Non-Qualified Deferred Compensation Plans Best Practices

Transcription

1 A P RO FESSIO N AL CO RP O RATIO N ERISA AND EMPLOYEE BENEFITS ATTORNEYS Non-Qualified Deferred Compensation Plans Best Practices J. Marc Fosse, Esq. March 28,

2 What is Section 409A? Section 409A applies to US taxpayers Section 409A applies non-qualified deferred compensation plans Section 409A requires: > A written plan document that includes at a minimum: Time and form of payment Any election rules Any ability to change an election Six-month delay for specified employees (discussed later) > Strict operational compliance Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

3 What is Section 409A? For non-qualified deferred compensation plans, Section 409A has strict requirements regarding: > Permissible payment events Death Disability Separation from service Specified date or schedule of payments Unforeseeable Emergency Change in Control > Permissible Deferral Elections > Restrictions on ability to change elections > Anti-acceleration provisions > Prohibitions on offsets from plan distributions Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

4 What is a non-qualified deferred compensation plan? A legally binding right during one taxable year to a payment that MAY be made in a later taxable year Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

5 What is a non-qualified deferred compensation plan? Unless an exemption or exception applies, it would cover most compensation programs, including, but not limited to, the following: > Traditional deferred compensation plans > Severance plans > Bonus programs > Long-term and short-term incentive plans > Reimbursement programs > Employment agreements that contain bonus or severance > Retention agreements > Change in control agreements > Stock option plans > Compensation and equity provisions in merger agreements Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

6 General Exemptions Exemptions: > US tax-qualified employer plans (such as a 401(k) plans, 403(b) plans or a traditional funded pension plans) > Broad-based foreign retirement plan Must be nondiscriminatory that provides benefits to a wide-range of employees substantially all of whom are non-resident aliens, certain resident aliens or bona fide residents of a US possession Must provide significant benefits for a substantial majority of covered employees The actual benefits provided are nondiscriminatory The plan contains provisions or is subject to legal restrictions that generally restrict access to benefits until retirement, separation from service or hardship. Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

7 General Exemptions (Cont) > Non-taxable welfare benefits > Stock options or stock appreciation rights with a strike price at FMV and no deferral features > ISOs > ESPP > Restricted Stock (Section 83 Property) > Short-Term Deferrals Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

8 Plan Aggregation For certain requirements under Section 409A, all non-qualified deferred compensation plans of a service recipient that are of the same category are treated as a single plan. Categories: > Elective account balance plans > Non-elective account balance plans > Non-account balance plans > Involuntary separation pay or window programs > In-kind benefits or reimbursement programs > Split-dollar insurance plans > Stock rights (other than those exempt from 409A) > Other Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

9 Service Recipient/Employer A service recipient under Section 409A includes the employer and all parent or subsidiary companies that would be part of the employers controlled group of companies for purposes of paying US taxes. Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

10 Why comply with Section 409A? Failure to comply with Code Section 409A can result in excise taxes and a premium interest tax (on top of regular income taxes) > 20% federal excise tax > 5% California excise tax Applies to all vested amounts (i.e., no longer subject to a substantial risk of forfeiture) The premium interest tax is the IRS underpayment interest rate plus an additional one percent > Underpayment interest rate is short-term AFR plus 3% > The premium interest rate is calculated based on the underpayment that would have occurred if the amount had been includible in income in the taxable year when first deferred or, if later, when vested Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

11 Commonly Used Exceptions/Exemptions to Section 409A Short-term deferral rule Limited separation pay upon an involuntary separation from service or pursuant to a window program Certain collectively bargained plans Non-taxable benefits Certain reimbursement arrangements Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

12 Short-Term Deferral Rule Any amount paid under a compensation program is not deferred compensation if an employee actually or constructively receives payment of the entire amount by the later of: > 2 ½ months from the end of the employee s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or > 2 ½ months from the end of the employer s taxable year in which the amount is no longer subject to a substantial risk of forfeiture The short-term deferral rule does not apply if under the terms of the plan there is a possibility of making the payment after the above deadline Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

