Tax-exempt entities may establish as many as three types of tax-favored retirement plans. They may, of course, establish qualified retirement plans. They may also establish Sec. 403(b) plans, generally known as tax-sheltered annuities. The tax law treats distributions from qualified plans and tax-sheltered annuities similarly, a treatment generally familiar to tax practitioners.
Less familiar, though, is the tax treatment of distributions from eligible retirement plans that most types of tax-exempt entities can establish. These eligible exempt entity plans are unfunded plans designed for select groups of management or highly compensated individuals (and are sometimes referred to as “top-hat” plans). Note that governmental units and churches, though tax exempt, may not establish these plans.
The Employee Retirement Income Security Act (ERISA) generally requires that employers fund retirement plans through a trust or custodial account. The top-hat exception to that requirement is the only ERISA funding requirement exception that is consistent with the tax law requirement that eligible exempt entity plans be unfunded.
Though unfunded, eligible exempt entity plans may involve related trusts or other vehicles that invest amounts deferred under the plans and may give plan participants the right to choose among selected investments. However, all property rights in the deferred funds and related income (whether or not segregated or invested) must belong exclusively to the eligible exempt entity and must be subject to the claims of the entity’s creditors.
Note that traditional nonqualified retirement plans are not a feasible alternative for eligible exempt entities. Unlike unfunded deferred compensation payable by a taxable entity, deferred compensation payable by an exempt entity under an ineligible plan is generally taxable as soon as it vests.
In treating eligible exempt entities differently, Congress showed that it was aware of the absence of the usual restraints imposed on deferred compensation payable by taxable entities. Taxable entities cannot deduct deferred compensation until it is includible in the recipient’s gross income. Exempt entities, of course, need not be concerned about the timing of deductions.
TAXATION OF PLAN BENEFITS
A retiree or beneficiary must include in gross income the entire amount of a payment from an eligible exempt entity plan in the year received. In addition, he or she must generally include amounts the plan makes available, whether or not actually paid. However, tax law limits how soon the plan may make amounts available and also limits how late the plan may begin payments.
An eligible exempt entity may allow a retiree to elect an additional deferral of plan payments if he or she makes the election before any payments are available. A plan may also allow a second election to further delay payments if the retiree makes the second election before any payments are available under the initial election. In addition, a plan may allow a retiree to elect the form of payment (that is, the number and amount of payments) at any time before the payments begin under the elections.
For a detailed discussion of the issues in this area, see “Retiree Tax Planning for Eligible Retirement Plans of Tax-Exempt Entities,” by Vorris J. Blankenship, J.D., CPA, in the January 2012 issue of The Tax Adviser.
—Alistair M. Nevius,
The Tax Adviser
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or email email@example.com for a subscription to the magazine or to become a member of the Tax Section.
More from the JofA: