors. With one importantexception,firmscanhedgetheincomestatementvolatility(aswellastheeconomicrisk)thatarisesfromparticipantnotionalinvestmentsinnonqualifiedDCplansbypurchasingidenticalsecuritieswiththefundsintherabbitrust,COLI,orsegregatedaccount.Theincomestatementeffectsoffluctuationsinthedeferredcompensationliabilityandthehedgeoffset.66 The important exception is company stock. Suppose that an executivenotionally invests her nonqualified DC account balance in own-company stock.Assuming that the account balancewill be paid in cash, gains and losses on thatnotional investmentmust bemarked tomarket in each period aswith any othernonqualified plan liability.67 Now assume that the company repurchases anequivalentnumberof shares in themarketor sets aside an equivalentnumberoftreasuryshares,placingthesesharesinitsrabbitrust,COLI,orsegregatedaccount.Thathedgewillbeeffectiveasaneconomicmatter,butitwillnotoffsettheincomestatement impactof the liability. Gainsor lossesonsharesofacompany,heldbythatcompany,evenifacquiredtohedgeobligationssuchasthese,arenotreflectedon the income statement.68 Income statement volatility associated with notionalown-company stock investment can be approximately hedged using a closely

63Accounting Standards Codification 710-10-35-4 (Fin. Accounting Standards Bd.). Thisstatement is trueunless thedeferral is in the formof company stock, isnotdiversifiable,andwillbesettledusingcompanystock,inwhichcasetheobligationistreatedasanequityinstrumentratherthanasaliability.EmergingIssuesTaxForceNo.97-14(Fin.AccountingStandardsBd.)[hereinafterEITFNo.97-14].64Lee Nunn, “InformalFunding”ofNQDCPlans, in TAXATIONANDFUNDINGOFNONQUALIFIEDDEFERREDCOMPENSATION205(MarlaJ.AspinwallandMichaelG.Goldstein,eds.,2ded.2012).65Nunn,supranote64,at204.66Nunn, supra note 64, at 200. Mark-to-market accounting for mutual funds held insegregated accounts to hedge plan liabilities is not automatic, but requires a sponsorelection. ASC825-10-25. Seealso LeeNunn,FinancialAccountingandNQDC, in TAXATIONANDFUNDINGOFNONQUALIFIEDDEFERREDCOMPENSATION296 (Marla J.Aspinwall andMichaelG. Goldstein, eds., 2d ed. 2012). Mark-to-market accounting for COLI gains and losses isautomatic. Accounting Standards Codification 325-30-35-2 (Fin. Accounting StandardsBd.);Nunn,supranote64,at204.67EITFNo.97-14,supranote63.68EITF No 97-14, supra note 63. See also MULLINTBG, AN OVERVIEW TO DEFERRAL PLANNOTIONALSTOCKACCOUNTING(2014).


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correlated security, such as an index, but cannot be perfectly hedged with own-companystock.69 This accounting problem arises whenever nonqualified deferredcompensationisnotionallyinvestedinown-companystockbutpayableincashorispayable in stockbutdiversifiable at somepoint intoother investments. In eithercase,mark-to-marketaccountingof the liability is requiredandnoperfect incomestatement hedge is available. On the other hand, if an executive defers companystock in kind,will receive stock in kind, and is not allowed to diversify,mark-to-market accounting of the obligation is not required, and no income statementvolatilityarises.70

E.EfficientAssetAllocationandOtherFeaturesofNonqualifiedDeferredCompensation

While the concerns of nonqualified DB plan participants are essentiallylimited to the security of their benefits, DC plan participants are also concernedaboutallocating theirnotionalassets insuchawayas tomaximize theamountoftheir benefits while managing investment risks. The investment portfoliooptimizing choices of participants may conflict with tax minimization goals andaccountingconcerns. Forexample,expertssuggestthatindividualsshouldinvestarelativelylargefractionofretirementsavingsinequitysecuritiesandarelativelysmall fractionindebt, particularly when an individual is far from retirement.71 But participantnotional investment in equities results in greater earningsvolatility andgenerallypoorerjointtaxconsequencesthannotionalinvestmentindebtsecurities.

Moreover, while the nonqualified DC joint tax advantage is large whenexecutivesnotionally invest inown-companystockand firmshedgewith treasuryshares,financetheorysuggeststhatthispracticewouldnotbeprevalent.Typically,executives are poorly diversified, with too much of their personal and financialcapital invested in their firms.72 Of course, firms often compensate these under-69MULLINTBG,BENEFITTRENDS INSIGHTS, COMPLEMENTINGRESTRICTEDSTOCKWITHADEFERREDCOMPENSATIONPLAN[hereinafterCOMPLEMENTINGRESTRICTEDSTOCK] (noting that the incomestatementimpactofnotionalown-companystockinvestmentcannotbeadequatelyhedgedwithtreasuryshares).70EITFNo.97-14,supranote63;COMPLEMENTINGRESTRICTEDSTOCK,supranote69.71Rulesofthumbdiffer,butonewaytogetasenseofrecommendedassetallocationsistolookat the compositionof retirement targetdate funds. Forexample, Fidelity’sFreedomFundtargetedata40-year-oldindividualanticipatingretirementin25yearsallocates90%ofinvestmentstoequities,whilethefundtargetedata60-year-oldanticipatingretirementin 5 years still allocates 60%of investments to equities. See,e.g.,FidelityFreedomFunds,FIDELITY, https://www.fidelity.com/mutual-funds/fidelity-fund-portfolios/freedom-funds(lastvisitedJuly26,2016).72Brian J.Hall,SixChallengesinDesigningEquity-BasedPay, 15 J.APPLIEDCORP.FIN. 21, 26


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diversified executives with equity to align incentives with shareholders, butshareholderspaya cost to induceexecutives toaccept this risky,non-diversifyingpay.73 It is one thing to ask executives to accept a grant of stock options, whichmightonlypartiallyreplaceothercompensation;it isanothertoaskthemtodefercurrent pay into company stock. If given a choice betweennotional investments,few well-advised executives would select company stock absent additionalinducements.74 Related lines of research have considered whether nonqualified deferredcompensation, as an unsecured claim against corporate assets, might serve acorporate governance function in aligning executive incentives with those ofdebtholders,aquestionthatgainedincreasedurgencyfollowingthe2008financialcrisis,75or whether nonqualified deferred compensation might be a means ofcamouflaging top executive compensation, in which case heavy use might be asymptom of managerial power.76 This research does not directly inform the taxanalysis that is the focus of this Article, so I will not summarize it here, but willdirect interested readers to the discussion provided in a recent article by RobertJackson and ColleenHonigsberg,77andwill simply echo Jackson andHonigsberg’spoint that these two stories are not mutually exclusive, nor are they mutually

(2003).73SeeBrian J.Hall&Kevin J.Murphy,StockOptionsforUndiversifiedExecutives, 33 J.ACCTANDECON.3,6(2002).74Benartzi et al.,TheLawandEconomicsofCompanyStockin401(k)Plans, 50 J.L.&ECON.45,50(2007),estimatethatqualifiedplanparticipant investments inown-companystockcan be worth less than fifty cents on the dollar, depending on the investment horizon,fraction of assets invested in own-company stock, and volatility. To some degree,nonqualifieddeferredcompensationbalancesnotionally invested incompanystockmightsatisfy executive share-holding requirements, in which case notional investment ofnonqualifieddeferredcompensationbalancesinown-companystockmightnotworsenanexecutive’saggregatediversificationposition.75This explanation for nonqualified deferred compensation would be consistent with an“optimal contracting”viewof executivepay. Inbrief, theoptimal contractingviewpositsthat executive pay arrangements are selected to minimize managerial agency costs andmaximize shareholder value. See David I. Walker, The Law and Economics of ExecutiveCompensation:TheoryandEvidence, inRESEARCHHANDBOOKONTHEECONOMICSOFCORPORATELAW232,234(ClaireA.Hill&BrettH.McDonnelleds.,2012);JohnE.Coreetal.,ExecutiveEquityCompensationandIncentives:ASurvey,9ECON.POLICYREVIEW27,27-28(2003).76Themanagerialpowerviewpositsthatexecutivepayarrangementsreflectagencycosts,aswellascombat them,and thatcompensationdesign isnotconsistentwithshareholdervaluemaximization. Under this view, the threator realityof investor and financialpressoutrageplays an important role in disciplining compensation, and, as a result, executivesand directors seek out low salience channels of pay and other means of camouflagingcompensation tominimizeoutrage. LucianA.Bebchuk, JesseM.Fried,&David I.Walker,ManagerialPowerandRentExtractionintheDesignofExecutiveCompensation, 69U.CHI.L.REV.751,789(2002).77Jackson&Honigsberg,supranote39,at483-85.


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exclusive vis-a-vis potential tax motivations for nonqualified deferredcompensation.

II.ApproachandMethodology Ideally, tax (and accounting78) rules would be neutral with respect toalternative compensation choices. Neutral rules avoid potentially inefficientdistortions in pay practices as well as adverse distributional impacts.79 In thenonqualifieddeferredcompensationrealm, the idealsetof taxruleswouldensureneutrality asbetween current anddeferred compensation irrespectiveofnotionalinvestmentsmadebyexecutives,theusestowhichfirmsputdeferredamounts,andthe tax rates faced by both parties. Commentators have proposed twomeans ofachieving that neutrality: applying current or accrual taxation to nonqualifieddeferred compensation contributions and earnings80and imposing a special,neutralizing tax on the investment income arising from nonqualified deferredcompensation.81 Under an accrual-based scheme, nonqualified deferred compensationparticipants,orplansponsors,wouldremittaxesbasedoncontributionsandannualgainsorlosses.82Thisschemewouldimposecompliancecostsonsponsorsand/orparticipantsandwouldrequireestimationsand“truing-up”withrespecttodefinedbenefitplans,butaccrual taxationofnonqualifieddeferredcompensationappearsto be administratively feasible.83 However, accrual taxation raises the specter ofliquidity concerns inhibiting the use of nonqualified deferred compensation.84Commentatorshavearguedthat theseconcernsareoverblown,85andthat is likelytrue, but applying accrual taxation to nonqualified deferred compensation, as ageneralmatter,maybepoliticallyunacceptable,nonetheless.86

UnderHalperin’sproposal,employerswouldremitaspecialtaxassessed(atthe top individual marginal rate) on nonqualified deferred compensation

78DavidI.Walker,ReconsideringRealization-BasedAccountingforEquityCompensation5-6.(BostonUniv.Sch.ofLaw,Law&Econ.WorkingPaperNo.16-03,Jan.14,2016),availableathttp://ssrn.com/abstract=2715624 (arguing formark-to-market accounting for long-termequitypayinordertoleveltheaccountingplayingfieldbetweencompetinginstruments).79Halperin,supranote12,at539(1986)(arguingthattheNQDCjointtaxadvantagecouldcreateanunwarrantedsubsidyforhighincometaxpayers).80SeeDoran,supranote12,at2.81Halperin,supranote12,at14-15;Yale&Polsky,supranote12,at574;Halperin&Yale,supranote12,at943.82Doran,supranote12,at5,15.83Doran,supranote12,at15-16.84Halperin&Yale,supranote12,at940.85Doran,supranote12,at16;Halperin,supranote12,at541;Halperin&Yale,supranote12,at940;Yale&Polskyat632-33.86Halperin&Yale,supranote12,at940;Yale&Polskyat633.


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investment returns, while leaving the other tax rules applicable to nonqualifieddeferredcompensation inplace.87Thisapproachallays liquidity concerns, and, inconcept,yieldsanoverallresultthatiseconomicallyequivalenttoaccrualtaxation.88However,asYaleandPolskyargue,therewouldbetradeoffsbetweentheaccuracyand administrability of a special tax regime.89 This is not to suggest that theobstaclestoaccrualtaxationortheimpositionofaspecialtaxareinsurmountable,onlythatlevelingthetaxplayingfieldinthisareamaynotbeassimpleorasfeasibleasonemighthope.90 At the same time, one canquestionwhether a lackof taxneutrality in thisrealmpresentsaseriousproblemintermsofcompensationdistortion,high-incometaxpayersubsidy,oradverseimpactonthepublicfisc.Tobesure,employersfacingloweffectivemarginal tax ratesand theirexecutivescangenerate significant jointtax advantages on deferred compensation. But at current tax rates, deferredcompensation plans sponsored by firms with positive tax liabilities can generatejoint tax consequences ranging from disadvantage to advantage, depending onnotional investmentsbyparticipants andusesofdeferredamountsby employers.Including the 3.8% net investment income surtax91and an estimated 1.2% pointeffectivemarginalrateimpactoftheitemizeddeductionphaseout,92topindividualmarginalfederaltaxratestotal25%onlong-termcapitalgainsanddividends,and44.6% on interest and short-term capital gains. The top corporate rate of 35%applies to capital gain (except for gains on own-company stock), interest, andbusiness profits.93 Most dividends on shares of other companies are effectivelytaxedtocorporaterecipientsata10.5%rateoncethedividend-receiveddeductionisfactoredin.Andfirmspaynotaxongainsontheirownstockper§1032.94

87Halperin,supranote12,at544-50.88Halperin,supranote12,at544-50.89Yale andPolsky, supra note12, at574,passim (analyzing the implicationsof, inter alia,choiceswithrespecttothepartyremittingthespecialtaxandthetimingofremittance).90Polsky,supranote40,at640(notingthat“neutralizationwouldbesomewhatcomplex”);Halperin&Yale,supranote12,at939.91I.R.C.§1411(a)(1)(2012).92Alan D. Viard, TheBasicEconomicsofPeaseandPEP, 146 TAXNOTES 805, 808 (Feb. 9,2015)(reportingTaxPolicyCenterestimateoftheimpactoftheitemizeddeductionphaseoutfortaxpayerswithcashincomeinexcessof$1millionfor2013).93Theeffectivemarginalratefacedbybusinesseseligibleforthe§199ProductionActivitiesDeduction is reducedby3.15percentagepoints. MOLLYF.SHERLOCK,CONG.RESEARCHSERV.,RL41988,THESECTION199PRODUCTIONACTIVITIESDEDUCTION:BACKGROUNDANDANALYSIS(Feb.27,2012).94The jointtaxanalysis isalso impactedbydifferences instateand local incometaxratesapplicabletoinvestmentsmadebyindividualandcorporatetaxpayers.Becausetheseratesvarywidely, I followpreviouscommentators in ignoringsub-Federal taxes inmy joint taxanalysis.ItseemslikelythattherewillbechangesinbothcorporateandindividualratesundertheTrump administration, but the impact on the joint tax consequences of nonqualifieddeferredcompensationisunclear.TheTrumpcampaignproposedamaximumrateof20%


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Firmsandexecutivesmaybeoperatingnonqualifieddeferredcompensationplans insuchawayas togenerate joint taxadvantages,or theymaynot. Variousfrictions may prevent firms and executives from doing so. As we have seen,accounting rules may conflict with tax-optimizing behavior, and participantsseeking to optimize their investment portfolios may desire to notionally investnonqualifiedDCamountsinwaysthatarenotconducivetominimizingthejointtaxbill. There are, in short, tensions between the various objectives of participants,plansponsors,andshareholders.