13 Non-Taxable Benefits Code Section 409A does not apply to a legally binding right to receive a nontaxable benefit > IRS has informally indicated that this exemption can be used if the employer pays for all or a portion of an employee s health benefits for a period of time after the employee s separation of service > This exemption does not apply to employer paid health benefits that are provided on a discriminatory based under Section 105(h) of the Internal Revenue Code. In that case, the benefit is a taxable benefit subject to Section 409A Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

14 Certain Reimbursement Arrangements Certain reimbursements that occur in connection with a separation from service are exempt from Code Section 409A > Provided the expense is incurred or the benefit is provided by the end of the second year in which the separation from service occurs and reimbursement is paid by the end of the third year Amounts the employer could otherwise deduct under Code Sections 162 or 167 Reasonable outplacement expenses and reasonable moving expenses Certain in-kind benefits > Taxable medical expenses incurred and paid for by the employee (but reimbursed by the employer) to the extent they are incurred during the period of time the employee would be entitled to COBRA Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

15 Certain Reimbursement Arrangements Common Mistakes Taxable Reimbursements For a US employee who works abroad, the company reimburses his or her rent for a home in the foreign country and grosses-up the employee for his or her taxes paid on the reimbursement A program for taxable reimbursements can be drafted to comply with the short-term deferral rule. However, some companies find the short-term deferral period is insufficient time to collect receipts and process the reimbursements. In that case, a reimbursement program that complies with Section 409A is required Post-Employment Taxable Reimbursements: Agreement provides for reimbursement of country club dues for five years up to an aggregate of $100,000 after separation from service > This benefit cannot be drafted to comply with short-term deferral rule and must comply with Code Section 409A Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

16 Permissible Payment Events Death Disability Specified Date or Schedule Separation from Service Change of Control Unforeseeable Emergency > Other than death, each of the payment events above are specifically defined in the Section 409A regulations Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

17 Payments Upon Death Under Section 409A of the Internal Revenue Code ( Code ), nonqualified deferred compensation may be paid only at a specified time or upon certain events > Death is a permissible event Final Code Section 409A regulations provide that payment is treated timely if made on: > Date of event > Later date within the same taxable year, or, if later, by the 15th day of the third calendar month following the date specified under the plan 17

18 Payments Upon Death, cont d The proposed regulations under Code Section 409A ( Proposed Regulations ) provide that an amount payable following the death of a participant, or following the death of a beneficiary, is timely paid if paid at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs is treated as timely paid Provides greater flexibility for employers 18

19 Payments Upon Death, cont d A plan is not required to specify any particular date within this period as the payment date May rely on this rule if the plan provides that an amount will be paid at some time during this period, including if the plan provides that payment will be made upon death without defining the period for payment following death in any other manner > Including if the plan permits the beneficiary to select the payment date during this grace period 19

20 Payments Upon Death, cont d May amend a nonqualified deferred compensation plan at any time to add this new payment provisions without violating the anti-acceleration provisions or subsequent deferral rules under the Code Section 409A final regulations 20

21 Permissible Payment Events Common Mistakes Impermissible Events: If a payment is subject to Code Section 409A, then any payment on any event other than those listed above is a violation. For example: > IPO > Attaining a certain stock price or other business goal > Child s enrollment in college > Promotion to Senior Vice President Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

22 Permissible Payment Events Common Mistakes Undefined or Ambiguously Defined Payment Events: > Termination of employment > Disability > Change of control Each of the above terms, without further definition can contain events that fit under the definitions under Section 409A or do not. For example, retirement from full time employment and commencing part-time consulting work is a termination of employment, but it is not a separation from service under Section 409A IRS Notice says that documentary compliance under Section 409A requires that these terms be defined in accordance with Section 409A or a plan can contain a savings clause stating that the provisions will be interpreted in accordance to Code Section 409A Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

23 Permissible Payment Events Common Mistakes Toggles Section 409A generally permits only one time and form of payment with any permissible payment event Limited exceptions > Age > Change in Control Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

