II. Explanation of the Bill
(Sec. 5001 of the Bill and Sec. 404 of the Code)
For deduction purposes, any method or arrangement that has the effect of a plan deferring
the receipt of compensation or other benefits for employees is treated as a deferred compensation
plan (Sec. 404(b)). In general, contributions under a deferred compensation plan (other than
certain pension, profit-sharing and similar plans) are deductible in the taxable year in which an
amount attributable to the contribution is includible in income of the employee. However, vacation
pay which is treated as deferred compensation is deductible for the taxable year of the employer in
which the vacation pay is paid to the employee (Sec. 404(a)(5)).
Temporary Treasury regulations provide that a plan, method, or arrangement defers the
receipt of compensation or benefits to the extent it is one under which an employee receives
compensation or benefits more than a brief period of time after the end of the employer's taxable
year in which the services creating the right to such compensation or benefits are performed. A
plan, method or arrangement is presumed to defer the receipt of compensation for more than a brief
period of time after the end of an employer's taxable year to the extent that compensation is
received after the 15th day of the 3rd calendar month after the end of the employer's taxable year in
which the related services are rendered (the "2-1/2 month" period). A plan, method or arrangement
is not considered to defer the receipt of compensation or benefits for more than a brief period of
time after the end of the employer's taxable year to the extent that compensation or benefits are
received by the employee on or before the end of the applicable 2-1/2 month period. (Temp.
Treas. Reg. Sec. 1.404(b)-1T A-2).
The Tax Court recently addressed the issue of when vacation pay and severance pay are
considered deferred compensation in Schmidt Baking Co., Inc., 107 T.C. 271 (1996). In Schmidt
Baking, the taxpayer was an accrual basis taxpayer with a fiscal year that ended December 28,
1991. The taxpayer funded its accrued vacation and severance pay liabilities for 1991 by
purchasing an irrevocable letter of credit on March 13, 1992. The parties stipulated that the letter
of credit represented a transfer of substantially vested interest in property to employees for
purposes of section 83, and that the fair market value of such interest was includible in the
employees' gross incomes for 1992 as a result of the transfer. The Tax Court held that the
purchase of the letter of credit, and the resulting income inclusion, constituted payment of the
vacation and severance pay within the 2-1/2 month period. Thus, the vacation and severance pay
were treated as received by the employees within the 2-1/2 month period and were not treated as
deferred compensation. The vacation pay and severance pay were deductible by the taxpayer for
its 1991 fiscal year pursuant to its normal accrual method of accounting.
Reasons for Change
The Committee believes that the decision in Schmidt Baking reaches an inappropriate and
unintended result. To permit methods such as that used in Schmidt Baking to be considered
payment or receipt would allow taxpayers to avoid the 2-1/2 month rule and inappropriately
accelerate deductions. The Committee believes that the intent of the 2-1/2 rule was clearly to
provide that a deduction for deferred compensation is not available for the current taxable year
unless the compensation is actually paid to employees within 2-1/2 months after the end of the
year. Moreover, previous legislative histories reflect Congressional intent and understanding that
compensation actually paid beyond the 2-1/2 month period is deferred compensation.
Further, the Committee is concerned that taxpayers may inappropriately extend the rationale
of Schmidt Baking to other situations in which a deduction or other tax consequences are
contingent upon an item being paid. The Committee does not believe that, as a general rule, letters
of credit and similar mechanisms should be considered payment for any purposes of the Code.
Explanation of Provision
Under the bill, for purposes of determining whether an item of compensation is deferred
compensation (under Code Sec. 404), the compensation is not considered to be paid or received
until actually received by the employee. In addition, an item of deferred compensation is not
considered paid to an employee until actually received by the employee. The provision is intended
to overrule the result in Schmidt Baking. For example, with respect to the determination of
whether vacation pay is deferred compensation, the fact that the value of the vacation pay is
includible in the income of employees within the applicable 2-1/2 month period would not be
relevant. Rather, the vacation pay must have been actually received by employees within the 2-1/2
month period in order for the compensation not to be treated as deferred compensation.
It is intended that similar arrangements, in addition to the letter of credit approach used in
Schmidt Baking, do not constitute actual receipt by the employee, even if there is an income
inclusion. Thus, for example, actual receipt does not include the furnishing of a note or letter or
other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any
other instrument or by any third party. As a further example, actual receipt does not include a
promise of the taxpayer to provide service or property in the future (whether or not the promise is
evidenced by a contract or other written agreement). In addition, actual receipt does not include an
amount transferred as a loan, refundable deposit, or contingent payment. Amounts set aside in a
trust for employees are not considered to be actually received by the employee.
The provision does not change the rule under which deferred compensation (other than
vacation pay and deferred compensation under qualified plans) is deductible in the year includible
in the gross income of employees participating in the plan if separate accounts are maintained for
While Schmidt Baking involved only vacation pay and severance pay, there is concern that
this type of arrangement may be tried to circumvent other provisions of the Code where payment is
required in order for a deduction to occur. Thus, it is intended that the Secretary will prevent the
use of similar arrangements. No inference is intended that the result in Schmidt Baking is present
law beyond its immediate facts or that the use of similar arrangements is permitted under present
The provision does not affect the determination of whether an item is includible in income.
Thus, for example, using the mechanism in Schmidt Baking for vacation pay could still result in
income inclusion to the employees, but the employer would not be entitled to a deduction for the
vacation pay until actually paid to and received by the employees.
The provision is effective for taxable years ending after the date of enactment. Any change
in method of accounting required by the bill is treated as initiated by the taxpayer with the consent
of the Secretary of the Treasury. Any adjustment required by section 481 as a result of the change
will be taken into account in the year of the change.