How these tensions are resolved is an empirical question. But given thedifficulties (political or otherwise) of achieving tax neutrality, it is worthinvestigating how nonqualified deferred compensation plans are operated inpractice todeterminewhetheror towhat extent frictionsorother considerationsdeter firms and executives from minimizing taxes associated with nonqualifieddeferredcompensation.Isachievingtaxneutralityworthit?95

Currently, firms are not required to disclose the notional nonqualified

definedcontribution investmentsofseniorexecutivesorotherplanparticipants;96nor are they required to disclose how deferred amounts arising from DB or DCprogramsareused.Thesedecisionsarealmosttotallyopaque.FirmsarerequiredtodiscloseannualreturnsonnonqualifiedDCbalancesfortheir“top5”executives,and in recentwork, Jackson andHonigsbergutilized this data to reach inferencesregardingexecutivenotionalinvestment.97

The strategy employed in this paper is different. I interviewed ten

individuals at eight firms with extensive experience in the nonqualified deferred

on capital gains and dividends received by individuals and amaximum corporate rate of15%.JimNunnsetal.,AnAnalysisofDonaldTrump’sTaxPlan,URBANINSTITUTE&BROOKINGSINSTITUTION TAX POLICY CENTER (Dec. 22, 2015),http://www.taxpolicycenter.org/publications/analysis-donald-trumps-tax-plan/full. In2016, House Republicans proposed amaximum corporate rate of 20% and a top rate of16.5% on individual receipt of interest, dividends, and capital gains. Kyle Pomerleau,DetailsandAnalysisofthe2016HouseRepublicanTaxReformPlan,TAXFOUNDATION (July5,2016), http://taxfoundation.org/article/details-and-analysis-2016-house-republican-tax-reform-plan.95YaleandPolsky,supranote12,at589(2007)askwhetherrevisingnonqualifieddeferredcompensationtaxationisworthit,buttheyfocusonthepossibilityoffirmsshiftingtoothertax-advantagedcompensationinstruments,suchasequitypay,ifthenonqualifieddeferredcompensationopportunityiseliminated. Thisisavalidquestion,butIamaskingwhethernonqualifieddeferred compensation tax reform is “worth it” fromadifferentperspective.Given frictions and other considerations, does the current regime result in substantialadverseconsequences?96Jackson&Honigsberg,supranote39,at507-08,proposemandatorydisclosureofseniorexecutivenotionalnonqualifieddeferredcompensationinvestments.97Seeinfranote121.


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compensation“space.”Theseindividualsincludeconsultantsthatadvisecompanieswith respect to the adoption and design of nonqualified deferred compensationplans, and individuals employed by firms engaged in administering nonqualifieddeferredcompensationplans.98Theseindividualshaveaccesstoinformationthatisnotpubliclyavailable.Ialsoconsultedsurveysconductedbynonqualifieddeferredcompensation administrators, Newport Group and MullinTBG, and other publicsources. However,asdiscussedbelow, Iwascautioned thatsurveyresponsesarenotrandomandthatwhilethesurveyinformationisquitehelpful,someofthedataislikelytobeaffectedbyaresponsebias.

The interviews were open-ended telephonic discussions that focused on

factual, oftennumeric questions, such as “what fraction of your clients informallyfund nonqualified deferred compensation obligations,” although sources verygenerously took the time to explain motivations, e.g., why accounting rulesencourage funding in certain situations. While therewassomevariation inviewsamong these sources, perhaps reflecting differences in client bases or experience,these individualspainteda reasonably consistentpictureofnonqualifieddeferredcompensationprogramsastheycurrentlyoperateinpractice.99

The interview and survey evidencewas supplementedwith hand-collected

data gleaned from the proxy statements and nonqualified defined contributiondeferred compensation plan documents of a small sample of S&P500 companies.Thesedocumentsshedconsiderablelightontherangeofwhatispermissiblewithinnonqualified deferred compensation plans, but only limited light on actualpractices.100

98Interviewees included individuals employed by the large,well-known executive benefitconsultanciesincludingErnst&Young,Mercer,andWillisTowersWatson;andbysmallerconsulting and/or plan administration firms Lockton, MullinTBG, Newport Group andOctoberThree.Somesourceshadexperienceinbothplanadministrationandplandesign.Somesourcespreferredthattheirnamesandcompanyaffiliationsnotbedisclosedandarereferencedaccordingly.Intervieweeswereidentifiedinseveralways. Someindividualswerelistedascontactsonwhitepapers or client memos issued by their firms that addressed various nonqualifieddeferredcompensationtopics.Otherswereidentifiedthroughreferralswithinthevariousorganizations.99While the interviewevidencemustbeclassifiedasanecdotal, Igainedconfidence intheinformation I receivedasaresultof internalcoherence,consistencywithsurveyevidenceandproxystatementdisclosures(whenavailable),andconsistencywiththeory.100Ibeganwitharandomsampleof50S&P500companies. Proxystatementdisclosuresindicatethe40ofthesecompanieshaveanactivenonqualifiedDCdeferredcompensationprogram. Ofcourse,proxystatementdisclosurespertainonlytothemostsenior“namedexecutive officers” (NEOs) of a company. It is possible that some of these firms operatenonqualified programs that are not open to their NEOs, but this seems unlikely. DatareportedonusageoftheidentifiednonqualifiedprogramsisnecessarilylimitedtousagebytheNEOs.


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III.NonqualifiedDeferredCompensationinPractice ThisPartdescribesevidence fromsurveys, interviews,andcompany filingsthat bearsonnotional investmentsbynonqualifiedDCplanparticipants andplansponsor use of funds freed up as a result of the decision to defer compensation.Bothare critical factors indetermining the joint tax consequencesofnonqualifiedplansastheyoperateinpractice,asdetailedinthefinalsectionofthisPart.

A.ParticipationandSourceofFunds

Whileplandetailsvary,mostnonqualifiedDCplansinvolveelectivedeferralsby participants of a fraction of salary, annual bonus, and sometimes othercompensation.101 But employer contributions to nonqualified DC plans arecommon,aswell. Fiftypercentof firmsresponding to theNewportGroupsurveythat maintain nonqualified DC plans reported that they make companycontributionstotheseplans.102Sourcesgenerallyagreed,however,thatparticipantelective deferrals make up well over 50% of total nonqualified DC plancontributions.103Of course, thenominal sourceof fundsdoesnot establishwhichpartybearstheburden,butthenominalsourceoffundsmaybeimportantwhenitcomes to the notional investment of these funds. Some plans place vesting orinvestment allocation restrictions on “company” funds that do not apply to“participant”contributions.

101E.g., Newport Group Survey, supranote 37, at 23 (indicating that 93% of respondingcompaniesallowparticipantstodefersomeoralloftheirbasesalaryandannualbonusandthat most of these firms allowed participants to defer 75% or more of these sources ofincome).SixpercentofthefirmsrespondingtotheNewportGroup’ssurveyindicatedthatparticipantsarepermittedtodeferrestrictedstockandrestrictedstockunits.Id.102Newport Group Survey, supra note 37, at 15. An executive who makes electivenonqualifiedDCplandeferralswilloftenfaceareductionincompanymatchingfundsunderherfirm’squalified401(k)plan.“Make-up”contributionstotheexecutive’snonqualifiedDCplanmake the executivewholewith respect to the reduction. This is themost commoncompany approach, but some firmsmake discretionary contributions to nonqualified DCplans,andsomefirmsmatchparticipantcontributionsasifthe401(k)planhadnoceilingoncontributions.NewportGroupSurvey,supranote37,at15.103TelephoneInterviewwithDouglasB.Frederick,Partner,andKevinL.Mitchell,Principal,Mercer [hereinafterFrederick&Mitchell Interview] (Feb.29,2016);Telephone Interviewwith Michael D. Shannon, Vice President, Non-Qualified Consulting, Newport Group[hereinafterShannon Interview] (Feb.23,2016) (estimating that,dependingoneconomicconditions, 80% of the contributions in nonqualified DC plans come from participants);Telephone Interview with Senior Vice President of Executive Benefits Consulting andDesign Firm [hereinafter Interview with Senior VP of Executive Benefits Consulting andDesignFirm](Feb.19,2016)(estimatingthat90%ofcontributionsarefromparticipants);TelephoneInterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39.FormysampleofS&P500firms,73%ofthecontributionsinthemostrecentyearconsistedofemployeedollars.


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Nonqualified DC plans are generally open to executives and employeesbeyond the senior executive suite. Eligibility is generally determined by position(mostcommonlyseniorvicepresidentsorabove)orbycompensation level (mostcommonly in the $115,000-$150,000 range or above).104 Respondents to theNewport Group survey reported that about 46% of eligible individuals elected todefercompensationin2013.105

NonqualifiedDBplansarecommonlystructuredas supplementalexecutiveretirement plans. Participation is defined by contract, and the plan sponsorgenerallymakesallcontributions.

B.ParticipantNotionalInvestment

DB plans are typically designed to replace a fraction of participants’ pre-retirementincome.106Theplansponsorisresponsibleforensuringthatfundswillbeavailabletoprovidebenefits,andparticipantsarenotinvolvedinthesedecisions.There is no notional investment in own-company stock, or any other notionalinvestmentforthatmatter,intheseDBplans.

DCplansgenerallyshifttheinvestmentresponsibility,atleasenotionally,to

participants.Companiesarestillresponsibleforensuringthatfundsareavailabletoprovidebenefits(recall thatthebenefitreflectsanunsecuredpromisetopay),butthe level of promised benefits is determined by participant notional investmentchoices,notbyapre-determinedformula. Typically, participants are offered a range of notional investment optionsthatisthesameasorsimilartotherangeofinvestmentsofferedinafirm’s401(k)program. Two-thirds of the firms responding to the Newport Group survey thatofferedmutualfundinvestmentsreportedthattheirplansincludedtentonineteeninvestment options.107 One source suggested that the idea is to cover all of themajorinvestmentcategories,whileminimizingduplication.108104NewportGroupSurvey,supranote37,at18-19.105NewportGroupSurvey,supranote37,at21.106NewportGroupSurvey,supranote37,at42.107NewportGroupSurvey,supranote37,at24.FortypercentofasampleofS&P500firmsthat offer nonqualifiedDC plans disclosed in proxymaterials or plan documents that thenotionalinvestmentoptionswerethesameasorsimilartotheir401(k)investmentoptions,butabouthalfoffirmsfailedtomakeanydisclosuresonthisissue. Anobscure,butpossiblyimportantreasonformirroring401(k)investmentmenusisqualificationofnonqualifiedDCbenefitsas “retirement income”undera federalstatutethatbarsstatesfromtaxingretirementincomereceivedbyout-of-stateresidents.4U.S.C.§114(1996). Forexample,supposethatanexecutiveworksinNewYork(ahightaxstate)andsubsequentlyretirestoFlorida(anotaxstate).Underregulartaxprinciples,NewYorkwouldhavegroundsfortaxingretirementincomeearnedinNewYorkalthoughreceivedinFlorida.4U.S.C.§114barssuchout-of-statetaxation,butonlytotheextentof“retirementincome,” a defined term. Retirement income includes nonqualified DC benefits that are


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Survey and interview responses indicate that a minority of firms allowparticipants to notionally invest in own-company stock. Only 21% of the firmsresponding to the Newport Group’s survey reported that company stock was apermissible investmentoption.109 Interviewsourcesconfirmedthatmost firmsdonotincludeown-companystockasanotionalinvestmentoption.110

Sources agreed that a primary reason many companies exclude own-companystock fromtheirnotional investmentmenus is thedifficultyofmanagingincome statement volatility associated with this investment choice.111 But otherreceivedintheformofaten-yearorlongerannuity,butlumpsumpaymentsareconsideredretirement income only if the DC program exists “solely” to supplement a tax-limitedqualified plan. Although the law on this point has not been clarified, firmsmay think itprudent to mimic 401(k) terms as closely as possible in order to qualify lump sumnonqualified deferred compensation payouts as retirement income that is insulated fromout-of-statetaxation.108InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39.Sourcesnotedthatsomeplanslimitinvestmentchoiceswithrespecttounvestedemployercontributions, e.g., to fixed income investments only. Telephone Interview with EricKaufman, Senior Vice President, Lockton Companies (Feb. 16, 2016); Shannon Interview,supranote103.While one might expect highly compensated corporate executives to gravitate towardshedge funds and other aggressive investment alternatives, I have no evidence of thesealternativesbeingofferedthroughnonqualifieddeferredcompensationarrangements.109NewportGroupSurvey,supranote37,at26.Only6.5%offirmsrespondingtoasurveyconductedbynonqualifieddeferredcompensationplanadministratorMullinTBGreportedcompanystockasaninvestmentoption,butthisfractionseemstoolowtobeplausible.Idonot have the survey questionnaire, but perhaps there was confusion between offeringcompany stock as one option or as the sole vehicle. MULLINTBG,2014EXECUTIVEBENEFITSURVEY,SUMMARYOFRESULTS7(2015)[hereinafterMullinTBGSurvey].110Telephone Interview with Peter Neuwirth, Senior Consultant, Willis Towers Watson[hereinafter Neuwirth Interview] (Feb. 19, 2016); Interview with Executive BenefitsConsultantswithanInternationalFirm,supranote39;ShannonInterview,supranote103;InterviewwithSeniorVPofExecutiveBenefitsConsultingandDesignFirm,supranote103.SeealsoChenyangWei&DavidYermack, InvestorReactionstoCEOs’InsideDebtIncentives,24REV.FIN.STUDIES3813,3823(2011)(findingthat38%ofasampleoflargecompaniesinwhichCEOshadpositivenonqualifieddeferredcompensationbalancesprohibitednotionalinvestment in own-company stock); Frederick Tung & XueWang,BankCEOs, InsideDebtCompensation,andtheGlobalFinancialCrisis 53 (BostonUniv. Sch.ofLaw,WorkingPaperNo.11-49,2012) (reviewingproxystatements for83bankingcompaniesand finding that28 allowed senior executives to notionally invest in own-company stock, that 27 did notprovidethisoption,andthatanother27didnotoffernonqualifieddeferredcompensationorhadCEOswithazerobalance).ElevenofthefortyS&P500companiesIanalyzedallowparticipants todirect theircontributions intocompanystock;eightdidnotallowthis; therestweresilentonthisissue.111Newport Group Survey, supra note 37, at 26; Interview with Executive BenefitsConsultantswithanInternationalFirm,supranote39;ShannonInterview,supranote103;InterviewwithSeniorVPofExecutiveBenefitsConsultingandDesignFirm,supranote103.