24 Section 409A Grace Periods Section 409A permits certain grace periods for making payments under a non-qualified deferred compensation plan Later of December 31 of the taxable year in which the distribution event (death, disability, separation from service or retirement) occurs or 2 ½ months after the date of the distribution event. 90 days after payment event Date within a single year Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

25 Section 409A Election Rules In general, an employee s election to defer compensation for a taxable year must be made by the close of the preceding taxable year For example an employee would need to make a deferral election with respect to 2019 compensation no later than December 31, 2018 This rule can also be applied with respect to compensation earned on a fiscal year > This is the most straightforward of the election rules Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

26 First Year of Eligibility For the first year of eligibility, elections can be made within 30 days of becoming eligible, provided that such elections apply only to services to be performed subsequent to the election. In addition, all similar plans are aggregated for the purposes of this rule > Plan aggregation can be a trap. As discussed earlier, there are several types of plans that are aggregated under Section 409A > If an employee has already used the 30-day election period under a nonqualified deferred compensation plan, he generally cannot use it again under another non-qualified deferred compensation plan that would be aggregated with the first plan. Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

27 Annual Bonuses Deferral elections must be made in the year before the compensation is earned > Earned means performing services It does not matter when it is paid Example: > Employee made a deferral election December 31, 2017 to defer 100% of employee s bonus 2017 annual bonus is paid March 1, annual bonus is paid February 26, 2019 Totally discretionary bonuses Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

28 Performance-Based Compensation For performance-based compensation, the election may be made up to six months before the end of the performance period if: (a) the employee performs services continuously for the period beginning on the later of the first day of the performance period or the date the performance criteria are established, and ending on the date of the election with respect to the performance-based compensation and (b) the election is not made after the amount of performance-based compensation becomes readily ascertainable Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

29 Offsets Under Section 409A, a plan may accelerate a payment to satisfy a debt to the employer solely if: > The debt is incurred in the ordinary course of the relationship between the employee and employer > The reduction in any taxable year does not exceed $5,000 > The reduction is made at the same time and in the same form as otherwise would have been due and collected > The offset provision does not need to be in the plan document Common Mistakes: > Plan has a general offset provision > The plan offsets benefits against benefits earned in another plan For example, under the IRP the company had the discretion to reduce benefits under the IRP if they were excessive if added to benefits earned in other programs or if the benefits were duplicative IRP benefits relating to matching contributions and earnings credits can only be offset as permitted by Section 409A (described above) Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

30 Specified Employees For public companies, Section 409A provides that, with respect to a specified employee, a payment of nonqualified deferred compensation on account of separation from service may not be made before the date that is six months after the date of the separation from service (unless the payment is due to death) An employee is a specified employee if he or she is a key employee as defined under Section 409A Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

31 Specified Employees Specified employees must be designated each year as of a uniform identification date elected by the company. The identification does not become effective until the beginning of the 4 th calendar month after the identification date and the identified individuals remain specified employees for the next 12 months Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

32 Specified Employees Common Mistakes The rules relating to specified employees must be set out in a written document adopted by the controlled group The company must actually make the designations each year and not only when an officer terminates If the payment was due upon separation from service, the payment can only be made during that six-month period i.e., accelerated due to the death of the specified employee and not on account of disability, change in control or an unforeseeable emergency during that six-month period Copyright Trucker Huss, APC 100 Montgomery Street, 23rd Floor, San Francisco, California

33 2018 Federal Tax Rates Maximum Federal Income Tax Rate > For taxpayers with income of $500,000 ($600,00 for joint filers) the new rate is 37% Social Security and Medicare Rates > Social Security Rate 6.2% > Medicare rate is 1.45% For individuals with income above $200,000 ($250,000 for joint filers) there is an additional Medicare tax of 0.9% Note: Employers are required to withhold on an employee s taxable wages over $200,000 even if a joint filer Net Investment Income > 3.8% tax on net investment income 33

34 NQDC SPD Tax Explanations Non-qualified deferred compensation ( NQDC ) plans are not required to have an summary plan description ( SPD ) (claims procedures still required) Many employers do provide SPDs that contain income and employment tax withholding information regarding contributions and distributions 34

