DocketNumber: Docket No. 10439-87
Citation Numbers: 95 T.C. 415, 1990 U.S. Tax Ct. LEXIS 99, 95 T.C. No. 30, 12 Employee Benefits Cas. (BNA) 2567
Judges: Ruwe,Nims,Korner,Hamblen,Clapp,Jacobs,Gerber,Colvin,Whalen,Halpern,Hamblen,Cohen,Parr,Fay,Chabot,Swift,Wright,Wells
Filed Date: 10/9/1990
Status: Precedential
Modified Date: 11/14/2024
*99
P, an accrual basis taxpayer, established nonqualified deferred compensation arrangements (DCA's) for eight "key" executives and one outside member of its board of directors (DCA participants). Under the DCA's, P and the DCA participants agreed to defer payments for future personal services the DCA participants would otherwise have been entitled to receive upon the performance of those services. The DCA's were unfunded and represented the unsecured contractual obligations of P to pay each DCA participant upon termination, retirement, or attainment of a specified age. P maintained bookkeeping accounts to calculate the deferred compensation of each DCA participant. The accounts for each DCA participant reflected the amount of compensation that was originally deferred plus an amount designated as "interest." P compounded and accrued the interest component of the DCA's with respect to each DCA participant's accumulated account balance. P deducted this amount separately as an "interest expense."
*416 Respondent determined a deficiency in petitioner's Federal income tax in the amount of $ 718,936 for fiscal year ending February 3, 1983. Originally, three issues were presented for decision: (1) The investment tax credit issue; (2) the WIN credit issue; and (3) *101 the interest/deferred compensation issue. By an order dated December 27, 1988, this Court severed the investment tax credit issue from the other issues and decided it in petitioner's favor. See
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.
Petitioner, *102 a Delaware corporation, had its principal place of business in Boise, Idaho, at the time the petition in this case was filed. During the year in issue, petitioner operated over 400 retail food and drug stores in the Western, Southern, and Southeastern United States. Petitioner is an accrual basis taxpayer.
Prior to the fiscal year in issue, petitioner established nonqualified deferred compensation arrangements (DCA's) for eight "key" executives (employee DCA's) and for one outside member of its board of directors (director DCA). The executives and the director participating in the DCA's will *417 be referred to as DCA participants. The DCA's were unfunded and represented the unsecured contractual obligations of petitioner to pay a specified sum, determined in accordance with the terms of each DCA, to each DCA participant at or after a specified time. The time specified was retirement, termination of employment, or, in the case of the outside director, age 72. Petitioner's purpose in establishing the DCA's and offering them to its executives and directors was to attract and retain the services of qualified persons for those positions.
Under the DCA's, petitioner and the *103 DCA participants agreed to defer payments for future personal services the DCA participants would otherwise have been entitled to receive in the year they performed said services. The agreement was struck as a result of arm's-length negotiations conducted prior to the year personal services were performed. Each participant in an employee DCA deferred either a specified portion of his or her future salary or an annual bonus, or both. The participant of the director DCA deferred 100 percent of his monthly retainer fees and board and committee meeting fees.
Prior to the beginning of a fiscal year of petitioner, each DCA participant could elect not to participate in his or her respective arrangement for that year. If a DCA participant elected not to participate, his or her compensation for the year would not be deferred and would actually be paid to him or her as earned.
Petitioner maintained bookkeeping accounts to calculate the deferred personal service compensation of each DCA participant. The accounts for each DCA participant reflected the amount of compensation that was originally deferred plus an amount designated as "interest." For the year in issue, the provisions defining*104 deferred compensation that were contained in the employee DCA's were as follows: *418 terminated. The compensation to be deferred in each fiscal year shall be as set forth in subparagraphs (a) and (b) below:
(a) The sum of $
(b) The bonus earned by EMPLOYEE for such fiscal year pursuant to any bonus plan or plans then in effect unless EMPLOYEE, by written notice to the Secretary of the COMPANY prior to the beginning of any fiscal year, elects to have only a portion of such bonus deferred for such fiscal year. In such event, the portion of such bonus which EMPLOYEE elects not to be deferred shall be paid in accordance with the provisions of the bonus plan.