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reasons were offered as well.112 Notional nonqualified deferred compensationinvestmentinown-companystockheldbydirectorsandofficersistreatedlikeothercompany shares held by these individuals for purposes of proxy disclosure;SecuritiesExchangeAct(SEA)§16reportingrequirementsandshort-swingtradingrestraints under SEA §16(b); and Sarbanes-Oxley limitations, including tradingrestrictionsduringqualifiedplanblackoutperiods.113

Somecompanies,however,alloworevenencouragenotionalDCinvestment

in own-company stock. Six percent of the companies responding to theNewportGroup’ssurveyindicatedthatparticipantsarepermittedtodeferrestrictedstockorrestrictedstockunits.Typically,thesedeferralswouldbeinandremainintheformof shares, avoiding the accounting problems associatedwith diversifiable or cashsettled balances tied to own-company stock.114 More generally, one sourceindicatedthatabout10%ofhisclientsrequirenonqualifiedDCinvestmenttobeinown-companystock.115

Inmysampleof S&P500nonqualifiedDCprograms,no companies limitedparticipantcontributionstoowncompanystock,butthreecompaniestiedemployercontributions to their stock prices,116and two companies provided significantincentives for participants to notionally invest in own-company stock. Leggett &Plattprovidesa20%bonus fordeferredamountsnotionally invested in companystock.117Aetnaoffersonlytwochoicesforinvestment–acompanystockfundandafixed income fund.118 But such cases seem rare. Much more common are112In addition to the obstacles that follow, MullinTBG notes that in some states own-company shares held in a rabbi trust count towards dilution in addition to the notionalown-company shares held in participant DC portfolios, doubling the dilutive impact ofhedgingown-companystock inkind. MULLINTBG,ANOVERVIEWTODEFERRALPLANNOTIONALSTOCKACCOUNTING(2014).11315U.S.C.§78p(2012);15U.S.C.§7244(2012);COMPLEMENTINGRESTRICTEDSTOCK,supranote 69; Andrew C. Liazos, Sarbanes-Oxley Act - Implications for Executive Compensation,MCDERMOTT,WILL&EMORY(Sep.9,2002);Frederick&Mitchell Interview, supra note103;Shannon Interview, supra note 103; Interview with Senior VP of Executive BenefitsConsultingandDesignFirm,supranote103.114NewportGroupSurvey,supranote37,at23;Shannoninterview,supranote103.ThirtypercentoftheS&P500companiesIanalyzedpermittedRS/RSUdeferrals,althoughseniorexecutivestookadvantageofthisopportunityatonly3or4ofthe40firms.115NeuwirthInterview,supranote110.116These companies are The Home Depot, J.M. Smucker, and PPG Industries. THEHOMEDEPOT,PROXYSTATEMENTANDNOTICEOF2016ANNUALMEETINGOFSHAREHOLDERS38(Mar.24,2016);THEJ.M.SMUCKERCOMPANY,PROXYSTATEMENTANDNOTICEOF2015ANNUALMEETINGOFSHAREHOLDERS48-49(Jul.1,2015);PPGINDUSTRIES,INC.,DEFERREDCOMPENSATIONPLAN14(asamended and restated effective Jan. 1, 2011) (Exhibit 10.11 to Form 10-K filed Feb. 18,2016).117LEGGETT & PLATT, INC., PROXY STATEMENT AND NOTICE OF 2016 ANNUAL MEETING OFSHAREHOLDERS26(Mar.30,2016).118AETNA,INC.,PROXYSTATEMENTANDNOTICEOFANNUALMEETINGOFSHAREHOLDERSOFAETNA,INC.49(April8,2016).


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nonqualifiedDC plans thatmirror 401(k)s and provide no apparent incentive forinvestmentinown-companystock. SohowdononqualifiedDCparticipantsactually(notionally)invest?Surveysandproxystatementdisclosuresdonotreachthisquestion,but interviewsourcesagreed on the general picture. Consistent with their diversification needs,participantsgenerallydonotvoluntarilyinvestdeferredcashcompensationinown-company stock. Some sources simply noted that they generally do not seeexecutives investing in their own companies’ stock.119 Another indicated thatparticipantsdosoonlywhenrequiredtodoso.120 Most sources declined to estimate the fraction of nonqualified DC fundsnotionally invested in own-company stock, preferring to focus on the limitedopportunitytodoso,butonesourcesuggestedthatlessthan20%offundbalanceswerenotionallyinvestedinown-companystockamongtheirclients,inaggregate.121

119Telephone Interview with John Lowell, Consultant, October Three [hereinafter LowellInterview] (Feb. 16, 2016); Interview with Executive Benefits Consultants with anInternationalFirm,supranote39.120NeuwirthInterview,supranote110.121Frederick&MitchellInterview,supranote103.

Whileconsistentwithdiversificationpressuresandlimitedaccesstoinvestmentinown-company stock, the relativelymodest notional investment in own-company stockbynonqualifiedDCplanparticipantsdescribedbysourcesappearstoruncountertofindingsinrecentworkbyJacksonandHonigsberg.SeeJackson&Honigsberg,supranote39,at496.JacksonandHonigsbergwereinterestedinwhetherexecutiveretirementaccountbalanceswerenotionallyinvestedsoastoalignexecutiveincentiveswithdebtholders,assomehadtheorized.JacksonandHonigsbergarguedthattotheextentthatretirementbalanceswerenotionally invested in own-company stock, they tended to align executives withshareholders,ratherthanwithdebtholders.Becausenotionalretirementplaninvestmentsare not disclosed, Jackson and Honigsberg looked for a correlation between definedcontribution plan returns,which are disclosed for “top 5” executives, and company stockreturns. JacksonandHonigsbergnoted that thisapproachhas limitations,but they foundevidence suggesting that “the value of a large proportion of executive retirement pay islinkedtocompanystockprices,”andthat“theretirementbenefitsofmorethanoneoutofthreeexecutivesare investedentirely in [their] company’s stock.” Jackson&Honigsberg,supranote39,at481.AlthoughIcannotreadilyidentifythesourceofthediscrepancy,onefactor thatmight contribute is that proxy statement disclosures of nonqualified deferredcompensation include vested, but undelivered restricted stock and performance shares,even if these shares are deferred for only two or three years. Inmy sample of S&P 500companies, short-term deferrals at two banks – Goldman Sachs and Morgan Stanley –accounted for almost 70% of aggregate contributions to nonqualified deferredcompensationaccountsasdisclosedinproxystatements.

Tobeclear,JacksonandHonigsbergwereonlyinterestedinnotionalinvestmentofaccountbalancesandtheimpactontheincentivesoftheexecutivesholdingthesebalances.Theywerenotinterestedinwhatcompaniesdidwiththedeferredcompensationamountspriortopayout.Thelatterquestion,aswewillsee,isofgreaterimportanceindeterminingthejointtaxconsequencesofnonqualifieddeferredcompensation.


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Movingbeyondown-companystock,onesourcesuggestedthatparticipantsgenerally select notional investments in an economically rational manner, with agreater emphasis on equities during early earning years, shifting tomore debt asparticipants near retirement.122 Other sources suggested that balances weretypically notionally invested somewhat more conservatively than 401(k)balances. 123 One source explained that because nonqualified deferredcompensation is anunsecuredpromise topay, participantswere advised todrawdown these funds before drawing on secured qualified plan funds, leading to ashorter investment horizon and a more conservative investment strategy.124Another source noted that some participants use nonqualified elective deferralplans as ameans of saving for their children’s college education, rather than forretirement,againsuggestingashorterhorizonandamoreconservativeinvestmentapproach.125 Again, most sources declined to estimate the typical investmentportfolio, but one source suggested a ballpark estimate for aggregate definedcontribution balances at large firms of 40% debt/10% own-company stock/50%otherequities.126

C.InformalFundingByPlanSponsors

Companiessponsoringnonqualifiedplansfacethreedecisionsintheinterimbetween deferral and payout: 1) to what extent to set aside or informally fundobligationsversususingdeferredamountsinthebusinessandoperatingtheplanonapay-as-you-gobasis,andiffundsaresetaside,2)whatvehiclestousetomanagethesefunds,ifany,and3)howtoinvestthosefunds.

Extentof InformalFunding. Firms cannot formally fund nonqualified planobligations as they would qualified plan obligations without jeopardizingparticipanttaxdeferral.Butfirmscan,andoftendo,informallysetasidefundsthatoffsetnonqualifiedplanobligations.Thefirstdecisioniswhethertosetasidefundsor leave those funds in thebusiness, reduceborrowing, etc. Sources and surveysprovide several rationales for informal funding. First, income statementvolatilityarisingfromplanobligations(companystockexcepted)canbemanagedbysettingaside funds and purchasing identical securities.127 Second, ratings agencies and

122InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39.123Frederick&MitchellInterview,supranote103.124Frederick&MitchellInterview,supranote103.Johnson&Honigsberg’sstudyconfirmsexecutives do tend to heed this advice. SeeJackson&Honigsberg, supranote 39, at 501(findingthatthemedianexecutiveintheirsamplereceivesallretirementpaywithinthreeyearsoftheirseparationfromthecompany).125NeuwirthInterview,supranote110.126Frederick&Mitchellinterview,supranote103.127Newport Group Survey, supranote 37, at 50;MullinTBG Survey, supranote 109, at 9;NeuwirthInterview,supranote110;InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39.


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analysts may be uncomfortable with large, unfunded plan liabilities on companybalancesheets.128Third, informal fundingmay, in fact,provideaddedsecurity forplanparticipantsintheeventofbankruptcyorinsolvency.Onesourcerecountedasconventional wisdom that while funds set aside in a rabbi trust technically areavailable to general creditors, the existenceof sucha trust tends to result inplanparticipants receiving a larger share of assets in bankruptcy or insolvencyproceedings.129

On theotherhand, large companieswith relatively smallnonqualifiedplanobligationsmay feel littleneedtosetaside funds,whileother firmsmayprefer tousethedeferredcompensationamountsinthebusiness.130 Practitioner Robert Miller, writing in 2002, reported that it was mostcommonnot to informally fundnonqualifiedplans,131but the situationapparentlyhas changed. Sixty-two percent of the firms responding to theMullinTBG surveyreported that they informally funded nonqualified plan obligations,while 71% oftheNewportGroup’srespondentsreportedfundingnonqualifiedDCobligationsand55% reported funding nonqualified DB obligations.132 One source cautioned thatthesesurveysmayoverstatetheprevalenceoffunding,133butintervieweeestimateswere not materially different, ranging from 50% to 80-90% of firms informallyfundingnonqualifiedplanobligationstosomedegree.134

128MullinTBGSurvey,supranote109,at9; InterviewwithSeniorVPofExecutiveBenefitsConsultingandDesignFirm,supranote103.129Neuwirth Interview, supra note 110. See also COMPLEMENTING RESTRICTED STOCK 3(reporting that “there is anecdotal experience that an informally funded [nonqualifieddeferredcompensation]arrangementdoeshavesome increased likelihoodof successfullynavigating the dangers of company insolvency”); MBENEFITSOLUTIONS,WHITEPAPER:WHYCOMPANIESUSERABBITRUSTS 4 (“M Benefit Solutions has had several clients go through abankruptcyandtheexistenceofarabbitrust,webelieve,helpedexecutivestheretoobtainpaymentofallora largepercentageoftheirnonqualifieddeferredcompensationbenefits.Whethertheywouldhavebeenabletoobtainthisresultwithoutanassetalreadysetasidetomakethebenefitpaymentsisdifficulttosay,butislesslikely.”).Tobesure,someofthesourcesofthisanecdotalevidencehaveafinancialinterestinfirmsadopting rabbi trustsorother informal fundingvehicles,but increasedprotectionagainstinsolvencyriskwouldruncountertothenonqualifieddeferredcompensationbargain.130MullinTBG Survey, supranote 109, at 9; Newport Group Survey, supranote 37, at 52;Lowell interview, supra note 119; Interviewwith Executive Benefits Consultantswith anInternationalFirm,supranote39.131MILLER,supranote34,at284.132MullinTBGSurvey,supranote109,at9;NewportGroupSurvey,supranote37,at51.133LowellInterview,supranote119.Theconcernisthatthefirmsconductingthesurveysareprovidersoffundingvehicles,suchasCOLI,andthatclientsofthesefirmsmayrespondatahigherratethanfirmswithoutaclientrelationship.134The estimates I received were as follows: 50-65% (Frederick and Mitchell Interview,supranote103),55%(NeuwirthInterview,supranote110),65%(InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39),75-90%(LowellInterview,


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Informalfundingisnotanallornothingdecision.Lessthanhalfofthefirmsresponding to MullinTBG’s survey reported funding 100% of liabilities.135 Onesource indicated that some of his clients fund only the equity portion of the DCnotionalinvestmentportfoliosofparticipants.Liabilitiestiedtodebtsecuritiesarelessvolatile,andsomefirmsseelessofaneedtohedgetheseliabilities.136 Informal Funding Vehicles. Firms that informally fund nonqualified planobligationsmustchooseavehicleorvehiclestodoso. Theoptionsareessentiallyrabbi trusts, corporate owned life insurance policies, and segregated accounts,althoughthesecanbeandoftenarecombined.