35 Deferrals/Contributions/Accruals Account Balance Plan > Employee deferrals > Employer credits Subject to Social Security and Medicare taxes in the year of employee deferral or employer contribution Should be update to include 0.9% Medicare withholding May explain that 3.8% net investment tax is not applicable to unfunded investment gains in a NQDC plan Defined Benefit Plans (e.g., SERP) > Generally not subject to Social Security and Medicare taxes at the time benefit accrues because amount of benefit is not reasonably ascertainable (i.e., time and form of payment is not yet know) > If benefit is reasonably ascertainable at time of accrual, then accrued benefit is subject to Social Security and Medicare taxes > Employer may also elect to include early (with later true up) If benefit accruals are included in income for Social Security and Medicare Taxes, then SPD should be updated for 0.9% Medicare withholding 35

36 Distributions Account Balance Plans > If Social Security and Medicare Taxes were properly withheld at the time of deferral or credit, then no Social Security or Medicare Taxes are withheld on the distributions (including any earnings credited to the account) > Net Investment Income does not apply on earnings on investments in an unfunded account balance plan May update SPD to state that net investment income does not apply to earnings in the NQDC plan. > Income Tax Withholding Supplemental Wages Optional flat rate now 22% Mandatory flat rate for payments of supplemental wages aggregated over $1,000,000 the rate has gone up to 37% Should update SPD to include new 37% mandatory flat rate 36

37 Distributions Defined Benefit Plans > Social Security and Medicare Taxes: Generally withheld on the present value of the benefit the time the amount of the benefit is reasonable ascertainable (i.e., time and form of payment are both known) and not on stream of payments SPD may need to be updated to include 0.9% Medicare tax on employees with income over $200,000 ($250,000 for joint filers) > Income Taxes: Supplemental Wages Update SPD for 37% mandatory flat rate withholding Regular Wages Update for top 37% income tax rate 37

38 State Income Taxes on NQDC Payments April 2013 NY State Department of Taxation and Finance found that payments from a SERP and Deferred Compensation Plan that were earned while employee worked in NY were not subject to NY state income tax because employee was not a NY resident 38

39 Federal Statute Preempts State Tax Laws 4 USC 114 No state may impose an income tax on the retirement income of an individual who is not a resident or domiciliary of the State Not applicable to all payments from a NQDC plan 39

40 Federal Preemption Any plan, program, or arrangement described in section 3121(v)(2)(C) of such Code..., if such income > is part of a series of substantially equal periodic payments (not less frequently than annually which may include income described in subparagraphs (A) through (H)) made for the life or life expectancy of the recipient (or the joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient), or a period of not less than 10 years, or 40

41 Federal Preemption Is a payment received after termination of employment and under a plan, program, or arrangement (to which such employment relates) maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by 1 or more of sections 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k), or 415 of such Code or any other limitation on contributions or benefits in such Code on plans to which any of such sections apply 41

42 Federal Tax Withholding Wage Withholding Section 3402 of the Internal Revenue Code (the Code ) requires employers to withhold income taxes on wages paid FICA Withholding Code 3102 requires employers to withhold FICA (Social Security and Medicare) taxes FUTA Code 3301 requires employers to pay federal unemployment taxes based on employees earned wages 42

43 Tax Reporting Income Statements > Form W-2 > Form 1099 Returns > Form 941 Employment Tax Return Income taxes and FICA > Form 940 FUTA 43

44 Employer Liability Employer is responsible for payment of the income and FICA taxes even if not collected from the employee (Code 3102(b) and 3402(a)(1)) Employer entitled to credit for amounts employee actual pays when employee return is filed (Code 3402(d)) 44

45 Trust Fund Liability (Code Section 7501) Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States. The amount of such fund shall be assessed, collected, and paid in the same manner and subject to the same provisions and limitations (including penalties) as are applicable with respect to the taxes from which such fund arose 45