3.2 The COMPANY agrees to pay to EMPLOYEE a further sum of money equal to the amount of interest accrued which shall be calculated by applying a rate of interest to the total accumulated amount of deferred compensation*105 including accrued interest compounded monthly. The rate to be used will be the weighted average of the COMPANY'S long term borrowing rate for that current fiscal year.
3.3 As used in Section 3.2 above, "total accumulated amount of deferred compensation" means compensation deferred pursuant to previous deferred compensation agreements between the COMPANY and EMPLOYEE (including phantom stock agreements) as well as this agreement.
3.4 For purposes of this agreement a "year" is defined as a "fiscal year" coincident with the COMPANY'S fiscal year.
With respect to the director's DCA, the interest component was also compounded monthly, but was determined by reference to the Wall Street Journal and the rate there quoted as being paid by major banks on new issues of negotiable certificates of deposit in amounts of $ 1 million or more. The DCA participants' rights to receive payment under the DCA's could not be commuted, encumbered, assigned, or otherwise disposed of.
*106 For taxable years prior to the year in issue, petitioner did not claim a deduction with respect to its DCAs' interest component unless a deduction was permitted by
*107 Relying on the permission granted, petitioner compounded and accrued on a monthly basis the interest component of the DCA's with respect to each DCA participant's accumulated account balance. Petitioner treated this amount separately as an "interest expense" for purposes of its fiscal year 1983 consolidated earnings statement. On its Federal income tax return for the year in issue, petitioner claimed an interest expense deduction in the amount of $ 667,142 for the DCAs' interest component accruing during the year.
By notice of deficiency dated March 6, 1987, respondent determined that his August 26, 1983, letter permitting petitioner an accounting method change would be revoked under section 7805(b) retroactive to the date of its issuance. Based on his retroactive revocation, respondent disallowed the deduction petitioner claimed with respect to the DCAs' interest component for the year in issue because no interest was actually paid during the year.
As originally presented for trial, the interest/deferred compensation issue involved three questions:
(1) Whether respondent acted properly in revoking retroactively his permission for petitioner to change its method of accounting for*108 the DCAs' interest component (the retroactive revocation question);
(2) Whether the DCAs' interest component actually constitutes "interest" within the meaning of
(3) If the amounts in question are interest, whether
When called for trial on May 23, 1988, the Court, on its own motion, severed the retroactive revocation question from the remainder of this case and took it under advisement. Thereafter, a trial was held and evidence was presented only with respect to the other issues remaining for decision. At the trial's conclusion, this case stoodsubmitted.
*420 Upon further consideration, the Court decided to take evidence on the retroactive revocation question so it could be decided along with all other issues previously submitted. Accordingly, trial of the retroactive revocation question was scheduled for December 18, 1989. On that date, a pretrial conference was held with counsel for petitioner and respondent. During the conference, the parties' positions with respect to the retroactive revocation question were discussed at length. Petitioner's counsel averred petitioner, after further consideration, *109 did not desire to pursue any relief with respect to the retroactive revocation question. Petitioner's counsel was given an opportunity to again consult with petitioner. When this case was recalled from the calendar later in the day, petitioner's counsel read into the record a statement concerning petitioner's understanding of the consequences of its abandonment of the retroactive revocation question. The parties then filed a stipulation of settled issues. By these actions, petitioner effectively conceded the retroactive revocation question scheduled to be tried.
OPINION
We must now decide the remainder of the interest/deferred compensation issue. Specifically, we address whether the amount designated as interest under the DCA's is "interest" within the meaning of
Respondent argues that the amount designated as interest under the DCA's is not interest. Instead, respondent contends that the amounts in question represent additional deferred compensation for personal services, deductible only as permitted by
Petitioner concedes that if the amounts in issue represent compensation for personal services,
Our first inquiry is whether the amounts in question represent interest or compensation for personal services. In answering this question, we must consider all relevant facts and circumstances and make our determination based on*111 the substance of the transaction and not the form in which it is cast.