Rabbi trusts are very common.137 A rabbi trust is a grantor trust, andtypically these trusts are designed to be irrevocable, providing plan participantswith protection against an employer’s change of heart or a possible change ofcontrol.138But, asnoted, trust assets are available to general corporate creditors.Income earnedwithin rabbi trusts is taxed to the employer, and thus holding setaside funds in a rabbi trust (versus in anon-trust segregatedaccount)hasno taxconsequences.139 Rabbi trusts are frequently used because they are simple andinexpensive to implement, because they provide a platform for hedging activities,andbecause,despitetherequirementthat trustassetsremainavailabletogeneralcreditors, in practice they may provide some participant security, as explainedabove.140

Formerly, employers sometimes held set aside funds in offshore trust

accountsasameansof increasingparticipant security. However, I.R.C. §409A(b)nowprovides forcurrentparticipant taxationwithrespect toassetssetaside inaforeign trust to informally fund nonqualified deferred compensation obligations,unless substantially all participant services are performed in the foreignjurisdiction. Presumably, substantially all rabbi trusts backing U.S. employment-basednonqualifieddeferredcompensationarelocatedintheU.S.supra note 119), 80-90% (Interview with Executive Benefits Consultants with anInternationalFirm,supranote39).135MullinTBGSurvey,supranote109,at9.136NeuwirthInterview,supranote110.137NewportGroupSurvey,supranote37,at54(88%ofDCplanswithinformalfundingand71%ofDBplanswithinformalfundingutilizedrabbitrusts in2013). Butnotethatthesefiguresmay be overestimated because of the likely survey response bias discussed supranote133.138The term “rabbi trust” reflects thehistorical accident that the first IRS letter rulingonthesevehiclesaddressedatrustcreatedbyacongregationforthebenefitofitsrabbi.TheIRS has provided a model rabbi trust document that serves as a safe harbor for thesearrangementsandspecifiesthebasicterms.Rev.Proc.92-64,1992-2CB.22.139GrantortrusttaxrulesarefoundinI.R.C.§§671-679(2012).140Seetextaccompanyingsupranotes66,129.


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Corporate-owned life insurance is commonly employed as a means ofinformally funding and sometimesmanaging nonqualified deferred compensationarrangements. COLI insures the livesof currentand formeremployees,141but thepolicies are owned by plan sponsors who pay the premiums and are thebeneficiaries. ACOLIpolicyisageneralcorporateasset,althoughapolicymaybeheldwithinarabbitrust,providinglimitedsecuritytoplanparticipantsasdiscussedabove. Alternatively,employerscanuseCOLIproductstomanageset-asideassetsandhedgeparticipantnotionalinvestmentswithoutthenecessityofcreatingarabbitrust.142Eitherway,employerstypicallypurchasevariableuniversallifeinsurancepolicies that allow them to select a mix of investments that match participantnotionalinvestmentportfoliosandtoadjusttheseinvestmentsovertime.143

COLI products provide certain tax benefits. Although premiums are notdeductible,144tax is deferred on the cash value buildupwhile a policy is in force,allowing plan sponsors to rebalance their hedging portfolios without incurringcurrent tax; and death benefits, including both the pure insurance payout andinvestmentreturns,arereceivedtaxfreeifcertainIRSrequirementsaremet.145Inthe not uncommon case in which a policy is liquidated prior to the death of an

141Although the cases are not uniform, employers have been held to have an insurableinterestinthelivesoftheiremployeesunderstatelaw,andthatinterestextendsbeyondtheterminationof their employment. Social security systemdata isused todeterminewhendeath benefits are due with respect to former employees. See ROBERT E. KEETON ET AL,INSURANCELAW:A GUIDE TO THEFUNDAMENTALPRINCIPLES, LEGALDOCTRINES, ANDCOMMERCIALPRACTICES 158 (2d ed. 1988) (noting that some “courts have…upheld COLI programs, atleastwhentheemployeeconsentedtotheplacementofthelifeinsuranceontheemployee’slifeandtheemployermadeacolorableclaimoffinanciallossresultingfromthedeathoftheemployee”).Moreover,statuteshavebeenenactedinsomestatesexplicitlyrecognizingthatemployersmayhave insurable interests in the livesofemployees. See STEVENPLITTETAL,COUCHONINSURANCE3D,§43:14(2009)(citingIndianaCode§27-1-12-17-1asanexample).142InterviewwithSeniorVPofExecutiveBenefitsConsultingandDesignFirm,supranote103.143 Frequently Asked Questions about Coli, BOLICOLI.COM,http://www.bolicoli.com/frequently-asked-questions-about-coli.144I.R.C. § 264(a)(1) (2012) disallows deductions for insurance premiums when thetaxpayeristhebeneficiary.145Nunn, supra note 64, at 201 (citing I.R.C. §§ 101(j), 72(e)(5)(A), (e)(10) (2012));Nonqualified Plan Basics, WELLS FARGO (2013), available athttps://www08.wellsfargomedia.com/assets/pdf/commercial/retirement-employee-benefits/perspectives/nonqualified-plan-basics.pdf. Death benefits are taxable if acorporateownerfailstocomplywithIRC§101(j).Seeinfranote178.NotealsothatCOLIusecanalsoresultinincreasedAlternativeMinimumTaxobligations.TaxConsequencesofNQDC for theEmployer, in TAXATIONANDFUNDINGOFNONQUALIFIEDDEFERREDCOMPENSATION41-43(MarlaJ.AspinwallandMichaelG.Goldstein,eds.,2ded.2012).


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insuredemployee,gainsaretaxedatthatpoint,resultingindeferraloftaxbutnotexemption.146

While Congress has acted several times to limit abusive, leveraged COLI

plans,147few steps have been taken to address the fundamental tax advantagesarisingfromCOLI.ThePensionProtectionActof2006isanotableexception.ThatactcreatedI.R.C.§101(j),whichcurtailstheexclusionofdeathbenefitsinthecaseof employer-owned life insurance. COLI death benefits are now excluded fromincomeonlyiftheuniverseofinsuredemployeesislimitedtodirectorsandthetop35%ofearnersandinsuredemployeesprovideinformedwrittenconsent.Congresshas not acted, however, to curtail the benefit of deferral of tax on the cash valuebuildupwithintheseplans.148

While tax advantaged, COLI products are expensive and complex.149 Firms

purchasing these policies are paying for insurance, in addition to a tax-preferredinvestmentvehicle.AndonesourcenotedthatitcantakeuptoayeartoputaCOLIinplace.150A furtherpotentialdrawback is that investmentoptionswithinaCOLIvehiclearegenerally limitedandmaynotperfectlymatch theoptionsavailable toplan participants.151 One source suggested as a general matter that COLI use isprevalent for large plans with large obligations since the tax benefits offset the

146Frederick&MitchellInterview,supranote103,notingthatmanyfirmsusingCOLIfailtoreapthefulltaxadvantagessincetheytendtoliquidatepoliciestosatisfyplanobligationsbeforedeathbenefitsarepaid.147Leveraged COLI plans, often covering thousands of employees (and generally havinglittleornothingtodowithnonqualifieddeferredcompensation),wereapopulartaxshelterduringthe1980sand1990s.Inatypicalarrangement,aplansponsorwouldpaypremiumsusing a combination of death benefits, dividends, and loans from the insurance companyderivedfromthecashvaluebuildupwithintheplan.Deductionofinterestandfeescouldturn a pre-tax losing arrangement into a post-tax winner. Leveraged COLIs of this typewereeliminatedthroughacombinationofIRSlitigationvictories,basedprimarilyonanti-abuseprinciples,andachangeoflawin1996thatsignificantlylimitedthedeductibilityofinterestonCOLI-backedloans. Becausemoneyisfungible,itremainspossibleforfirmstoindirectly leverage COLI arrangements. See Jennifer L. Brown, The Spread of AggressiveCorporate Tax Reporting: A Detailed Examination of the Corporate-Owned Life InsuranceShelter, 86 ACCT. REV. 23, 23-25 (2011) (describing the leveraged COLI shelter andlegislative and judicial responses);MarkP.Gergen,TheLogicofDeterrence:CorporateTaxShelters,55TAXL.REV.255,256-57(2002)(same);BAIRDWEBEL&DONALDJ.MARPLES,CONG.RESEARCH SERV., RL33414, CORPORATE-OWNED LIFE INSURANCE (COLI): INSURANCE AND TAXISSUES(Jan.21,2011)(describingandanalyzingevolvingCOLItaxrules).148Asdiscussedmorefullyintextaccompanyinginfranote179,legislationhasbeenofferedasrecentlyas2003thatwould,withlimitedexceptions,requireemployerstoincludeCOLIcashvaluebuildupinincomeonanannualbasisandeliminateexclusionofdeathbenefits.149COLIpurchasealsointroducescounterpartyrisk,whichcanbesignificantgiventhelongtimehorizonsinvolved.Nunn,supranote64,at202.150Frederick&MitchellInterview,supranote103151NeuwirthInterview,supranote110.


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administrativecostsandotherdrawbacks.152Another source suggested thatCOLIuseisactuallydecliningamonghisclients.153 Ultimate Investment of Set Aside Funds. From a joint tax perspective, theimportant questions here involve the extent of COLI use and the ultimateinvestment of set aside funds. The two surveys suggest extensive use of COLI.Fifty-four percent of firms that informally fund and responded to MullinTBG’ssurvey reported using COLI, 42% taxable securities, and 19% cash.154 Obviously,some firms combine these. Newport Group’s survey respondents indicated evenmoreoverlappinguseoffundingmechanismsforDCplanswith73%usingCOLItosomeextent,39%taxablemutualfunds,14%bonds,13%companystock,and11%separately managed investment accounts.155 Sources, however, suggested thatthesesurveyslikelyoverstateCOLIuse.Sourcesestimatedthatfundingwasdividedabout 50/50 between COLI and taxable securities.156 Generally, these taxablesecuritieswouldbeheldinarabbitrust,but,asnotedabove,theinterpositionofarabbitrusthasnoimpactonjointtaxconsequences. Companies appear to only rarely informally fund nonqualified deferredcompensationliabilitieswiththeirownstock.ThirteenpercentofNewportGroup’ssurveyrespondentsreportedfundingDCobligationstosomedegreewiththeirownstock, while none reported funding DB liabilities in this fashion.157 One sourceestimated that less than 10% of funds set aside are in company stock.158 Heexplainedthatwhenparticipantnotionalinvestmentisincompanystockandwillbepaidinstock,firmsoftensetasidesharestofundtheobligation,butwhennotionalstock investment will be paid in cash, firms generally do not set aside sharesbecausedoingsodoesnotoffset the incomestatementvolatility.159Thus, it isnotsurprisingthat ifparticipantnotional investment instock ismodest tobeginwith,informalfundingincompanystockisevenmoremodest.160

152NeuwirthInterview,supranote110.153Frederick&MitchellInterview,supranote103.154MullinTBGSurvey,supranote109,at9.155NewportGroupSurvey,supranote37,at53.156Frederick & Mitchell Interview, supra note 103; Interview with Executive BenefitsConsultantswithanInternationalFirm,supranote39.157Newport Group Survey, supra note 37, at 53. Company stock was not listed as aninformalfundingvehicleusedbyMullinTBGSurveyresponders,butitisnotclearwhetherthisshouldbeinterpretedaszerouseofcompanystock,afailuretolistcompanystockasanoptiononthesurvey,orsomethingelse.Itisunlikely,however,thatfundingwithown-companystockisprevalentforMullinTBGSurveyresponders,giventhesilence.158ShannonInterview,supranote103.159ShannonInterview,supranote103.Alternatively,plansponsorsmayhedgecash-settlednotional own-company stock investments with mutual funds that approximate theperformanceoftheshares.COMPLEMENTINGRESTRICTEDSTOCK,supranote69.160It is interesting to compare the use of own-company stock to fund nonqualified planobligations to its use in funding qualified plan obligations. While ERISA rules cap own-company stock holdings at 10% of qualified DB plan assets, until recently own-company


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With the exception of own-company stock, it is reasonable to assume thatfundssetasidebynonqualifiedDCplansponsorsareultimatelyinvestedinsuchaway as to mirror as closely as possible the notional investment portfolios ofparticipants. This follows fromplan sponsors’ emphasisonmanaging the incomestatementvolatilityarisingfromtheliabilities,andshouldgenerallybetruewhetherthefundingvehicleisaCOLIorataxableaccount. It is less obvious how amounts set aside to fund DB liabilities wouldultimatelybe invested. TheNewportGroupsurveysuggests that firmscommonlyuse COLI to fund these obligations, and that among taxable investments, mutualfundsareemployedabouttwiceasoftenasbonds.161Ofcourse,thefactthattwiceasmany sponsors utilize taxablemutual funds as bonds does not tell us that theratioofdollars is two toone,but itdoes suggest amixofdebt andequity isheldoutsideofCOLIaccounts. Non-SetAsideFunds.Whathappenstodeferreddollarsthatarenotsetasidetomeetplanliabilities?Thesefundsareusedinthebusiness,oftensubstitutingforborrowing.Onesourcenotedthatindecidingwhetherortowhatextenttofund,hisclientstypicallylookatoneofthreebenchmarksforreturnsonnon-setasidefunds– their borrowing costs, return on cash investments, or internal rate of return.162Theappropriatebenchmarkwoulddependonafirm’sparticularcircumstances.

D.JointTaxConsequencesofNonqualifiedPlansinPractice

Thejointtaxconsequencesofnonqualifiedplansinpracticeareafunctionofemployer actual use of deferred amounts as compared with counterfactualparticipantinvestmentoutsidetheplan.Intheanalysisthatfollows,Iusenotionalparticipant investments in DC plans as a proxy for these hypothetical outsideinvestments. In cases in which sponsors informally fund DC plan obligations, Igenerallyassumethat the instrumentsare thesame,e.g.,equityhedgingequityordebthedgingdebt.

Theoneexceptiontothisisthatnotallnotionalinvestmentinown-companystockishedgedwithcompanystockgiventhefactthatgainsorlossesonstockheldtohedgenotionalstockinvestmentsdonotflowthroughtoincomestatements.The§1032taxadvantageislimitedtotheextentofsponsorhedgingwithown-companystock.Suppose,forexample,thatIBMemployeesnotionallyinvestnonqualifiedDCaccounts in IBM stock and that IBM purchases S&P 500 index funds as a hedge,placing these index funds in a taxable account. Participants will receive cashbenefits based on IBM’s return, but IBMwill pay tax at its regular rates on indexstock accounted forhalf of qualifiedDCplan assets for almost20%ofparticipants in thelargestplans.SeeinfraPartIV(E).161NewportGroupSurvey,supranote37,at53.162NeuwirthInterview,supranote110.


33

fundgainsandlossesanddividends.Thejointtaxadvantageordisadvantageinthiscase would be determined by comparing IBM’s tax rate on the index fundinvestmentwithparticipants’counterfactualtaxrateonoutsideinvestmentsinIBMstock(orotherequities,whichislargelythesame).

In cases in which sponsors do not informally fund nonqualified plan

obligations, taxation of business returns is compared with counterfactualparticipant investment in debt or equity securities, as suggested by DC notionalinvestments.