46 Trust Fund Tax Penalty (Code Section 6672) Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax on the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. No penalty shall be imposed under section 6653 or part II of subchapter A of chapter 68 for any offense to which this section is applicable 46

47 Responsible Persons The person is "responsible" had the duty to account for, collect, and pay over the trust fund taxes to the government; and The person "willfully" failed to collect or pay over trust fund taxes to the government Penalty = 100% of taxes 47

48 Responsible Person A determination of "responsibility" depends upon the facts and circumstances of each case Common factors considered by the court: > Person is an officer, director, or principal shareholder of the corporation > Authority to sign checks > Person who controls the financial affairs of the business > Person who had authority to determine which creditors would be paid and those who exercised that authority > Person who controlled payroll disbursements > Person who signed the employment tax returns 48

49 Responsible Person The crucial test is whether the person has the effective power to pay the taxes owed A person is deemed to have such power if he or she possesses the authority to exercise significant control over the company s financial affairs whether or not such control is in fact exercised Significant control generally relates to the person s status, duty, and authority in the business that failed to carry out one of the statutory withholding and payment duties 49

50 Willful Conduct Definition of willful intentional, deliberate, voluntary, reckless, knowing (not accidental). No evil intent or bad motive is required To show "willfulness," the government must show that the responsible party was aware of the outstanding taxes and either deliberately chose not to pay the taxes or recklessly disregarded an obvious risk that the taxes would not be paid 50

51 FICA Tax Withholding Social Security (also called old-age, survivor and disability insurance or OASDI) > Currently 6.2% > Wage base limitation for 2018 is $128,400 Medicare (also called hospital insurance or HI) > Currently 1.45% > Supplemental.9% on wages in excess of $200,000 > No wage limitation. Applies to all wages 51

52 FICA Tax Withholding General Rule: Tax is collected at the time it is actually or constructively paid Special Timing Rule: (Code 3121(v)) Nonqualified Deferred Compensation is taken into account as of the later of > Date services are performed; or > Date NQDC is no longer subject to substantial risk of forfeiture (e.g., vested) 52

53 Exceptions to Special Rule Non-account balance (i.e., defined benefit) NQDC plans For non-account balance plans, FICA taxation is not required until the entire amount deferred is reasonably ascertainable (the resolution date) A benefit from a non-account balance plan is generally reasonably ascertainable when the time and form of payment is known and the only factors to determine the benefit are interest, mortality and cost-of-living assumptions 53

54 Non-Account Balance NQDC Plans For example: > Time of payment is not known because payment commences on termination of employment > Amount of future compensation in benefit formula is unknown 54

55 Non-Account Balance NQDC Plans Issues > Benefit amount frequently becomes reasonably ascertainable before payment commences Generally, payment is triggered by termination of employment. At that time, benefit amount usually becomes reasonably ascertainable However, payment may be delayed to a subsequent tax year Retire at end of calendar year and payments commence in next calendar year Specified employees under Code 409A required to have 6- month delay in payment commencement date FICA tax withholding required to be made in year of termination of employment (resolution date) FICA taxation on present value of benefit on resolution date 55

56 Non-Account Balance NQDC Plans Employee may have hit the wage limitation on Social Security taxes and owe no taxes on present value of NQDC benefit Still owes Medicare portion of FICA on entire present value of benefit on resolution date If fail to withhold at resolution date (i.e., termination of employment), then FICA will be due on each payment. For an annuity or installment payments this may substantially increase FICA tax liability 56

57 Non-Account Balance NQDC Plans > Withhold from final paycheck May not be enough in the case of large SERP-type benefit > Employee writes a check May not be popular with employees Difficult to administer > Employer pays up front and then reduces future payment stream For publicly traded companies, could be a loan to an executive officer that is prohibited by the Sarbanes-Oxley Act > Reduce Future Benefits by FICA taxes Accelerated payment (409A exception) Employer discretion OK, employee discretion is 409A violation Income and employment taxes on benefit reduction 57

