Employment Tax Examinations: Executives in the Crosshairs

Transcription

1 Employment Tax Examinations: Executives in the Crosshairs Selected Issues Certain to Annoy Tax Departments Anthony G. Provenzano Marianna G. Dyson November 3, 2017

2 Employment Tax Exams: Executives in the Crosshairs Hot topics in IRS Employment Tax Examinations Update on current IRS audit climate Voluntary correction strategies State Sourcing Nonresident Employees and Deferred Compensation Special timing rule for the application of FICA taxes to certain nonqualified deferred compensation Section 409A Examination Activity Section 162(m) Examination Activity Miller & Chevalier Chartered 2

3 HOT TOPICS IN IRS EMPLOYMENT TAX EXAMINATIONS

4 Employment Tax Examinations Analysis of National Research Program ( ) data IRS reports anecdotally that there is a lot of mischief going on GAO Report (April 2017) worker classification and fringe benefits were among the most frequently misreported and led to highest wage adjustments on average Increased focus on fringe benefits provided to employees Increased interaction between IRS corporate exam team and employment tax examiners coordination of issues direction of employment tax issues by IRS corporate exam team Miller & Chevalier Chartered 4

5 Employment Tax Examinations Automatic application of negligence penalties and proclivity towards assertion of information reporting penalties Detailed examinations of payments Challenges to allocation between wages and non-wages in employment-related settlements Failure to correctly report and allocate attorneys fees Failure to timely solicit TINs before making payments (backup withholding) Other backup withholding issues, including failure to timely deposit backup withholdings and to file Form 945/945A Miller & Chevalier Chartered 5

6 Categories of Fringe Benefits in Recent IDRs IRS is focusing on fun, food and moving around by executives, in particular Car allowances Company cars Chauffeured cars Personal use of aircraft Security benefits Transportation-related Home security Sporting events, tickets and luxury boxes Employee discounts Club memberships Spousal travel Tax return preparation Financial planning services Travel expense reimbursements (tax home issue) Relocation assistance Severance payments Stock options/stock plans Deferred compensation Loans Miller & Chevalier Chartered 6

7 A Little Review: How to Calculate Federal Liability for Failing to Treat a Taxable Fringe Benefit as Wages Employer is secondarily liable ( 3403) for failing to withhold income taxes and will be assessed: 25% (currently) with respect to additional wages paid to employees receiving less than $1 million in supplemental wages in the aggregate during the year, and 39.6% (currently) for additional supplemental wages in the aggregate equal or exceeding $1 million during the year. Treas. Reg (g)-1. Employer is secondarily liable for failing to withhold the employee s share of FICA taxes (6.2% OASDI up to annual wage base, 1.45% Medicare + 0.9% AdMedTax on high earners). Employer is liable for failing to pay its share of FICA taxes (6.2% OASDI up to annual wage base % Medicare). Miller & Chevalier Chartered 7

8 Federal Liability for Failing to Treat a Taxable Fringe Benefit as Wages (cont d) Employer is liable for FUTA taxes to extent employee s other wages are not over the annual FUTA tax wage base. Employer is liable for 6656 late deposit penalty on its share of FICA taxes only (i.e., 10% of FICA taxes it should have paid). Standard information reporting penalties under 6721/6722 (indexed; currently $260 each and capped at $3.193 million in the aggregate; sometimes only one penalty is assessed). Negligence penalty of 20% under 6662 is routinely asserted by Exam but is not often sustained in Appeals. Interest, but only if error was ascertained in a prior period or assessment is not paid timely under the interest-free adjustment rules of See Rev. Rul Miller & Chevalier Chartered 8

9 Offensive Strategy: Self-Correction Tools Interest-free adjustment rules of 6205(a)(1) and Treas. Reg provide rules for the adjustments of income tax withholding and FICA taxes without interest. Employers have the opportunity to correct underreporting errors through the Form 941-X process, interest free, if the taxes are paid by the due date of the return for the quarter in which the error was ascertained. Employer may self-correct FICA taxes (except the AdMedTax) for all open years, but cannot self-correct an income tax withholding or AdMedTax failure from an earlier open year; but employer may issue Forms W-2c to report more wages in Box 1. Employer should decide whether or not to take advantage of voluntary correction rules for past failures to treat taxable fringe benefits as wages, to include contacting the IRS. Correct tax treatment going forward may not want to wait for the IRS examination. Miller & Chevalier Chartered 9

10 STATE SOURCING OF WAGES NONRESIDENT EMPLOYEES AND DEFERRED COMPENSATION

11 When Does an Employer Have to Withhold? In general, employers must withhold income tax for a state if they are engaged in business within the state. In most cases, if an employee was working in the state at the employer s request, the employer will be required to withhold on compensation paid for the time in the state. In many states, even an employee working from home may create sufficient nexus to impose withholding liability. Miller & Chevalier Chartered 11

12 Applying State Sourcing Rules Income from the performance of services is typically sourced to the place where performed. States usually source income based on the ratio of working days within the state to total working days during the period for which compensation is paid. Income is generally first taxed in the source state and next in the state of residence. The residence of the employee and the location of the employer are irrelevant to determining the source of the employee s compensation. Miller & Chevalier Chartered 12

