Deferred comp plans termed unfair ‘tax avoidance’

The Democratic staff of the Senate Finance Committee has issued a report that calls nonqualified deferred compensation plans an unfair “tax avoidance” strategy and recommends ways to close “abusive loophole(s)” in the law.

The report also highlights other methods of “manipulating the timing of any taxes paid and minimizing the amount of tax that does get paid,” and makes several suggestions it said will cut tax avoidance and will also make the tax code “fairer and simpler overall.”

NQDC plans, however, are squarely in its sights.

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According to the report, “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions,” NQDC plans, along with several other strategies, are said to allow income to be manipulated to maximize tax benefits, either by postponing it or allowing it to grow tax-free or tax deferred.

The report, released as Congress begins to consider tax reforms, was produced by the staff of Sen. Ron Wyden, D-Oregon, ranking member of the committee. The strategies in the report were identified by the nonpartisan staff of the Joint Committee on Taxation and outside independent experts. They are categorized as the province of high-income earners, thus out of the reach of the average taxpayer and, according to the report, inherently unfair.

After going into detail on five other “tax avoidance” strategies and how they work, the report tackled the strategy of deferring compensation.

Many ways in which compensation can be deferred, it said, are provided to “executives and management employees.” But those same ways are inaccessible to “rank-and-file employees” who “only have the opportunity to defer compensation within very prescribed statutory limits, such as under a 401(k) plan or by contributing to an IRA.”

The report singled out NQDC plans as “raising a number of issues of fairness.”

NQDC plans not only allow a highly compensated employee to postpone receiving income for as long as 20 years — or even longer — without being subject to taxes on the money, but also “provides highly compensated employees with the compounding benefit of accruing earnings tax-free during the deferral period,” the report said.

The maximum deferral that rank-and-file employees can take advantage of is limited to $18,000, and that’s only by means of 401(k)s or IRAs. “Contrast that with a NQDC arrangement, which has no limitations on the amount of deferral,” the report said.

Not only are such strategies unequal, the report said, they are also inefficient and they cost the taxation system money — a lot of money — because of the “inconsistent taxation of financial products.”

Two comparably sized portfolios belonging to people in different jobs are treated differently, taxwise. That gives some taxpayers advantages, and causes the others to expend both time and money looking for more beneficial tax strategies that can benefit them.

The report went on to make a number of recommendations with regard to each of the six “tax avoidance” strategies it identified. For NQDC plans, it had plenty to say.

First, it called attention to a provision in a draft discussion of tax reform from Rep. Dave Camp, R-Michigan, the former chair of the House Ways and Means Committee. That provision “provides that under a NQDC plan, all compensation deferred under the plan would be included in gross income for the taxable year of vesting.”

That single provision is estimated as being able to raise $9.2 billion in taxes over 10 years. The report said it should be adopted.

Next, the report suggests that it is unfair that rank-and-file employees are subject to a limit on the amount of income they can defer, while highly paid employees are not. One solution it offered to that is capping at $1 million the amount of income that can be deferred through NQDC plans.

Last but not least, it pointed out that NQDC arrangements can allow evasion of tax code section 162(m)’s deduction limit on executive compensation. Under 162(m), it said, employers may not deduct compensation paid to certain senior executives in excess of $1 million, subject to some limitations.

But, the report says, if by means of a NQDC plan the compensation is deferred until the employee has retired, the $1 million cap restriction no longer applies. That’s because, under what the report terms an “abusive loophole,” compensation is only subject to the cap if it is paid during a year when the employee is a senior executive on the last day of the year.

So all the employee has to do is take advantage of a NQDC plan to put off compensation until Jan. 1 of the year following his retirement. That means his employer is not subject to the deduction limit on his compensation.

In addition to the other recommendations it makes for tax reform, regarding not only NQDC plans but also the other “tax avoidance” strategies, the paper also advocates that this particular loophole be closed.