The Internal Revenue Service (IRS) recently updated its “Nonqualified Deferred Compensation Audit Techniques Guide.” The Guide provides a framework for the IRS to audit nonqualified deferred compensation (NQDC) plans. Since the enactment of the American Jobs Creation Act of 2004 and the addition of Section 409A to the Internal Revenue Code (Code), the tax rules for NQDC plans have become increasingly complex. The Guide offers some helpful insight into how the IRS interprets the rules and intends to apply them in an audit, although it is not as extensive as some practitioners had hoped.
A NQDC is generally an arrangement to pay an employee or independent contractor compensation in the future. NQDC plans include various arrangements such as salary deferral plans, bonus deferral plans, supplemental executive retirement plans (SERPs), and excess benefit plans, as well as certain stock option, stock appreciation rights, phantom stock, and similar arrangements. NQDC must be in writing, although plans range in formality. In any case, plan documents need to comply with Code Section 409A, and they must also be operated in compliance with Code Section 409A. The Guide includes a series of questions designed to help the examiner evaluate the different types of NQDC plans.
The Guide notes the techniques the examiner will use:
Interview company personnel that are most knowledgeable on executive compensation practices, such as the director of human resources or a plan administrator.
Determine who is responsible for the day-to-day administration of the plans within the company (i.e., who processes the deferral election forms and maintains the account balances).
Review the deferral election forms and determine if changes were requested and approved.
Review the executive compensation disclosures in SEC filings such as proxy statements and exhibits to Form 10-K, including notes to the financial statements and disclosures relating to stockholder votes on compensation plans.
Determine whether the company paid a benefits consulting firm for the executive’s wealth management, including reviewing the consulting contract, determining who is administering the plan, and reviewing documents created for the administration of the plan.
Review the ledger accounts/account statements for each plan participant, noting current year deferrals, distributions, and loans. The examiner will compare the distributions to amounts reported on the employee’s Form W-2; determine the reason for each distribution; check account statements for any unexplained reduction in account balances; and review distributions other than those for death, disability, or termination of employment.
According to the Guide, a NQDC plan examination will “focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer.” In this regard, the IRS intends to address the tax doctrines of constructive receipt and economic benefit. The IRS will also address whether deferred amounts were properly taken into account for employment tax purposes, particularly given the difference in the timing rules for income tax and FICA/FUTA taxes. In addition, the examiner will review the employer’s deduction. The Guide includes a final note for examiners to consider if an employer has both a 401(k) plan and a NQDC.
Constructive Receipt and Related Doctrines
Under the constructive receipt doctrine, codified in Code Section 451(a), income not actually in the taxpayer’s possession is constructively received in the taxable year during which it is credited to the taxpayer’s account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given, unless the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The IRS will scrutinize plan provisions relating to each type of distribution or access option and will consider how plans have been operating. The Guide states that “[d]evices such as credit cards, debit cards, and check books may be used to grant employees unrestricted control of the receipt of the deferred amounts.” It also notes that “permitting employees to borrow against their deferred amounts” can achieve the same result.
Under the economic benefit doctrine, an employee is required to include in current gross income the value of assets that have been unconditionally and irrevocably transferred as compensation into a fund for the employee’s sole benefit, if the employee has a nonforfeitable interest in the fund. The IRS will review whether, under the NQDC plan, that individual has received a current economic benefit. As a related matter, under the cash equivalency doctrine, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income. As a related matter, under Code Section 409A(b), there is a prohibition on contributions to a Rabbi trust during certain restricted periods, which are generally periods during which the sponsoring employer also sponsors a single-employer defined benefit plan that is “at risk” under the qualified plan rules. The examiner will consider whether this has occurred.
FICA, FUTA, and Withholding
NQDC amounts are taken into account for FICA tax purposes at the later of when the services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts in a later calendar year. Thus, amounts are subject to FICA taxes at the time of deferral, unless the employee is required to perform substantial future services to have a legal right to the future payment. If the employee is required to perform future services to have a vested right to the future payment, the deferred amount (plus earnings up to the date of vesting) is subject to FICA taxes when all the required services have been performed. FICA taxes apply up to the annual wage base for Social Security taxes and without limitations for Medicare taxes. NQDC amounts are taken into account for FUTA purposes at the later of when services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts up to the FUTA wage base. Employers are required to withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee.
The employer’s deduction must match the employee’s inclusion of the compensation in income. The employer must be able to show that the amount of deducted deferred compensation matches the amount reported on the Forms W-2 that were furnished and filed for the year. In addition, the employer’s deduction may be limited by Code Section 162(m). The examiner will verify that a Schedule M adjustment was made to Form 1120 for the amount of deferred compensation expensed on the employer’s books but not deductible because it was not includible in income by the employees. The examiner will verify that the employer made appropriate Schedule M adjustments in prior years for amounts distributed and for which the employer took a deduction in the current year. The examiner will determine whether the employer took a deduction in the year the employee deferred the income and another deduction in the year the employer paid the deferred compensation to the employee.
The Guide notes that a NQDC plan that references the employer’s 401(k) plan may contain a provision that could cause disqualification of the 401(k) plan. Code Section 401(k)(4)(A) provides that a 401(k) plan may not condition any other benefit (including participation in a NQDC) upon the employee’s participation or nonparticipation in the 401(k) plan. The IRS will also review NQDC plans looking for a provision that limits the total amount that can be deferred between the NQDC plan and the 401(k) plan; it will look for a provision which states that participation is limited to employees who elect not to participate in the 401(k) plan.
If you have any questions about the Guide or your NQDC plan generally, please contact one of the attorneys in the Employee Benefits and Executive Compensation group at Bradley Arant Boult Cummings LLP.
An Important Note on 409A Plan Correction
Earlier this year, the IRS issued Chief Counsel Advice Memorandum No. 201518013, in which it addressed a method of correction for NQDC plan errors that has been used by practitioners based on the proposed regulations regarding income inclusion (separate from the limited corrections permitted under other IRS guidance). Under the proposed regulations, an argument could be made that a failure to comply with Code Section 409A(a) could be corrected before the compensation becomes vested (no longer subject to a substantial risk of forfeiture). However, in the Memorandum, the IRS concluded that a failure to comply with Code Section 409A(a) cannot be corrected in the taxable year in which the compensation vests, even if such correction is made before such compensation vests.
Code Section 409A(a)(1)(A)(i) provides that, if an NQDC plan fails to comply, or fails to be operated in accordance, with Code Sections 409A(a)(2), (3), and (4) “at any time during a taxable year,” compensation deferred under the plan that is not subject to a substantial risk of forfeiture and that has not previously been included in income is includible in the service provider’s gross income for the taxable year. The IRS noted that the correction of a failure to comply with Code Section 409A(a) during a taxable year indicates that a failure existed during the taxable year in which the correction is made. Under Code Section 409A(a)(1)(A)(i), a failure applicable to deferred compensation subject to a substantial risk of forfeiture that lapses during the taxable year results in income inclusion of the deferred amount under Code Section 409A, regardless of whether the failure is corrected during the same taxable year but before the substantial risk of forfeiture lapses.
As a result of this guidance, if an employer has a NQDC plan with vesting provisions and an error is discovered, it will be very important to correct the error in the year before the year of vesting.