In a recently released private letter ruling, the Internal Revenue Service (IRS) held that a nonqualified deferred compensation payment to a charity (which is tax-exempt) would still be deductible by the employer. While the holding itself is not unexpected, some of the reasoning used by the IRS is interesting.
The letter ruling involved a corporation that adopted a nonqualified deferred compensation plan for a group of highly compensated employees. The plan allows the employees to defer portions of their salary and incentive compensation. The deferred compensation is payable upon death, separation from service, or termination of the plan. An employee is allowed to designate the beneficiaries to receive the deferred compensation in the event of the employee's death.
One employee participating in the plan designated his spouse as his beneficiary if she survives him by at least 45 days and does not disclaim the deferred compensation. In any other event, however, the amount is payable to a qualified charity.
Under the normal deduction rules for nonqualified deferred compensation, deferred compensation is deductible by the employer only in the taxable year in which the amount attributable to the contribution is included in the gross income of the employee. Also, the Treasury regulations recognize that the deduction is available even if the employee excludes some or all of the compensation from gross income under certain specific exclusions. The letter ruling says that those exclusions show that contributions are considered includable in gross income of an employee for purposes of these deduction rules even if it is excluded from the gross income of the beneficiary.
The IRS held that if the spouse makes a qualified disclaimer with respect to the deferred compensation or predeceases the employee so that the charity is the designated beneficiary of the deferred compensation, the deduction will still be allowed.
As part of its reasoning, the IRS spends most of the analysis discussing the rules regarding income with respect to decedent (IRD). The ruling also discusses the estate tax rules on qualified disclaimers.
Under the IRD rules, if amounts that would otherwise be taxable income to a decedent if they were received before death are not taxed before death, then those amounts are IRD and are includable as taxable income in the taxable year of the decedent's death or in the income of a beneficiary of the decedent who received the IRD. The IRS points out that the IRD rules state that if an estate or other person entitled to receive funds sells the right to those funds, then the fair market value of that right or the amount received upon the sale, whichever is greater, is includable in the gross income of the seller. The IRS also says that if the right is disposed of by gift, the fair market value of the right at the time of the gift must be included in the income of the donor. This may indicate the IRS view that either the estate or the surviving spouse (if a disclaimer is made) would have taxable income by reason of these funds going to charity.
As part of its discussion of the qualified disclaimer rules, the IRS says those rules provide that, in the case of a qualified disclaimer of an interest in property, the estate and gift tax rules (but not the income tax rules) of the Code apply with respect to the interest as if the interest had never been transferred to the disclaiming person. By pointing out the disclaimer rules that apply for estate and gift tax purposes, the IRS may be indicating that the concept of those rules does not apply for income tax purposes. Although the IRS does not say so in the ruling, it can be argued that either the spouse or the estate has taxable income by reason of the payment to the charity.
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