58 Exceptions to Special Rules Administrative Convenience > For non-qualified deferred compensation plans, the employer can treat any later date during the same calendar year as the taxable date (the resolution date ) > Many employers treat December 31 st as the resolution date for all FICA withholding for nonqualified plan FICA wages > FICA reporting (Form 941) and payment/deposits are then due by January 31 st of following year > FICA calculated on present value of benefit on delayed withholding date 58

59 Exceptions to Special Rule Estimate Method > Reasonable estimate of the benefit is taken into income on date prior to end of the year (or earlier resolution date) > If the amount is underestimated, can be corrected interest and tax free on Form 941-X for calendar quarter of estimated withholding > If overestimated, can apply for a refund 59

60 Exceptions to Special Rule Lag Method > FICA on NQDC can be taken into account as late as March 31 st of following calendar year > Employer must pay interest at the applicable federal rate on the FICA taxes for the period of January 1 to March 31 60

61 Box 11 The purpose of box 11 is for the Social Security Administration (SSA) to determine if any part of the amount reported in box 1 or boxes 3 and/or 5 was earned in a prior year The SSA uses this information to verify that they have properly applied the social security earnings test and paid the correct amount of benefits 61

62 Box 11 Under nonqualified plans or nongovernmental 457(b) plans, deferred amounts that are no longer subject to a substantial risk of forfeiture are taxable even if not distributed Report these amounts in boxes 3 (up to the social security wage base) and 5. Do not report in box 11 deferrals included in boxes 3 and/or 5 and deferrals for current year services (such as those with no risk of forfeiture) 62

63 Box 11 If you made distributions and also are reporting any deferrals in box 3 and/or 5, do not complete box 11 > See Pub. 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration, and Form SSA-131, Employer Report of Special Wage Payments, for instructions on reporting these and other kinds of compensation earned in prior years However, do not file Form SSA-131 if this situation applies and the employee was not 61 years old or more during the tax year for which you are filing Form W-2 63

64 Wages Regular Wages are amounts that are paid at a regular hourly, daily, or similar periodic rate (and not an overtime rate) for the current payroll period or at a predetermined fixed determinable amount for the current payroll period Supplemental Wages are all amounts that are not regular wages 64

65 Retirement Income Code Section 3504 Special Rules for Pension, Annuities, and Certain Other Deferred Compensation Sections 3504(a) and (b) permit electing out of income tax withholding Section 3504(c) discusses rollover distributions Section 3504(e)(5) defines employer deferred compensation plan as any pension, annuity, profit sharing or stock bonus plan or any other plan deferring the receipt of income 65

66 Retirement Income Treasury Reg T Q&A 18 Question: Do these withholding provisions apply to designated distributions under all nonqualified deferred compensation plans? Answer: No. Section 3405 only applies to those deferred compensation plans that are otherwise excluded from the definition of wages under Code 3401(a), which includes tax-qualified retirement plans, 457(b) plans, etc. 66

67 Supplemental Wages Regulatory examples of supplemental wages: > Nonqualified deferred compensation includible in wages > Severance pay > Bonuses > Commissions > Taxable noncash fringe benefits > Section 83 property 67

68 Withholding on Supplemental Wages Mandatory flat rate withholding on any supplemental wages over $1,000,000 during any calendar year > Excess amount withheld at maximum bracket rate (currently 37%) > W-4 Withholding exemptions disregarded 68

69 Withholding on Supplemental Wages Aggregate Method if supplemental wages are paid concurrently with regular wages, then > Supplemental wages are aggregated with regular wages paid for the current payroll period > Treated as a single wage payment for the regular payroll period > The withholding method used by the employer with respect to regular wages would then be used to calculate the income tax withholding on the aggregate wage payment > The employer would take into consideration the Form W-4 submitted by the employee 69

70 Withholding on Supplemental Wages Optional Flat Rate Method may be used if: > Mandatory flat rate does not apply; > Supplemental wages are either not paid concurrently with regular wages or are separately stated on the payroll records of the employer; and > Income tax has been withheld from employee s regular wages during the calendar year of the payment or the preceding calendar year Current rate is 22% Withholding made without regard to W-4 allowances 70