Interest is "the amount which one has contracted to pay for the use of
*114 The amounts recorded in the bookkeeping accounts as "interest" do not represent payments made by petitioner for the use of money "borrowed" from its employees and director. Nor do these amounts constitute liabilities owed to the DCA participants for the "forbearance" of money whose payment had become due. In determining the effect of a transaction for income tax purposes, formalities such as nomenclature and bookkeeping entries are not controlling.
DCA participants never had any legal basis to demand payment of the deferred amounts, and petitioner never had an obligation to pay deferred compensation in the year in issue. Petitioner could not have "borrowed" something from the DCA participants that the DCA participants never had the right to possess. One cannot forgo something to which one
In
We likewise refuse to make that assumption here. It is not enough, as urged by respondent, that "interest" or "indebtedness" in their original classical context may have permitted this broader meaning. We are dealing with the context of a revenue act and words which have today a well-known meaning. In the business world "interest on indebtedness" means compensation for the use or forbearance of money. * * *
[
For reasons previously explained, petitioner did not borrow money from the DCA participants. At the time the DCA's were entered into, the DCA participants had no right to money which could be the subject of their*120 forbearance. After they performed services called for by the DCA's, they still had no money or immediate right to receive money which could have been the subject of their forbearance during the year in issue. Rather, the amounts accrued as "interest" were an integral part of the method used by petitioner to calculate the total amount of deferred compensation to be paid to the DCA participants. As compensation, deductibility is governed by the provisions of
Employers may take immediate deductions for contributions actually made to "qualified plans." Strict requirements must be met to achieve qualified status. The most significant of these requirements relate to the funding of benefits, minimum coverage, prohibitions against discrimination, limitations on the benefits which may accrue to participants, and prohibitions against self-dealing. Secs. 401(a), 410, 411, 412, 415, and 4975. Qualified deferred compensation arrangements are subject to funding requirements imposed under the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA).
This accords, also, with the apparent policy behind the statutory provision, namely, that an objective outlay-of-assets test would insure the integrity of the employees' plan and insure the full advantage of any contribution which entitles the employer to a tax benefit. [
Contributions to qualified plans are held and invested by the trustee or insurance company until the time of distribution to the employee. The assets contributed to the trustee or insurance company cease to be assets of the employer and are not subject to the debts, obligations, and creditors of the employer. The income earned on these assets is not taxable to either the trustee, the insurance company, or the employer, and the employee incurs no tax as a result of participation*122 in a qualified plan until the time benefits are received.
Under
Petitioner's position runs counter to the statutory scheme. It would allow taxpayer-employers to characterize portions of deferred compensation benefits as interest, thereby providing an employer with current tax deductions for a part of the deferred compensation benefits without meeting the strict requirements necessary to assure the actual receipt of benefits by the participants. If the employer's credit rating degenerated, making it less likely that the employee*125 would ever receive benefits, there would be greater justification for a higher rate of "interest." If this "interest" element were deductible, the amount of deductions generated by nonqualified deferred compensation plans would increase in direct proportion to the risk that the employee might ultimately receive nothing. The deductible "interest" element would often exceed the original *428 amount of deferred compensation. See B. Bittker & L. Lokken, Federal Taxation of Income, Estates, and Gifts, par. 60.2.1, pp. 60-10-60-12 (2d ed. 1990). Such a result would be contrary to the legislative objective of
When
(2)(A) Except as provided*126 in subparagraph (B), the terms "employee pension benefit plan" and "pension plan" mean any plan, fund, or program which was heretofore or is hereafter established or maintained by an employer or by an employee organization, or by both, to the extent that by its express terms or as a result of surrounding circumstances such plan, fund, or program --
(i) provides retirement income to employees, or
(ii) results in a deferral of income by employees for periods extending to the termination of covered employment or beyond,
regardless of the method of calculating the contributions made to the plan, the method of calculating the benefits under the plan or the method of distributing benefits from the plan.
[
Petitioner's DCA's resulted in the deferment of income by its employees. The benefits under the DCA's were based upon the initial amount of compensation that was deferred and the period of the deferral. For practical and legal purposes, petitioner's plan could also be described as a pension plan.