In the analysis that follows, I assume that corporations and individualsgenerally are taxed at the highest U.S. marginal rates,163and I add the netinvestmentincomesurtaxtoindividualrates.IassumethatCOLIreturnsaretaxedat a zero rate, despite the suggestion of one source that COLI policies are oftenliquidatedprematurely.164Iignorethepossibilitythatindividualsuselifeinsuranceproductstoreducetaxesonoutsideinvestments.165WhilecomparingCOLIfundeddeferred compensationwith fully taxableoutside investmentmightbe consideredanapplestoorangescomparison, it istheassumptionthatmaximizesthejointtaxadvantage I am attempting to identify and helps us appreciate the worst-casescenario from the perspective of the public fisc. Moreover, there is no particularreasontomatchCOLIfundeddeferredcompensationwithinsurance-basedoutsideinvestment.Anyindividualwillingtoabsorbthecostcanreducetaxesonhisorhersavingsbyinvestingthroughlifeinsuranceproducts.

163Given the effective prohibition under I.R.C. § 409A on offshore rabbi trusts, it seemsreasonable to analyzenon-COLI-basedemployer investmentsusingU.S. corporate incometaxrates.Ofcourse,theeffectivemarginaltaxrateonU.S.incomemaybelessthanthetopmarginalratesasaresultofNOLs.SeeinfraPartIV.A.3.164Asdiscussedintextaccompanyingsupranotes91-94,themarginalratesassumedareasfollows:Individual: long-term capital gains and dividends, 25%; interest and short-term capitalgains,44.6%.Corporate:ownstockgainsandCOLIreturns,0;dividends,10.5%;capitalgain,interest,andbusinessprofits,35%.These rates are likely to change under the Trump administration, but at this point theimpactofthejointtaxconsequencesofnonqualifieddeferredcompensationareunclear.COLIpoliciesthatareliquidatedprematurelywouldstillprovidethebenefitoftaxdeferral,butnotexemption.Thetaxbenefit,however,wouldbeoffsetbytheunrecoveredcostoftheinsurance.Asnotedsupranote94,Ifollowpreviouscommentatorsinignoringtheimpactofstatelocalincometaxesonthejointtaxanalysis.165MICHAELJ.GRAETZ&DEBORAHJ.SCHENK,FEDERALINCOMETAXATION,PRINCIPLESANDPOLICIES159-61 (7th ed. 2013) (describing the preferential tax treatment (and limitations)associatedwithlifeinsurancecontracts).


34

To place the following analysis in perspective, note that DC commitmentsprobably represent about half of total nonqualified deferred compensationobligationscurrently,166butthattheDCfractionisincreasingovertime.1.DefinedContributionPlans Asan initialmatter, letusassumethatabout50%ofdeferredDCsumsareset aside by plan sponsors tomeet future obligations.167 Sources suggest that nomore than 10% of dollars set aside by plan sponsors (perhaps 5% of total DCcommitments)areinvestedinown-companystocktohedgestock-basedobligationsto participants. The joint tax advantage is large. A plan sponsor pays no tax ongains on its own stock; the participant would have paid tax at individual ratestoppingoutat25%. But the§1032advantage is currentlybeingenjoyedononlyabout5%(andunlikelytobemorethan10%)oftotalDCbalances.Employer Participant JointTaxAdvantageOwnstock:t=0 Ownstock:t=25% 25% Sources suggest a roughly even split between the use of COLI and taxablesecurities in funding plan obligations.168 If so, roughly a quarter of totalcommitmentswouldbefundedwithCOLI.TheseCOLIdollarsareusedprimarilytohedge the income statement volatility of participant notional investments, so inaggregateCOLIcontainamixofdebtandequitymirroringparticipant investment.It appears, however, that firms are somewhat less likely to fund the debt side ofparticipantportfolios. If so,COLI likelyholdsomewhatmoreequity thana40/60overalldebt/equitynotionalinvestmentestimatewouldsuggest. Inanyevent,useof a COLI does generate a joint tax advantage. That advantage is greater if thecounterfactual investment would be individual investment in debt securities (orshorttermcapitalgains),butitissignificant,nonetheless.Employer Participant JointTaxAdvantageCOLI:t=0COLI:t=0

Equity:t=25%Debt:t=44.6%

25%44.6%

TheuseoftaxablesecuritiestofundnonqualifiedDCcommitmentsresultsinmixedjointtaxconsequences.Long-termcapitalgainsaretaxedatahigherratetocorporations thanto individuals (35%versus25%),while interest,dividends,andshort-termcapital gainsare taxedat a lower rate (interest and short-termcapital166Jackson&Honigsberg found thatDCbalances accounted for44%of total nonqualifieddeferredcompensationforseniorexecutivesin2011.Jackson&Honigsberg,supranote39,at491-92.167Sourcessuggestthatover50%ofplansponsorssetasidefundstomanageDCobligationsbut firmsfrequently fund lessthan100%of thoseobligations,so50%ofdollarssetasideseemsareasonableassumption.168Supratextaccompanyingnotes154-156.


35

gains: 35% versus 44.6%; dividends: 10.5% versus 25%). Sources suggest thatfirms are more likely to set aside funds to hedge the equity-side of notionalportfolios, but returns to equity in the form of long-term capital gains are taxdisadvantaged, while short-term capital gain and dividend returns are taxadvantaged.Inaggregate,dividendshaveaccountedforoveralmosthalfofS&P500companyreturnsoverthelonghaulandasomewhatlesserpercentageofU.S.equityreturnsoverall.169Nonetheless,withoutfurtherdata,itwouldappearthatthejointtaxconsequencesofnotionalequity investmenthedgedwithtaxablesecuritiesareroughlyneutral.170Employer Participant JointTaxAdvantageTaxableLTCG:t=35%Taxabledivs:t=10.5%Taxabledebt:t=35%

LTCG:t=25%Divs:t=25%Debt:t=44.6%

(10%)14.5%9.6%

Finally,wehavetheroughly50%ofdeferredDCdollarsthatare left in thebusiness.Thesedollarsareassociatedwithnotionaldebtandequityinvestmentsofparticipants that may be somewhat more debt-heavy than our overall 40%debt/60%equitybenchmark,becausefirmsaresomewhatmorelikelytoleavedebtobligationsun-hedged. Assumingthattheappropriatetaxrateonbusinessprofitsis35%(andthatbusiness returns roughly mirror market returns), the parties face a joint taxdisadvantage on equity held in participant portfolios (both long-term gains anddividends:35%corporateversus25%individual)andajointtaxadvantageondebtreturns(35%corporateversus44.6%individual).Employer Participant JointTaxAdvantageBusiness:t=35%Business:t=35%


(10%)9.6%

These joint tax consequences are summarized in the graphic that follows.Joint tax advantage is good from the point of view of the private parties, hencegreen,andjointtaxdisadvantageisbad,hencered.Neutralisyellow.Moreintensecolorsrepresent larger joint taxadvantageordisadvantage. Forsimplicity, Ihaveassumed a 60/40 equity/debt split and that equity returns are an equal mix of

169Adam Johnson, ShowMetheMoney:WhyDividendsMatter, BLOOMBERG (Sept. 10, 2014,11:52 AM), http://www.bloomberg.com/news/articles/2014-09-10/show-me-the-money-why-dividends-matter(calculatingthatdividendsaccountedfor46%ofthetotalreturnontheS&P500between1989and2014).170It is in the context of sponsor funding with taxable securities (and the context ofunfunded liabilitieswhich follows) that any change inmarginal rates adopted during theTrumpadministrationwillbemostconsequential forthejointtaxanalysisofnonqualifieddeferredcompensation.


36

dividends and long-term capital gains. Obviously, this chart reflects only a roughapproximationofjointtaxconsequencesinpractice.

2.DefinedBenefitPlans AlthoughDBplansaredeclininginimportance,manyFortune500executivesaregrandfatheredintoDBplans,andDBplanswilllikelycontinuetobeimportantincertainindustries,suchasutilities.Therearenonotionalparticipantinvestmentsandthereislittleincomestatementvolatilityassociatedwiththeseplans,and,asaresult,theyarelesslikelytobefunded. Itseemslikelythatwellunder50%ofDBobligationsarefunded. CompaniesdonotreportusingtheirownsharesasafundingmechanismforDBplans,so§1032plays littleornorolehere. However, firmsoftendouseCOLIproducts to fundDB liabilities. Half or even three-quarters of dollars fundingDBliabilitiesmaybeinvestedthroughCOLI,likelygeneratingajointtaxbenefit.Employer Participant JointTaxAdvantageCOLI:t=0COLI:t=0


25%44.6%

Theremainingset-aside fundsare invested ina taxable fashion,whichmay

ormaynotresultinajointtaxbenefit.Interestanddividendsaretaxedatalowerrate to companies than individuals; long-term capital gains are taxed at a higherrate.

Funded&'&Co.&Stock&

Funded&(COLI)&

Funded&(Taxable)&'&Debt&

Funded&(Taxable)&'&Equity&

Unfunded&'&Equity&

Unfunded&'&Debt&

Nonqualified,DC,Plans,1,Joint,Tax,Consequences,in,Prac8ce,


37

Employer Participant JointTaxAdvantageTaxableLTCG:t=35%Taxabledivs:t=10.5%Taxabledebt:t=35%

LTCG:t=25%Divs:t=25%Debt:t=44.6%

(10%)14.5%9.6%

AsinthecaseofDCplans, firmuseofdeferredDBdollarsintheirbusinessoperationsmay result in a joint tax advantage or disadvantage, depending on thecounterfactual outside investment by participants. The corporate tax rateapplicable to business earnings is greater than the individual rate on long-termcapital gains anddividends (joint taxdisadvantage)but lower than the individualrateoninterestandshort-termcapitalgains(jointtaxadvantage).Employer Participant JointTaxAdvantageBusiness:t=35%Business:t=35%


(10%)9.6%

These joint tax consequences of nonqualified DB plans in practice are

portrayed in the graphic that follows. As before, I have assumed a 60/40equity/debt split and that equity returns are long-term capital gains. Again, thischartreflectsonlyaroughapproximationofjointtaxconsequencesinpractice.

Funded&(COLI)&

Funded&(Taxable)&2&Debt&

Funded&(Taxable)&2&Equity&

Unfunded&2&Equity&

Unfunded&2&Debt&

Nonqualified,DB,Plans,1,Joint,Tax,Consequences,in,Prac9ce,


38

IV.Discussion

A.IsThereaJointTaxAdvantageIssuetoWorryAbout,and,IfSo,WhatIsIt?

It isnotclearthatthe jointtaxadvantageenjoyedbynonqualifieddeferredcompensationparticipantsandsponsorsjustifiesreformofthebasictaxrules. Ontheotherhand,itmaybeworthconsideringreformtargetedatCOLIuse.1.I.R.C.§1032 Section1032islessrelevanttononqualifieddeferredcompensationpracticethan onemight surmise.171Diversification concerns deter participants from tyingdeferred compensation returns to own-company stock and accounting concernstend to deter sponsors. As discussed below, apparently no more own-companystock issetasideto informally fundnonqualifieddeferredcompensation liabilitiesthanhashistoricallybeencontributedtoqualifiedplantrusts,despitethefactthat§1032 provides a tax advantage only with respect to nonqualified plancontributions.172 To be sure, some firmsmay hold treasury shares that are not specificallyallocated to informally fundingnonqualifieddeferredcompensation liabilities,andthese firms may have deferred compensation liabilities that exceed amounts setasideinrabbitrustsorCOLIaccounts. Shouldweassumeazeroemployerrateoftaxonnonqualifieddeferredcompensationtotheextentthatafirmholdstreasurysharesandhasunfundedliabilities? Inmyviewweshouldnot. Iftreasurysharesare held for another reason – to provide a pool for issuing restricted stock oroptions or because firmmanagement thought its shares undervalued and a goodinvestment – and ifwe posit that these shareswould be held irrespective of anydeferred compensation liabilities, then it does notmake sense to effectively treatthese treasury shares as fundingdeferred compensation. Of course,we generallycannotbecertainwhetherthereisorisnotaconnectionabsentanexplicittie,butgiventheprevalenceofinformalfundingarrangements,itseemssensibletoassumethatunfundedliabilitiesareindeedunfunded.2.COLI The largest source of joint tax advantage in private-sector nonqualifiedarrangementslikelystemsfromtheuseofCOLItoinformallyfundtheseplans.TheprevalenceofCOLIuseis,infact,consistentwithastoryinwhichplansponsorsfailtominimizejointtaxburdensthroughinvestmentdecisions. If, forexample, firmswere using § 1032 to minimize the joint tax burden of nonqualified deferred171Recallthatunder§1032companiespaynotaxongainsorlossesonown-companystock.Seesupratextaccompanyingnote55.172Infratextaccompanyingnotes212-217.


39

compensation,therewouldbenoneedtopurchaseCOLI.Asnoted,firmspayapricetogaintheCOLItaxadvantage,butapparentlythetaxbenefitoutweighsthecostatmany companies. And even if the potential COLI tax benefit is often not fullyrealizedbecauseofprematurepolicyliquidations,theuseofCOLIraiseslegitimatetaxpolicyconcernswithrespecttohigh-incometaxpayersubsidy,costtothepublicfisc,andpotentialdistortionsincompensationdesign. On the other hand, one could argue that the COLI tax advantage simplyparallelsthetaxbenefitavailabletoindividualswhouselifeinsuranceproductsassavingsvehicles.173MyimpressionistheuseofCOLIasaninvestmentvehiclemaybemorecommonthan individual investmentthroughinsuranceproducts,but it isdifficult to distinguish tax motivated individual investing from insuranceacquisition, andultimately this is anempiricalquestion. Moreover,whateveronethinks of themarket failure arguments put forward to justify tax preferences forindividualpurchaseoflifeinsurance,theseargumentsdonotextendtoCOLI.174 OnecouldalsoarguethattheCOLIissueisseparablefromthenonqualifieddeferredcompensationissueperse.COLIiswidelyusedtofundvariousemployeebenefits,suchashealthcarebenefits,andforotherpurposes,suchasproviding“keyman”insurance.175 Nonetheless,Iwouldarguethatsocialwelfarewouldbeenhancedbylimitingor eliminating the tax benefits of COLI as used to fund nonqualified deferredcompensationandsimilaremployeebenefits.Thisisnottheappropriateforumforexhaustiveprescriptionandanalysis,soIwillsimplysketchoutpossibleavenuesofattack.Luckily,severalarealreadyinthepublicrecord. Asdiscussedabove,therearetwomaintaxissuesassociatedwithCOLI–theunderlying taxbenefitsofdeferralandexemptionand theadditional taxarbitrageassociated with leveraged arrangements. Tax savings from direct leverage –borrowingtieddirectlytocashvaluebuildup–havebeenallbuteliminated.Undercurrentlaw,interestisdeductibleonnomorethan$50,000ofCOLI-baseddebtwith

173Whole life and other long-term insurance arrangements involve a savings element inaddition to insurance. Investment gains under these policies are excluded from incomewhenreceivedasdeathbenefits,IRC§101(a),and,althoughtherulesaremorecomplex,asa practical matter, investment gains generally are excluded from income even whenamountsarewithdrawnpriortodeath.GRAETZ&SCHENK,supranote165,at159-61.174Itissometimesarguedthatindividualssystematicallyunderestimatetheriskandcostofdeath and that adverse selection undermines accurate insurance pricing, but theseconcerns,evenifvalid,donottranslatetoCOLI. WEBEL&MARPLES,supranote147,at6-7.Of course, companies and insurance providers will argue that preferential COLI taxtreatment is needed to incent firms to provide nonqualified deferred compensation andotheremployeebenefits.ButCongresshasalreadydecidedthatnon-qualifiedplansshouldnotbetaxadvantaged,sothisargumentshouldcarrylittleweight.175WEBEL&MARPLES,supranote147,at1.