71 Withholding on Supplemental Wages Example 1 In the event of an involuntary termination without cause, employee is entitled to payment of 24 months of current annual base salary payable in equal installments on employer s normal bi-weekly payroll. Employee s annual base salary is $300,000 Assume no other supplemental wages paid Employee was involuntarily terminated without cause on November 1,

72 Withholding on Supplemental Wages Example 1 (cont d) Optional flat rate can be used for severance payments Severance payments are paid conditioned on termination of employment and therefore are not made concurrently with regular wages; > Severance payments in any tax year will not exceed $1,000,000; and > Withholding on regular wages (base salary) was made in the same year or immediately preceding taxable year 72

73 Withholding on Supplemental Wages Example 1 (cont d) For severance payments made from January 2019 to October 2019, optional flat rate cannot be used because no income taxes were withheld on regular wages in the same tax year (2018) or immediately preceding tax year (2017) Aggregate method must be used > This means that withholding must be based on current income tax brackets and Form W-4 on file 73

74 Domestic Relations Orders Income Taxes > Distributions to alternate payee (non-employee former spouse) are included in income of alternate payee > Report income on Form 1099-Misc, Box 3 No reduction for FICA taxes withheld > Supplemental wage rate withholding (currently 22%) and report income taxes withheld in Box 4 > Withhold any applicable FICA taxes (based on employee s wages) FICA Taxes > If not previously taken into account, report distribution to alternate payee as FICA wages and report any FICA taxes withheld on employee s Form W-2 74

75 Example 1 Deferral that is immediately vested (no substantial risk of forfeiture) with no distributions and no vesting of prior-year deferrals > For the taxable year: Regular pay was $200 Employee deferred $20 of the pay into NQDC plan. The deferral of $20 was vested upon deferral Employer match of $10 under the plan, which was also vested > Regular pay = $200; Deferral, vested = $20; Employer match, vested = $10 75

76 Example 1 Form W-2 Completion Amount Box 1 ($200 Regular pay minus $20 vested deferral) $180 Box 3 ($200 Regular pay plus $10 Employer match, vested) 210 Box 5 ($200 Regular pay plus $10 Employer match, vested) 210 Box

77 Example 2 Deferral with delayed vesting (substantial risk of forfeiture) of employee and employer portions (no distributions and no vesting of prior-year deferrals) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into NQDC plan. The deferral of $20 was not vested upon deferral Employer match of $10 under the plan, which was also not vested > Regular pay = $200; Deferral, not vested = $20; Employer match, not vested = $10 77

78 Example 2 Form W-2 Completion Amount Box 1 ($200 Regular pay minus $20 Deferral, not vested) $180 Box 3 ($200 Regular pay minus $20 Deferral, not vested) 180 Box 5 ($200 Regular pay minus $20 Deferral, not vested) 180 Box

79 Example 3 Deferral that is immediately vested with prior-year deferrals and investment earnings on the prior-year deferrals that are now vesting (no distributions) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into NQDC plan. The deferral of $20 was vested upon deferral $100 of prior-year deferrals and $15 of investment earnings on the $100 of prior-year deferrals became vested > Regular pay = $200; Deferral, vested = $20; Vesting of prior-year deferrals = $100; Vesting of investment earnings on $100 of prior-year deferral = $15 79

80 Example 3 Form W-2 Completion Amount Box 1 ($200 Regular pay minus $20 Deferral, vested) $180 Box 3 ($200 Regular pay plus $100 vested prior-year deferral plus $15 earnings on deferral) 315 Box 5 ($200 Regular pay plus $100 vested prior-year deferral plus $15 vested investment earnings on prior year deferral) 315 Box 11 ($100 vested prior-year deferral plus $15 earnings)

81 Example 4 No deferrals but there are distributions (no vesting of prior-year deferrals) > For the taxable year: Employee s regular pay was $100, and the employee deferred no pay into the employer s NQDC plan No vesting of prior-year deferrals under the plan Total distributions of $50 from the NQDC plan > Regular pay = $100; Distribution = $50 81