*128 Another reason why deductions attributable to petitioner's DCA's should be limited to amounts actually paid and includable in the gross income of recipients can be inferred from the literal provisions of
The "interest" factor in petitioner's DCA's*130 is not interest within the meaning of
Halpern, Fay, As the majority correctly pointed out (majority op. at 419), this Court severed the retroactive revocation issue, *136 retroactive revocation issue. I set the case for a second trial in Boise, Idaho. However, when the case was called from the calendar, petitioner conceded the arbitrary retroactive revocation issue. This example is indistinguishable from the facts of the instant case. In the example, S transferred the real property to B, thus providing the consideration that gave rise to S's It is important to stress that, in both the example and the instant case, the seller (whether of realty or services) The majority's discussion of constructive receipt (majority op. at 422) appears to be accurate, but it is quite irrelevant to the dispute before us. In neither the example nor in the case before us has there been constructive receipt; in both there has been forbearance that should lead to the conclusion that the disputed amounts are interest. One final note on the interest issue, we find the majority's reliance on Having found the amounts in question are interest, the statute is clear: the deduction is not limited by *435 By reading if compensation is paid or accrued Such judicial amendments of the statute are improper, ill-advised, and imprudent. "It is best, we may observe, where the laws are enacted upon right principles, that everything should, as far as possible, be determined absolutely by the laws, and as little as possible left to the discretion of the judges." Aristotle (384-322 *141 B.C.), The Rhetoric, bk. 1, ch. I (J.E. Welldon trans.). Moreover, such an amendment is Contributions may * * * be deducted under Based on these regulations, Further support for deductibility can be found in (b) Contributions made after August*142 1, 1969 -- (1) In general. A deduction is allowable for a contribution paid after August 1, 1969, under
*. Brief amicus curiae was filed by Michael J. Jones as attorney for the Northwestern Mutual Life Insurance Co.↩
*. By Order of the Chief Judge, this case was reassigned to Judge Robert P. Ruwe for purposes of opinion.↩
1. The DCA entered into by petitioner and Paul W. Mouser varies somewhat, but contains substantially similar language.↩
2. As discussed more fully
3. The terms borrow, forbearance, and rent are commonly defined as follows:
Borrow. To solicit and receive from another any article of property, money or thing of value with the intention and promise to repay or return it or its equivalent. If the item borrowed is money, there normally exists an agreement to pay interest for its use. In a broad sense the term means a contract for the use of money. * * * [Black's Law Dictionary 167 (5th ed. 1979).] Forbearance. Act by which creditor waits for payment of debt due him by debtor after it becomes due. * * * A delay in enforcing rights. * * * [Black's Law Dictionary 580 (5th ed. 1979).]
Rent. Consideration paid for use or occupation of property. * * * [Black's Law Dictionary 1166 (5th ed. 1979).]↩
4. See
5. It cannot be argued that the DCA participants were in "constructive receipt" of the deferred compensation. There can be no constructive receipt until the contractual conditions giving rise to a present right to payment are met.
6. Were we to accept the rationale that deferred compensation that an employee never had a present right to receive is, in substance, the same as a loan from the employee to the employer, it would seem to follow that such a characterization would be required whether or not the deferred compensation plan included an "interest" factor. Using this approach, it would logically follow that a deferred compensation arrangement that had no interest factor would be treated as an interest-free loan within the terms of
7. We doubt that the opportunity to lend one's employer money at market rates would normally be considered a recruitment device.↩
8. Bittker gives several examples showing the economic and tax impact of deferred compensation plans on the employer and employee. In the examples, the amount of the employee's deferred benefits is calculated by using prevailing interest rates. In each of the examples, it is assumed, without discussion, that the "interest factor" is not deductible until the benefits are actually paid to the employee. B. Bittker & L. Lokken, Federal Taxation of Income, Estates, and Gifts, par. 60.2.1, p. 60-11, 60-12 (2d ed. 1990).↩
9.