40

respecttoatmost20individualsataparticularcompany.176Butindirectleverageisstillpossible.Firmsmayborrowmoneyforotherpurposesanddeducttheintereston those borrowing while simultaneously holding COLI policies with large cashvalues. TheObama administration attempted to combat this indirect leverage bylimitingthedeductibilityofemployerinterestpaymentsbasedontheratioofCOLIcashvaluestototalfirmassets,whetherornotthedebtwasincurredtopurchaseorcarry theCOLI, and irrespective of the identity of the insured employees.177 ThisproposalhasnotbeenadoptedbyCongressbutremainsontheshelf. The second COLI tax issue has to do with deferral of tax on investmentincome and exclusion of death benefits, the “normal” tax preferences associatedwithinvestingthroughinsuranceproducts.IfoneconcludesthatthesepreferencesarenotwarrantedforCOLItypearrangements,theyshouldsimplybeeliminated.178In2003,RepresentativeRahmEmanuelofferedlegislationintheHousethatwouldhavedonejustthat.Underthatlegislation,withcertainspecificexceptionsfor,e.g.,“key man” insurance, employers would have been required to include incomeearnedonCOLIproductseachyear,anddeathbenefitsinexcessofpremiumspaidand gains already taxed would have been fully includable, as well.179 If thesereforms were to be enacted, presumably COLI would disappear as a means ofinformallyfundingnonqualifieddeferredcompensation,while,ofcourse,taxneutralrabbitrustswouldremain.3.LowMarginalTaxRateEmployers Theuseofnonqualifieddeferredcompensationbygovernmentalandotherformallytax-exemptorganizationsraisesadistinctsetofissuesandisnotafocusofthisArticle.180However,theuseofnonqualifieddeferredcompensationbyprivate

176I.R.C.§264(a)(4),(e)(2012).SeealsoWEBEL&MARPLES,supranote147,at3-4.177Proposal to Modify the Tax Treatment of Corporate-Owned Life Insurance Continues toReceive Attention, WR NEWSWIRE, AN AALU WASHINGTON REPORT (Feb. 3, 2014),http://rosestreetadvisors.com/wp-content/uploads/sites/22/2016/02/022014ProposaltoModifytheTaxTreatmentofCOLIContinuetoReceiveAttention.pdf;WEBEL&MARPLES,supranote147,at4.178The use of COLI has already been circumscribed to some extent by recent legislation.The“COLIBestPracticesAct,”partofthePensionProtectionActof2006,restrictsthefulltaxadvantage (tax freedeathbenefits) topolicies insuringdirectors, fivepercentowners,and the35%mosthighly compensatedemployees, andalso requiresemployers toobtaininformed consent prior to taking on policies on insureds. I.R.C. §101(j) (2012); PensionProtectionActof2006,PubL.No.109-280,§863(j),120Stat.786(Aug.17,2006).179H.R. 2127, 108th Congress, 1st Session (2003). SeealsoWEBEL&MARPLES, supranote147,at11.180This is not to suggest that these issues are unimportant, andunder recently proposedregulations, their importancemay grow. Unfunded, nonqualified deferred compensationoffered by tax-exempt entities (other than churches) is regulated under IRC §457 andconsistsof“eligibleplans”regulatedunder§457(b)and“ineligibleplans”regulatedunder§


41

sector firms thatareeffectively taxexempt,or that face loweffectivemarginal taxrates generally, is fair game and is potentially troubling from a tax policyperspective. Thereturnson investmentsat thesefirmsface littleornotax,whichmightincentthesefirmstoshiftcurrentcompensationintodeferredcompensation,andimposeacostonthepublicfiscthatwemightwishtorecoverthroughaccrualtaxationoraspecialtaxonnonqualifiedplaninvestmentreturns.181 Furtherworkisneededtodeterminehowwidespreadaproblemthisreallyis andwhether the effort involved in specifying and identifying lowmarginal taxratecompaniesandexcessiveuseofnonqualifieddeferredcompensationby thesecompanieswouldbeworthit.182Preliminaryinvestigation,however,suggeststhat457(f). § 457(b) eligible plansprovide limiteddeferral opportunities thatmirrorprivatesectornonqualifieddeferredcompensation,but,becausetheplansponsoristax-exempt,§457(b) plans produce after-tax results similar to those achieved through qualified plans.However,excluding“catch-ups,”themaximum§457(b)contributionfor2015was$18,000per employee. IRS, PUB.NO. 4484, TAX EXEMPT ANDGOVERNMENT ENTITIES EMPLOYEE PLANS(2015). §457(f)ineligibleplansprovideforunlimiteddeferral,buttaxationisimposedatthepointatwhichdeferredamountsarenolongersubjecttoasubstantialriskorforfeiture(SROF). Seealso Mark P. Altieri,NonqualifiedDeferredCompensationPlans, 75 CPAJ. 54,(2005); Kilgour, supra note 27, at 179. In the wake of the enactment of § 409A, whichincorporatesaratherstrictdefinitionofSROFandIRSNotice2007-62,whichsuggestedanintent to apply that definition to § 457(f) plans, some practitioners and commentatorsassumedthatelectivedeferredcompensationwouldbetaxedonanaccrualbasis(althoughtaxontheearningswouldbedeferred).Doran,supranote12,at5n.21;Polsky,supranote40,at640n.24.However,proposedregulationsissuedinJune2016adoptamoreflexibledefinitionof SROF, providing that certainnon-competition agreements can create a SROFandspecificallyrecognizingthatelectivedeferralisnotinconsistentwithaSROFincertainsituations.I.R.S.Reg.147196-07,2016-28I.R.B.SeealsoAmyS.Elliott&AndrewVelvarde,TreasuryFinallyIssuesDeferredCompRulesforTax-Exempts, 2016TAXNOTESTODAY120-1,available at http://www.taxnotes.com/tax-notes-today/benefits-and-pensions/treasury-finally-issues-deferred-comp-rules-tax-exempts/2016/06/22/18521201?highlight=treasury%20finally%20issues%20deferred%20comp%20rules (June 22, 2016). Assuming that the proposed regulations are adoptedessentially as drafted,wemay see increased tax-advantaged deferrals by or on behalf ofexemptorganizationemployees.181Thereisprecedentforapplyingaccrualtaxationtononqualifieddeferredcompensationpaid by tax-indifferent organizations. See I.R.C. § 457(f) (including “ineligible” deferredcompensationofemployeesoftax-exemptentitiesingrossincomeinthefirstyearinwhichthere is no substantial risk of forfeiture); §457A (2012) (applying accrual taxation tovested nonqualified deferred compensation paid by, e.g., foreign companies unlesssubstantiallyallincomeiseffectivelyconnectedwithaU.S.tradeorbusinessorissubjecttoa comprehensive foreign income tax). However, identification of effectively tax-exemptdomesticfirmsmaybesomewhatmoredifficultthanidentificationoftaxindifferentforeignfirms.182The existing literature examining the relationship between firm tax status and use ofnonqualified deferred compensation is slim and relies on rough proxies for companymarginaltaxrates.Thesestudiestypicallyfindnostatisticallysignificantrelationship.SeeKelli A. Alces & Brian D. Galle,TheFalsePromiseofRisk-ReducingIncentivePay:Evidence


42

firmsfacingloweffectivemarginaltaxratesmaynotbeexploitingtheopportunityto minimize their joint tax bills on executive retirement savings through use ofnonqualifieddeferredcompensation.

I analyzed contributions to nonqualified defined contribution accounts forfiscalyear2012bythe“topfive”seniorexecutivesofthecompaniesincludedintheCompustatExecucompdatabase,andbyemployersonbehalfoftheseexecutives.183Deferredcompensationbyandonbehalfof theseexecutives isreported inannualproxy statements. For each firm, I calculated the aggregate of executive andemployer contributions as a fraction of aggregate total compensation for theseindividuals.184Next,IaccessedestimatedU.S.effectivemarginalfederalincometaxrates (EMTRs) for each firm from two sources: 1) estimates produced using themethodology developed by Jennifer Blouin, John Core, and Wayne Guay andprovided in the Compustat database,185and 2) estimates determined by JohnGraham, which are available through his website.186 Although largely similar inapproach, the two sources often provide significantly different estimates. Giventhis,Isortedthefirmsintothreecategories–thosewithaU.S.EMTRof0.10orlessaccordingtotheestimatesofbothGrahamandBlouin,Core,andGuay(lowEMTRfirms),thosewithanEMTRof0.30ormoreaccordingtobothestimates(highEMTRfirms),andallothers. ForthelowEMTRgroupoffirms,totalNQDCcontributionsaveraged only 0.48% of total compensation (0 median), while total NQDCfromExecutivePensionsandDeferredCompensation, 38 J.CORP.L. 53, 99 (2012) (includingNOLlevelandtaxespaidasvariables);WeiCen,TheDeterminantsofCEOInsideDebtanditsComponents 30 (Working Paper, Jan. 2011) (employing an NOL indicator variable);Rangarajan K. Sundaram & David L. Yermack, Pay Me Later: Inside Debt and its Role inManagerialCompensation,57J.FIN.1551,1574,TableVI(2007)(same).183Ofcourse,thefivemosthighlycompensatedexecutivesateachfirmwouldgenerallybeasubset of the population eligible to participate in nonqualified deferred compensationprograms, but this is the only data that is publicly available. The Compustat Execucompdatabase is accessible through the Wharton Research Data Service: https://wrds-web.wharton.upenn.edu/wrds/.184TotalcompensationismeasuredperExecucompvariableTDC1.185JenniferBlouin et al.,HavetheTaxBenefitsofDebtBeenOverestimated?, 98 J.FIN.ECON.195 (2010). In a nutshell, Blouin, Core, and Guay (BCG) develop a nonparametric (non-randomwalk) approach to estimating a firm’s future taxable income that can be used todeterminethetotalpresentvalueofcurrentandfutureU.S.federalincometaxesassociatedwithanadditionaldollarof income today. Usingaccountingdata, they calculate effectivemarginal tax rates both before and after deductions for interest, the latter being theappropriate rate for incremental decision-makingwith respect tomatters such as use ofnonqualified deferred compensation. The BCG effective marginal tax rate database isavailablethroughCompustat.BCG’sestimationapproachisarefinementofthatdevelopedinJohnR.Graham,DebtandtheMarginalTaxRate,J.FIN.ECON.41(1996).AnimplicitassumptioninutilizingeitherBCGorGraham’smarginaltaxratedataisthattheincome generated on deferred compensation is taxed in the U.S. Given the effectiveprohibition under I.R.C. § 409A on offshore rabbi trusts, this seems a reasonableassumption,atleastforalargefractionofdeferredcompensation.186https://faculty.fuqua.duke.edu/~jgraham/


43

contributionsaveraged4.24%oftotalpayforthehighEMTRgroupoffirms(0.68%median).187Despitethepotential jointtaxadvantage,participationinnonqualifieddeferredcompensationatlowEMTRfirmsappearstoberelativelymeager.188

I plan to investigate the relative paucity of nonqualified deferredcompensation participation at low marginal rate firms in future work, but threepotential explanations come immediately to mind. First, some firms with loweffective marginal rates may be on shaky ground financially, in which caseexecutives might be loath to defer current compensation in exchange for anunsecured promise to pay in the future. Second, nonqualified deferredcompensationuse varies by industry and industry effectsmay explainpart of thepicture. Third, consistentwith recent survey evidenceprovidedby JohnGraham,MichelleHanlon,TerryShevlin,andNemitShroff,189somefirmsmaynottaketheirloweffectivemarginal taxrates intoaccount indecidinghowaggressively topushnonqualifieddeferredcompensation.

Furtherworkmaysharpenorevenflipthispicture.Aftercontrollingforfirmsize, industry, etc., it may turn out that low effective marginal tax rate firms doexploitthenonqualifieddeferredcompensationopportunity.Evenifthatturnsouttobethecase,however,asdiscussedbelow,itseemslikelythatshareholdersenjoythebenefitofthetaxsavingsondeferreddollarsatlowmarginaltaxratefirms,notplanparticipants.190Ifso,thisdistributionalconsequencewouldnotalleviatealloftheconcernsassociatedwithtax-preferrednonqualifieddeferredcompensationuseby loweffectivemarginal tax rate employersbutwouldmitigate the concern thatthesubsidyflowstohigh-incometaxpayers.

***** Withrespecttotaxableplansponsorsfacingmarginaltaxratesatornearthestatutory maximum, and setting COLI use aside, nonqualified deferredcompensationinpracticeseemstoyieldlittleornoaggregatejointtaxadvantage.187Thedifferenceinmeansisstatisticallysignificantatthe1%level.62firmssatisfiedthelowEMTRcriteria;492satisfiedthehighEMTRcriteria.188Data fromother years yields a pattern that is generally consistentwith the 2012datadiscussedherein.189JohnR.Grahamet al.,TaxRatesandCorporateDecisionMaking (WorkingPaper,March2016) (evaluating survey responses from tax executives at 500 companies subject to theU.S.corporatetaxandfindingthatmostfirmsuseeithertheU.S.statutorytaxrateortheirGAAPeffectivetaxrate(anaveragerate) insteadofeffectivemarginal taxrates inmakingincremental decisions). To be sure, while statutory rates will generally be larger thanmarginalrates,theGAAPeffectiveratecanbelargerorsmallerthanthemarginalrate.190InfraPartIV(B)(arguingthatnonqualifiedDCplanparticipantsgenerallyenjoyeffectiveabove-marketreturnswhetheremployedbytax-payingoreffectivelytax-exemptemployersand thatshareholdersbear thecosts, ifany,associatedwith taxationofgainsondeferredamountsheldbyemployers).