82 Example 4 Form W-2 Completion Box 1 ($100 Regular pay plus $50 Distribution) Amount $150 Box 3 ($100 Regular pay ) 100 Box 5 ($100 Regular pay) 100 Box 11 ($50 Distribution) 50 82

83 Example 5 Deferral that is immediately vested and there are distributions (no vesting of prior-year deferrals) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into the employer s NQDC plan Employer match in NQDC plan of $10 Both deferral and employer match are 100% vested No vesting of prior-year NQDC plan deferrals Distributions of $50 from the NQDC plan Regular pay = $200; Deferral, vested = $20; Employer match, vested = $10; Distribution = $50 83

84 Example 5 Form W-2 Completion Box 1 ($50 Special Wage Payment (Distribution) plus $200 Regular pay minus $20 Deferral, vested) Boxes 3 and 5 ($200 Regular pay plus $10 vested employer match) Amount $230 Leave Box 11 blank. File Form SSA Item 6 - amount of wages earned by the employee during the tax year ($230 from Box 1 of Form W-2 minus $50 Distribution plus $30 vested current year employee deferral and employer match) Form SSA-131 Completion $210 84

85 Example 6 Deferral with delayed vesting and there are distributions (no vesting of prior-year deferrals) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into the NQDC plan, which was unvested No vesting of prior-year deferrals under NQDC plan Total distributions of $50 from the NQDC plan Regular pay = $200; Deferral, not vested = $20; Distribution = $50 85

86 Example 6 Form W-2 Completion Amount Box 1 ($50 Special Wage Payment (Distribution) plus $200 Regular pay minus $20 Deferral, not vested) $230 Boxes 3 and 5 ($200 Regular pay minus $20 deferral that is not vested) 180 Box 11 ($50 Distribution)

87 Example 7 Deferral that is immediately vested and there are distributions (also vesting of prior-year deferrals and earnings on those prior-year deferrals) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into NQDC plan, which was vested Vesting of $100 of prior-year deferrals and $15 of earnings on the $100 prior-year deferral under the plan Total distributions of $50 from NQDC plan Regular pay = $200; Deferral, vested = $20; Distribution = $50; Vesting of prior-year deferrals ($100) and earnings on those prior-year deferrals ($15) = $115 87

88 Example 7 Form W-2 Completion Amount Box 1 ($50 Special Wage Payment (Distribution) plus $200 Regular pay minus $20 vested deferral $230 Boxes 3 and 5 ($200 Regular pay Plus $115 vested prior deferral (with vested earnings on the deferral)) 315 Leave Box 11 blank. File Form SSA Form SSA-131 Completion Item 6, amount of wages earned by the employee during the tax year ($230 from Box 1 of Form W-2 minus $50 Distribution plus $20 vested current year deferral) $200 88

89 Example 8 Deferral with delayed vesting and there are distributions (vesting of prior-year deferrals, including employer matches, and earnings on those deferrals) > For the taxable year: Employee s regular pay was $200 Employee deferred $20 of the pay into the NQDC plan. The deferral was not vested upon deferral Vesting of prior-year deferrals and employer matches and earnings on these amounts under the plan ($115) Total distributions of $50 from the NQDC plan Regular pay = $200; Deferral, not vested = $20; Distribution = $50; Vesting of prior-year deferrals and employer match = $100 plus earnings on that $100 of $15 89

90 Example 8 Form W-2 Completion Amount Box 1 ($50 Special Wage Payment (Distribution) plus $200 regular pay minus $20 Deferral, not vested) $230 Boxes 3 and 5 ($200 Regular pay plus $115 vested prior-year deferral and prior year employer match and earning on the prior year amounts minus $20 deferral that is not vested) 295 Leave Box 11 blank. File Form SSA Form SSA-131 Completion Item 6 ($230 Amount from Box 1 of Form W-2 minus $50 Distribution) $180 90