(a) General Rule. -- If contributions are paid by an employer to or under a stock bonus, pension, profit-sharing, or annuity plan, or if compensation is paid or accrued on account of any employee under a plan deferring the receipt of such compensation, such contributions or compensation shall not be deductible under section 162 (relating to trade or business expenses) or section 212 (relating to expenses for the production of income); but, if they satisfy the conditions of either of such sections, they shall be deductible under this section, subject, however, to the following limitations as to the amounts deductible in any year: * * * * (5) Other plans. -- If the plan is not one included in paragraph (1), (2), or (3), in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan, but, in the case of a plan in which more than one employee participates only if separate accounts are maintained for each employee. * * * *
(d) Deductibility of Payments of Deferred Compensation, Etc., to Independent Contractors. -- If a plan would be described in so much of subsection (a) as precedes paragraph (1) thereof (as modified by section (b)) but for the fact that there is no employer-employee relationship, the contributions or compensation -- (1) shall not be deductible by the payor thereof under section 162 or 212, but (2) shall (if they would be deductible under section 162 or 212 but for paragraph (1)) be deductible under this subsection for the taxable year in which an amount attributable to the contribution or compensation is includible in the gross income of the persons participating in the plan.↩
10. While the DCA's come within the definition of a "pension plan," ERISA provides a specific exemption from the coverage and funding requirements of ERISA for "a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees."
1. See, e.g., S. Rept. 98-169 (Vol. 1), at 249-250 (1984) ("Present law provides exceptions to the rules requiring annual recognition and deduction of OID for the following: * * * (6) obligations issued in exchange for services. fn. * * * Present law is unclear as to whether all deferred payments for services are within the scope of
2. Those individuals computed taxable income under the cash method of accounting. As a result, they do not, for tax purposes, realize income prior to receipt. Perhaps, then, for tax purposes, it could be said that, since they have received nothing, they have nothing to lend. Such an analysis, although helpful on a theoretical level, does not, I believe, aid in the problem of statutory construction here presented.↩
3. See H. Rept. 2333, 77th Cong., 1st Sess. (1942),
4. Compare sec. 1.404(a)-12(b)(1), which describes a deduction equal only to the employer's contribution to the plan but, apparently, deals only with a funded plan.↩
5. See Halperin, "Interest in Disguise: Taxing the 'Time Value of Money,'"
6. See the discussion in Halperin,
1. On June 14, 1982, petitioner submitted to respondent a request for a change in method of accounting (from cash to accrual) for the interest element of the DCA. On Aug. 26, 1983, respondent granted petitioner's request for a change of accounting method. On Jan. 29, 1986, respondent revoked its letter granting approval of petitioner's change of accounting method.↩
2. The parties presented no new evidence concerning the interest characterization and deductibility issues.↩
3. The extensive amicus brief filed by Northwest Mutual Insurance Co. highlights the importance other taxpayers place on these issues.↩
4. In recent years Congress has been attempting to identify hidden interest. See
5. The Commissioner approved of this treatment in granting permission to petitioner to change his method of accounting. This permission was later retroactively revoked.↩
6. See also B. Bittker & L. Lokken, Federal Taxation of Income, Estates, and Gifts, par. 60.2.1, p. 60-11, (2d ed. 1989) "
Commissioner v. Court Holding Co. , 65 S. Ct. 707 ( 1945 )
Don E. Williams Co. v. Commissioner , 97 S. Ct. 850 ( 1977 )
Commissioner of Internal Revenue v. Oates , 207 F.2d 711 ( 1953 )
Melvin S. Cohen, Eileen D. Cohen and Edith Phillips v. ... , 910 F.2d 422 ( 1990 )
Autenreith v. Commissioner of Internal Revenue , 115 F.2d 856 ( 1940 )
Times Publishing Company v. Commissioner of Internal Revenue , 184 F.2d 376 ( 1950 )
Doyle v. Mitchell Brothers Co. , 38 S. Ct. 467 ( 1918 )
Deputy, Administratrix v. Du Pont , 60 S. Ct. 363 ( 1940 )
Old Colony Railroad v. Commissioner , 52 S. Ct. 211 ( 1932 )
Gregory v. Helvering , 55 S. Ct. 266 ( 1935 )
wesley-heat-treating-co-v-commissioner-of-internal-revenue-spindler , 267 F.2d 853 ( 1959 )