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Ofcourse,onemighttakeadifferenttackentirelyandarguethatthepolicyfocusshouldbeonpotentialjointtaxadvantage,notrealizedadvantages. Thefactthata firmfails torealizeapotential joint taxadvantage inthisareamightsimplyreflectbetterafter-taxopportunitieselsewhere.Forexample,firmsthatfailtofullyhedgenonqualified liabilitiesnotionally invested individendpayingequitiesseemto be squandering the benefit of the dividend received deduction, butmight justhavebetterusesforthefunds.

Oneresponsetothislineofargumentisthatfirmsoftendosetasideassetstosatisfy nonqualified plan liabilities and sometimes the result is a clear joint taxdisadvantage,suchaswhenfirmshedgenotionalinvestmentingrowthstockswithtaxable funds. Another response is that the concerns of those advocating for aspecialtaxoraccrualtaxationarelessinevidencewhen,forexample,afirminvestsfreed up assets in its business generating robust but relatively high-tax returnsratherthanhedgingparticipantnotionalinvestmentsatrelativelylowrates.Whereis thecost to fisc, subsidyofhigh-earnersavings,ordistributionalconcern in thatscenario?

B.WhatAretheDistributionalConsequencesofDeferredCompensation?

Nonqualified defined contribution plan terms typically mirror those ofqualified plans, such as 401(k)s, promising participants returns on their notionalinvestments that are undiminishedby tax during the deferral period; i.e., tax-freegrowth. Nominally, participants gain an advantage – the difference between pre-andpost-tax returns191- and shareholdersbear the cost of providing this tax-freeinvestmentgrowthtoplanparticipants, totheextentthatthe firmincurstaxesonthe returns on the deferred dollars. Many plan sponsors also match participantdeferralstosomedegreeormakeothercontributionstononqualifiedaccounts.Butonemayquestionwhetherortowhatextentthesebenefitsareshiftedbacktothefirmandshareholdersthroughadjustmentstoothertermsofcompensation.

Theshortanswer is thatwedon’tknowthedistributional consequencesof

thesearrangements.However,forseveralreasons,Iamskepticalthatthenominalbenefitoftax-freegrowthondeferreddollarsisshiftedawayfromplanparticipants.First, the population of participants is heavily weighted in favor of a firm’smost

191 The advantage can be substantial when returns are substantial. Applying theassumptionsemployedbyProfessorsHalperinandWarren in theirexample,anexecutivedeferring compensation in a nonqualified plan operating under these terms couldaccumulate30%moreassetsovertenyearsthanshecouldbyinvestingafter-taxpayinthesame instrument. SeeAppendix. Tobesure,HalperinandWarrenemploya10%annualpre-tax rate of return to simplify their example, a return that has not been generallyachievableforsometime.Ontheotherhand,theyalsoassumea30%individualmarginaltaxrate,whichexceedsthetopeffectiverateonindividualequityreturnsbutisfarlessthanthecurrent topeffective rateondebt returns. Thenetadvantage toparticipants in theseplansincreaseswithpre-taxreturnsandwithindividualtaxrates.


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highly compensated andmostpowerful employees. Second, the cost of providingwhat are effectively above-market returns is not specifically disclosed toshareholders. Firms are required to disclose above-market returns accruing ondeferredcompensationaccountsheldby theirmost seniorexecutives,but returnsthatmatch thoseavailableunderqualifiedplansarenotconsideredabove-marketreturns for the purposes of these disclosures, even if plan sponsors incur greatercosts in delivering these returns on nonqualified accounts.192 Third, DC planparticipationislargelyelectiveandbynomeansuniversal.Itwouldbedifficultforfirms to adjust other terms of compensation to offset the deferred compensationreturn advantage when less than half of eligible individuals elect to defercompensation in any given year.193 Fourth, some firms provide explicitly above-market returnsonnonqualifieddeferred compensation.194 Itwould seemodd forfirmssubjecttoinvestorscrutinytoprovidesuchvisiblebenefitsthroughthefrontdoor and then to remove them surreptitiously through the back door. Fifth, torepeat, most nonqualified DC participants are getting the same deal as 401(k)participants. The dollars are larger and the firm tax consequences are lessfavorable,butfirmsareunlikelytoadjustothertermsofemploymenttooffsetthisobscure advantagewhen the arrangement seems comparable on the surface to a401(k).

Of course, at firms that are effectively tax-exempt or that face very low

effectivemarginalrates,therewouldbelittleornocosttoprovidingtax-freegrowthonnonqualifieddeferredcompensationdollarsfortheshareholderstobear. ButIsee no reason to think that plan participantswould realize a better deal at thesefirms;noreason,inotherwords,tothinkthatthefirm-leveltaxbenefitwouldflowthroughtoparticipants.Ofcourse,itmight.Plansmightbemoregenerousorothercompensation terms more generous at these firms, reflecting the tax savings onnonqualified deferred compensation, but this seems unlikely. Absent evidence tothiseffect,itseemssensibletoassumethatshareholders,notparticipants,enjoythetaxsavingsatthesefirms.

In sum, it seems likely that DC plan participants enjoy returns that are

undiminishedbytaxduringthedeferralperiod.Insomecases,providingthisreturnresultsinnocosttoshareholders.Thiswouldbethecaseateffectivelytax-exemptfirms and at tax paying firms to the extent that participants and sponsors take

192SEC,REG. S-K,COMPLIANCE&DISCLOSURE INTERPRETATIONS § 219.01 (Jan. 24, 2007) (“Aregistrantneednotreportearningsoncompensationthatisdeferredonabasisthatisnottax qualified as above-market or preferential earnings within the meaning of Item402(c)(2)(viii)(B)wherethereturnonsuchearningsiscalculatedinthesamemannerandatthesamerateasearningsonexternallymanagedinvestmentstoemployeesparticipatinginatax-qualifiedplanprovidingforbroad-basedemployeeparticipation.”).193NewportGroupSurvey,supranote37,at21(reportingthat46%ofeligible individualselectedtodefercompensationin2013).194Inmysampleof40S&P500companieswithactivenonqualifieddeferredcompensationplans,twoprovidedexplicitlyabove-marketreturns.


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advantageofIRC§1032.Inothercases,shareholderslikelybearacostthatmayberelatively low (e.g., when COLI products are employed) or quite significant (e.g.,whenparticipantaccountsarehedgedwithtaxableinvestmentinsecurities.

I alsosuspect,butam lessconfident, thatemployermatchingcontributionsmadetononqualifiedDCaccountsarenotoffsetbyothertermsofemployment.Allof the arguments favoring participant retention of above-market returns apply toemployercontributionsexceptfortheirvisibility.Thesecontributions,totheextentreceived by the NEOs, are explicitly disclosed in a prominent table in companyproxy statements. In this sense, matching contributions are similar to otherperquisitesthatarereceivedbyseniorexecutivesandaredisclosed.Thedifference,I think, is thatexecutiveparticipation inqualified401(k)andnonqualified401(k)supplementalprogramsseemsegalitariancomparedtomanydisclosedperks,suchasuseofcompanycarsandplanes.Asaresult,investorsmaybemorelikelytoviewcompanymatching dollars as an expected incident of employment, not an addedgive-awaytoexecutives.

ThedistributionalconsequencesofnonqualifiedDBplansarealsosomewhat

unclear,butitremainslikelythatparticipantswin,whileshareholdersloseorbreakeven.AswithnonqualifiedDCplans,nonqualifiedDBplansoftenmirrorthetermsofthecorrespondingqualifiedDBplans.Thetermsoftheplansincorporatethetaxadvantagesofqualifiedplans.And,again,othercompensationtermsareunlikelytobe adjusted because the benefit is not disclosed and is obscure, and becauseparticipation is focusedat the topof the corporatehierarchy. On theotherhand,nonqualified DB plans tend not to be elective, making it easier for employers toadjustothertermsofemployment,iftheyweretochoosetodoso.

Tobesure,nonqualifiedplanparticipantspayapricefortheirabove-market

returns and employer matching dollars. Even if their notional investments arediversified, these individualsremainunsecuredcreditorsand face theriskof totalloss of nonqualified benefits in the event of company bankruptcy. And, given§409A, it is much more difficult to protect against this possibility than it wasformerly.195 However, participation in nonqualified plans is almost entirelyvoluntary. Use of these plans indicates that the perceived benefits outweigh therisks.196

C.WhatRoleDoTaxesPlayintheAdoptionorOperationofNonqualifiedDeferredCompensationArrangements?

195SupraPartI(C).196Should the SEC mandate disclosure of effective above-market returns provided tononqualifieddeferredcompensationparticipants?Inprinciple,theyshould,butestimationofthebenefitwouldbecomplexasitdependsonratesofreturnachievedoverthedeferralperiodaswellasoncurrentandprojectedindividualtaxrates.Giventheapparentlylimitedimpactofexecutivepaydisclosureson themagnitudeofexecutivepay (seeWalker,supranote75,at246),itisnotclearthatthebenefitsofsuchdisclosurewouldjustifythecosts.


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Consistentwiththeforgoinganalysis,Iseelittleevidencesuggestingthatthejointtaxconsequencesofnonqualifieddeferredcompensationarrangementsareoffirst order importance in the decision to offer these plans or in the selection ofinvestments. If jointtaxconsequenceswerethedrivingforceonewouldexpecttoseeprogramsstructuredtoencouragenotionalandactualinvestmentinthetypesofinstrumentsthatyielda large jointtaxadvantage–companystock, incomestocks,anddebtsecurities.Butthereislittleevidenceofthis.Own-companystockappearsto be used at least as commonly in qualified plans, where §1032 provides noincremental benefit, as in nonqualified plans.197 Sources suggested that typicalnonqualifiedDCnotionalinvestmentportfoliosaresomewhatmoredebtheavythanthose found in 401(k)s. This might suggest tax-motivated allocation of debtinstruments to nonqualified plans, but these allocations are also consistent withshorter expected investment horizons for riskier unsecured nonqualified planinvestment,sothisisnotstrongevidencethattaxationisoffirstorderimportance.Thereisnoevidencesuggestingthatincomestocksrepresentagreaterproportionofnonqualifiedplanportfoliosthantheydoofretirementportfoliosmoregenerally.All indications suggest that DC plan notional investment menus are designed tomeetthelong-termsavingsneedsofparticipants,nothingmore. When asked whether “compensat[ing] executives in a more tax-efficientmanner,”was an important goal for their nonqualifiedbenefits programs, 18%ofrespondents to the Newport Group’s survey reported that thiswas critical, while52% rated this goal as very important.198 My source at the Newport Groupexplained, however, that this goal referred to tax efficiency from the executives’perspective.199 Firms think it important to provide their executives and highlycompensated employeeswith expandedqualified plan-type savings opportunities.Thiswasnotmeanttobeaquestionaboutjointtaxconsequences,andmycontactdidnotthinkitlikelythatsurveyrespondentsinterpreteditthatway.200 Havingdecided toofferanonqualifiedplan, joint taxconsiderationsclearlyplay an important role, at a certain level. Companies will not intentionallytrigger §409A,andsourcesreportedthatconsultingopportunitieshaveincreasedinthewakeof§409A’senactment,giventheadditionalcomplexityandhighstakesassociated with missteps.201 Reportedly, the use of COLI boils down to simpleeconomics,tradingoffthetaxbenefitsofCOLIagainstitscostandotherconstraints. However, as noted above, notional investment choices and actual use ofdeferred amounts do not reflect joint tax minimization. In this area as in manyothers,accountingconsiderationsappeartobeasormoreimportantthantax.

197Infratextaccompanyingnotes212-214.198NewportGroupSurvey,supranote37,at7.199ShannonInterview,supranote103.200ShannonInterview,supranote103.201InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39.


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Professor Doran has suggested that another tax rule, IRC §162(m), couldhelp explain the prevalence of nonqualified deferred compensation.202 Under§162(m),thedeductionfornon-performancebasedcompensationpaidtoapubliccompany’sCEOand the threemosthighly compensatedexecutivesother than theCEOislimitedto$1millionperexecutiveperyear. Deferringsalaryorothernon-performance-based compensation in excess of $1million until an executive is nolonger one of these “covered employees”would allow a firm to deduct otherwisenondeductible pay. Doran also notes that executiveswho are residents of stateswithhighstate incometaxratescandefercompensationuntil theyretire toa low(orno)taxstateandreduceoreliminatethestateincometaxburden.203

It iscertainlypossiblethat thesetaxrules influencetheuseofnonqualifieddeferredcompensation.Indeed,itseemslikelythatexecutiveswouldtakepotentialstate incometaxburdens intoaccount in theirpersonalplanning. Iamsomewhatskeptical that §162(m) plays a significant role, given that it applies only to fourindividualsateachcompany,thatmostcompensationotherthanannualsalarycanbe readily designed to satisfy the “performance based” exception to non-deductibility, and the fact that participants, not firms, generally elect whether todefercompensationandforhowlong.Buttheseareempiricalquestions,and,inanyevent, even if nonqualified deferred compensation is being used to maximizedeductibilityunder§162(m)oravoidstate income taxes, it’snot clear thateitherwouldjustifyreformofdeferredcompensationtaxation,perse.204

D.Why(Else)DoFirmsOfferNonqualifiedDeferredCompensation?

