Atlas Client Passes IRS Audit of Deferral of TRS Gains, Losses, and Expenses

One of the reasons companies utilize Total Return Swaps (TRS) to hedge their nonqualified deferred compensation plan (DCP) liabilities is it allows for a tax hedge election to defer the TRS gains, losses, and expenses until benefit payments are made to participants and an offsetting deduction is received.

This tax deferral is not available with physical hedging instruments like mutual funds and ETFs. The tax benefit can be material as the deferral period can last more than a decade. In this analysis, we detail how one company recently passed an IRS audit of its TRS hedge and deferred gains—using a tax opinion, Private Letter Ruling (PLR), and tax reporting and recordkeeping that were consistent with representations made in the tax opinion and PLR.

Tax Opinion and Private Letter Ruling

The company relied on a “Will-level” tax opinion and Private Letter Ruling #200415009, which detail the following:

• Under Section 1221(b)(2) the TRS may be designated as a hedge for tax purposes and the tax treatment of gains, losses, and expenses can match the tax characteristics of the DCP liability.

• The plan sponsor defers the taxable event for gains/losses and dividends attributable to the swap until distributions are made under the DCP to participants.

• Taxable swap gains are allocated to each distribution and taxed in the year of each distribution when the company also receives a tax deduction for the amount distributed.

Tax Reporting and Recordkeeping Consistent with Representations Made to the IRS

This company also ensured that comprehensive tax recordkeeping and reporting were conducted in a manner that was consistent with representations made to the IRS in the tax opinion and PLR:

• For each deferral, the company had tracked the TRS gains, losses, and expenses that resulted from hedging that specific deferral.

• When each benefit payment was made to a participant the plan sponsor was able to then report the portion of total TRS gains, losses, and expenses attributable to that specific benefit payment.

• This is no small matter: Atlas Financial Partners provides tax recordkeeping and reporting for $5 billion of TRS hedges of DCP liabilities and on average we maintain 250,000+ records per client.

Conclusion

Hedging DCP liabilities with a TRS can provide material tax benefits. One company recently passed an IRS audit of its TRS hedge and deferred gains using a tax opinion, Private Letter Ruling (PLR), and comprehensive reporting and recordkeeping.