Over80%offirmsrespondingtotheNewportGroup’ssurveyreportedthatitwas critical or very important “to allow executives to accumulate assets for theirfinancialplanningneeds”and“tohaveacompensationprogramthatiscompetitivewith peer companies.” 205 Interview responses supported paternalism andcompetition as the leading drivers of nonqualified programs.206 But sources alsosuggested that theseprogramsare in flux. Paternalismmay remainan importantfactorinsomeindustries(utilitieswerefrequentlymentioned)butlesssoforstart-202Doran,supranote62.203Doran, supranote 62, at 23-24 (describing the federal legislation that protects certainretirementincomefromout-of-statetaxation).Seealsosupranote107(discussinghowthedetailsofthisstatutemayinfluencethedesignofnonqualifiedDCplans).204As Doran notes, and as others have recognized, the limitation on deductibility under§162(m) ispoor taxpolicy. Fulldeductibilityof compensation is consistentwithgeneraltaxprinciples,andthe§162(m)limitationwasamisguidedattempttoshapecompensationpracticesthroughthetaxcode.Doran,supranote62at51.Doranfindsavoidanceofstatetaxmoreobjectionable,and Iagree,butarguably therootproblem is the federal lawthatpre-emptsout-of-statetaxationofcertainretirementincome.Id.at23.205NewportGroupSurvey,supranote37,at7.206InterviewwithExecutiveBenefitsConsultantswithanInternationalFirm,supranote39(competition);TelephoneInterviewwithMichaelT.Schoonmaker,Principal,Ernst&Young[hereinafterSchoonmakerInterview](Feb.23,2016)(paternalism).


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ups and firms in the tech and financial industries.207 Rational, utility-maximizingexecutives should not need a company-sponsored plan to put away assets forretirementorcollegeexpenses.

On the other hand, if I am right about the distributional effects ofnonqualifiedplans,participantsenjoyanopportunitytoinvestontermsthatarenotgenerallyavailable. Recall thatplansdonotmerelyprovideparticipantswith theafter-taxreturnsachievablebytheiremployersondeferredsums,butreturnsthatare wholly undiminished by tax during the deferral period. As detailed in theAppendix,applyingtheassumptionsemployedbyProfessorsHalperinandWarrenin their example, an executive deferring compensation in a nonqualified planoperatingunderthesetermscouldaccumulate30%moreassetsovertenyearsthanshe could by investing after-tax pay in the same instrument.208 Moreover, it iscertainly not a bad thing, from the perspective of boards and executives, that theopportunity to achieve tax-free growth on nonqualified deferred compensationportfoliosdoesnot factor intothecalculationof total“top5”compensationthat isprominentlydisclosedinannualproxystatements.Whilethispaperdoesnotarguethatmanagerial power drives the use of nonqualified deferred compensation, thefailuretotreatthisyieldadvantageasanabove-marketreturnrequiringdisclosureunder SEC rules is consistentwith the preference for low salience pay under themanagerialpowerview.209

Pathdependencemayalsoplayarole.Nonqualifieddeferredcompensation

arrangements date back at least to World War II when top individual tax ratespeakedat94%,whilecorporatetaxratestoppedoutat40%.210Althoughusageofnonqualifieddeferredcompensationremainedfairlymodestpriortotheadoptionofqualified plan limitations in the 1980s,211companies and executives would haveenjoyed large joint tax advantages on nonqualified arrangements throughout thisperiod. Today, absent COLI, that driving force is often lacking, but once acompensationpracticethatbenefitsexecutiveshasbecomecommonplace,itcanbe

207SchoonmakerInterview,supranote206.208As noted supra, Halperin andWarren employ a 10% annual pre-tax rate of return tosimplifytheirexample,areturnthathasnotbeengenerallyachievableforsometime. Ontheotherhand,theyalsoassumea30%individualmarginaltaxrate,whichexceedsthetopeffectiverateonindividualequityreturnsbutisfarlessthanthecurrenttopeffectiverateon debt returns. The net advantage to participants in these plans increaseswith pre-taxreturnsandwithindividualtaxrates.209See supra note 76 for a very brief description of the managerial power view of theprocessesinvolvedinsettingexecutivecompensation.210ChristopherDrew&DavidCay Johnston,SpecialTaxBreaksEnrichSavingsofMany intheRanksofManagement,NYT(Oct.13,1996)(notingthat“manycompaniesbeganlettingexecutives defer pay as the highest tax rate surged from 7 percent to 94 percent duringWorldWarII).211Id. (discussing the adoption of limitations on 401(k) contributions in 1986 and onpensionplansin1988and1993).


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difficult to eradicate, particularly when the benefits are poorly disclosed and notsalient.

Finally, while I am skeptical that executives can accurately predict their

futuremarginal taxrates,electiveplansdoprovideparticipantsanopportunity tomakeabeton lower individual rates at retirement (eitherdue to a change in thebrackets or their position within the brackets), if they wish to do so. Someexecutives might find this option to be valuable, and firms might respond toexecutives’demandforthatoption.

E.AFinalMystery?RelativeUseofOwn-CompanyStockinQualifiedandNonqualifiedDeferredCompensationPlans

It is interesting to compare notional investment of nonqualified deferredcompensation in own-company stock and informal funding of nonqualified planobligations with own-company stock with qualified plan investment in own-companystock.Historically,atleast,onewouldfindasmuchormoreown-companystockinqualifiedasinnonqualifiedplans.Between1985and1998,14%oftotalDCqualified plan assets of a broad sample of firms were invested in own-companystockonaverage.212 In2002,morethan50%ofemployeeassetswereinvestedinown-companystockat18ofthelargest100corporatequalifiedDCplansponsors.213In2005,17%ofparticipants inqualifiedDCplansadministeredbyVanguardhadover20%oftheirbalancesinvestedincompanystock.214 Froma joint taxperspective, this seemsodd. There is a significant cost intermsoflostdiversificationtoinvestinginown-companystock,215acostthatshoulddampen the appetite for own-company stock in retirement plans. While §1032results ina jointtaxadvantageforown-companystockinvestmentinnonqualifiedplans, and could offset the diversification cost to some degree, it provides noincremental benefit for own-company stockplaced inqualifiedplans.216Qualifiedplan trust assets grow tax free in anyevent.217Of course, not all employeeshave212Joshua D. Rauh, OwnCompanyStock inDefinedContributionPensionPlans:ATakeoverDefense?,81J.FINECON.379,388,table3(2006).213Rauh,supranote212,at382.214STEPHENP.UTKUS&JEANA.YOUNG,VANGUARDGROUP,THEEVOLUTIONOFCOMPANYSTOCKINDEFINEDCONTRIBUTIONPLANS5(May2014).HoldingsofcompanystockinqualifiedDCplanshas declined since the enactment of the Pension Protection Act of 2006, which requirespublic company plan sponsors to allow participants to diversify employer stockcontributions after three years and their own contributions at any time. 26 C.F.R. §1.401(a)(35)-1(2016);UTKUS&YOUNG,supra,at3.215Benartzietal.,supranote74,at50,putthecostatroughlyfiftycentsonthedollar.216Halperin&Warren,supranote32,at326(notingthattherelativeadvantagecreatedbyqualifiedplan exemptionof investment returnsdepends on the tax treatment of an assetclassoutsideofaqualifiedplan).217Duringthedeferralperiod,earningsonown-companystockfaceazerotaxratewhetherheld inaqualifiedplantrustor inasegregatedaccount informally fundinganonqualified


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accesstobothqualifiedandnonqualifiedplans,butfromajointtaxperspectiveitissurprising thatown-companystockwouldbeusedasormoreheavily inqualifiedplansasinnonqualifiedplans. A number of commentators have attempted to explain the use of own-companystockinqualifiedplans. Atonelevel, theuseisattributabletoemployercontributions in stock and to plan structures, such as defaults, that encourageemployeeinvestmentinstock.218Butwhydofirmsstructureplansinthiswayandwhy do employees accept these defaults, given the cost to diversification?Professors Benartzi, Thaler, Utkus, and Sunstein conclude that employeesunderestimatetheriskofholdingemployerstockwhileemployersoverestimatethebenefits in terms of enhanced productivity.219 But if so, why are notionalnonqualified plan investments in company stock lower? Is it because moresophisticatedexecutivesaremoresensitivetothevalueofdiversification? Professor Joshua Rauh has offered a corporate governance explanation forthe use of company stock in qualified plans.220 He observed that stock held inqualified plan accounts is in friendly hands in the event of a corporate controlcontest asworkers,whomay fear job losses, are likely to votewithmanagement.Rauh found that state law changes that increased takeover protections wereassociatedwithreducedown-companystockholdingsin401(k)s.221 WhileBenartziandcolleaguesconcludethatthemagnitudeofRauh’sresultswasnot large,222Rauh’sstorycouldhelpexplainwhyarelativetaxadvantagefailsto drive own-company stock out of qualified plans and into nonqualified plans.Unlikeown-companystockheldinaqualifiedplantrustthatwouldbevotedbythetrustee (or the employee if the vote is passed along), notional investment inemployer stock within a nonqualified plan is simply a bookkeeping entry thataffordsnovotingrights.Moreover,anyfundssetasidebythesponsorandactuallyinvested in own-company stock yields non-voting Treasury stock. In short, own-companystock“investment”innonqualifiedplansprovidesnotakeoverprotection. On the other hand, the accounting impediments – the inability to hedgeincome statement volatility arising from participant notional investment in own-company stock in nonqualifiedDC plans – are not a factorwith respect to actualinvestment inemployerstockwithinqualifiedplans. There isbothmoreofapull

plan liability. The difference is that other asset classes are also zero taxedwhile held inqualifiedplantrustsbutfacepositivetaxratesbackingnonqualifiedplanobligations,unlessaCOLIisused.218Rauh,supranote212,at380.219Benartzietal.,supranote74,at68.220Rauh,supranote212,at390.221Rauh,supranote212,at380.222Benartzietal.,supranote74,at61.


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(entrenchment) and less of a brake (accounting) associated with own-companystockinvestmentinqualifiedplans.223

V.Conclusion The real world tax consequences of complex nonqualified deferredcompensationprogramsdependsignificantlyonemployerandemployeepractices.Unfortunately, currently mandated corporate disclosures shed only limited lightuponthesepractices. However, interviewswithparticipantsandindustrysurveysprovide insights that suggest that the joint tax consequences of nonqualifieddeferredcompensationaremixed,at leastwithrespect toprogramssponsoredbytaxableandtax-payingemployers.Theuseofcorporateownedlifeinsuranceasaninformal fundingvehicle fornonqualifieddeferredcompensation results ina jointtaxadvantage,ofgreaterorlesserextentdependingonwhenpoliciesarecashedin,butfundingliabilitieswithtaxablesecuritiesorplowingdeferredamountsbackintothebusinessisaslikelytoresult inajointtaxdisadvantageasanadvantage. Thisevidence suggests that,whileCOLIuse and taxationmaydeserveanother lookbypolicy makers, the driving force behind fundamental reform of nonqualifieddeferredcompensationtaxationmaybelimited. Moreover,while lossfirmsfacinglow effective marginal rates can create a joint tax advantage through use ofnonqualified deferred compensation, preliminary investigation suggests that theyrarelydoso.Perhapstheheightenedriskassociatedwithanunsecuredpromisetopayoutweighsthepotentialtaxsavingsatlossfirms. Even if nonqualified deferred compensation does not turn out to be asubstantialdrainonthepublicfisc,thisArticlehasarguedthatitlikelyprovidesanundisclosed advantage to corporate executives, as it provideswhat are effectivelyabove-market returns on retirement savings. As a result, it appears thatshareholders, not taxpayers, often subsidize nonqualified deferred compensation.TheSECshouldconsiderrevisingitsrulestomandatedisclosureofthisadvantage.

223There are other differences that might help explain greater use of employer stock inqualifiedplans,andtwoofthemaretaxdifferences.First,in-kinddistributionsofcompanystockfrom401(k)smaybetaxpreferred.Inanutshell,ifcompanystockheldinaqualifiedplan is delivered to a participant as stock, only the market value at the time of thecontributionistaxedasordinaryincome;gainsaretaxedascapitalgainsandaredeferreduntildisposition.Bycontrast,proceedsreceivedonthedistributionofmutualfundsheldin401(k)andotherqualifiedplans(thatarenotRothplans)arefullytaxedatordinaryincomerateswhenwithdrawnfromtheplan(orfromarolloverIRA).I.R.C.§402(e)(4)(B)(2012);Benartzi et al., supra note 74, at 50. Second, employers can deduct certain reinvesteddividendspaidonstockheldinqualifiedplantrusts.I.R.C.§404(k)(2012);Benartzietal.,supranote74,at59-60.Onbalance,however,thesimilaritiesanddifferencesintheuseofemployer stock inqualified andnonqualifiedplans reinforce the conclusion that joint taxconsequencesaresecondorderconsiderationsintheoperationoftheseplans.


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Appendix

Illustration of the joint tax consequences of nonqualified deferredcompensation fromHalperin&Warren (2014) at328. (The following example issimplified,excludingthedemonstrationthatthetimingoftheemployer’sdeductiondoesnotaffectthejointtaxconsequences.)224

EmployeeEhastheopportunitytoreceive$100,000incurrent

compensation fromemployerER,whenE’s taxrateonallsourcesofincomeandgain is30%andER’s is20%. IfE investedtheafter-taxamount ($70,000) at an annualpretax returnof10%,Ewouldhave$137,701intenyears($70,000X1.0710). Now suppose that E agreed to forgo $100,000 in currentcompensationinexchangeforapaymentintenyears.ER’sdeductionisdeferredasrequiredbycurrentlaw. HoldingER’sYear0positionconstant,ERcansetaside$80,000inYear0,whichwouldcompoundto $172,714 ($80,000 X 1.0810) in ten years. That amount wouldpermitER topayEadeferredamountof $215,892after taking intoaccount the tax benefit ($43,178) of the compensation deduction,leavingEEwith$151,124aftertax. The advantage to E from deferral is $13,423 ($151,124 -$137,701), which is due to the investment compounding at theemployer’s after-tax rate rather than the employee’s after-tax rate(thatis,$70,000X(1.0810-1.0710)=$13,423).

Inpractice,employersoftenpromisenonqualifiedplanparticipantsreturns

that are equivalent to those achievable with qualified plans, i.e., returnsundiminishedby taxduring thedeferralperiod. Assuming thatcostsandbenefitsarenotredistributedthroughothertermsofcompensation,theimpactonEandERinHalperinandWarren’sexamplescenariowouldbeasfollows.

E agrees to forgo $100,000 in current compensation in

exchange for a payment in ten years. The notional investmentcompounds at a 10% rate yielding $259,374 at payout ($100,000 X1.1010),leavingEwith$181,562aftertaxes,anadvantageof$43,861(or32%)versusE’soutsideinvestmentopportunity.

Theafter-taxcosttoERofprovidingapaymentof$259,374is

$207,499, resulting in a $34,785 (20%) funding shortfall versus the$172,714compoundafter-taxbalanceonthesetasidefunds.

224Halperin and Warren provide a corresponding algebraic demonstration. Halperin &Warren,supranote32,at328-29n.33.

Documents

David I. Walker ABSTRACT