13 Sourcing Deferred, Equity, and Long-Term Compensation Deferred compensation, equity compensation, and long-term bonus plans often necessitate tracking an employee daily work locations over a number of years a significant issue for employers. Some states, including New York, look to the vesting period (grant date to vest date) and source the payment based on the location(s) services were performed during the period. Some states have a different approach. California uses the period from grant date to exercise date for stock option income (or termination date, if earlier). In contrast, California uses the period from grant date to vest date for restricted stock and restricted stock units. Miller & Chevalier Chartered 13

14 Income Tax and Withholding Thresholds 40% of states impose income tax liability and withholding liability on the very first day worked within the state. However, some states provide exceptions from withholding (and/or income tax) for employees who are in the state on a transitory basis. For example, New York has an administrative rule that provides that employers are not required to withhold on income paid to an employee who performs services both inside and outside of New York if certain conditions are met, including that the employee primarily works outside of New York, the employer reasonably expects that the employee will work in New York for no more than 14 days during the calendar year, and the employee does not work in New York for more than 14 days during the calendar year. Miller & Chevalier Chartered 14

15 Enhanced Enforcement The risk of noncompliance is growing. A 2015 survey by Ernst & Young found that 40% of employers with workers crossing state lines had been audited by state tax authorities and 21% reported they had been audited within the past year. New York and Connecticut have led the way with California, Minnesota, and Ohio close behind. Pennsylvania, North Carolina, Georgia, and Louisiana are increasing their focus on withholding compliance. States have focused significantly on withholding for payments of deferred compensation and stock-based compensation. Meanwhile, nearly half of surveyed employers that have some program for withholding nonresident state income tax follow all state guidelines concerning de minimis thresholds. Miller & Chevalier Chartered 15

16 Deferred Compensation Planning State statutes often exclude retirement pay from withholding requirements: Definition of retirement arrangement often vague Specific state rulings and informal interpretations Federal blocker under 4 U.S.C. 114 prevents states from requiring income tax withholding from nonqualified plans in certain situations: Plans providing benefits in excess of IRC limits and paid after termination; or If benefits paid over 10 years or life expectancy Miller & Chevalier Chartered 16

17 The Risk of Noncompliance Withholding Tax Liability Penalties and Interest Personal Liability for Officers Damaged Employee Relationships Loss of a Business License in Some States Reputational Harm Miller & Chevalier Chartered 17

18 FAILURE TO PROPERLY APPLY FICA TAXES TO DEFERRED COMPENSATION

19 Special FICA Timing Rule Applicable to NQDC Failure to Apply 3121(v)(2) Results in FICA Taxation at Distribution Under 3121(a), wages are subjected to FICA taxation when constructively or actually received. This is known as the general timing rule and it coincides with the application of income tax withholding. 3121(v)(2) mandates that amounts deferred under a nonqualified deferred compensation plan must be subjected to FICA taxation as of the later of the date the services were performed or the date on which there is no substantial risk of forfeiture. The application of 3121(a) is not elective! Miller & Chevalier Chartered 19

20 Special FICA Timing Rule Applicable to NQDC Failure to Apply 3121(v)(2) Results in FICA Taxation at Distribution If properly applied, the deferred comp and subsequent increases in its present value escape FICA taxation at distribution under the nonduplication rule. Application of 3121(v)(2) often viewed as favorable, because FICA taxation occurs in a year when employee s other wages exceed OASDI wage base. If not properly applied, employer may retroactively correct open years and IRS may assess FICA taxes for those years. Otherwise, FICA taxation occurs at distribution under general timing rule. Regs do not permit employer to correct closed years failures!! Miller & Chevalier Chartered 20

21 Davidson v. Henkel (January 6, 2015) Private Cause of Action Under ERISA for Failing to FICA Tax Properly Henkel maintained a SERP, which is a nonaccount balance plan under 3121(v)(2) regulations. FICA taxes are usually applied to the present value of the SERP benefits when the employee retires, i.e., when all events are known that allow the value of the lifetime retirement benefit to be reasonably ascertainable. An outside advisor told Henkel that it had failed to subject the present value of the SERP benefits to FICA taxation at retirement. Henkel also was not FICA taxing the distributions. Miller & Chevalier Chartered 21

22 Davidson v. Henkel (January 6, 2015) Three Ill-Advised Actions That Led Retirees to Seek a Remedy Under ERISA Henkel settled with the IRS without the retirees knowledge and began withholding FICA taxes at distribution under the general timing rule (with no gross up). In addition, Henkel withheld from distributions the employees shares of FICA taxes that it had paid to the IRS under the settlement. Henkel admitted to Davidson in writing, yes, at the time you commenced receipt of this benefit, Henkel should have applied FICA tax to the present value of your nonqualified pension benefit. Miller & Chevalier Chartered 22

23 Davidson v. Henkel (January 6, 2015) Private Cause of Action Under ERISA for Failing to FICA Tax Properly 2012: U.S. district court certified a class of 49 retirees; case was allowed to move forward on the premise that the Henkel SERP was governed by ERISA. Earlier this year, the court held that an employer s promise under a top hat plan to provide a stated benefit carried with it an obligation to administer the plan in a manner that essentially guaranteed the proper tax treatment of benefits under FICA. Henkel paid the benefits required by the plan formula, but, by its own admission, failed to withhold FICA taxes under the special timing rule of 3121(v)(2). Miller & Chevalier Chartered 23

24 Davidson v. Henkel (cont d) The court held Henkel liable under ERISA, because its failure to apply FICA taxes at the time of each employee s retirement required the application of FICA taxation at payment, which diminished the retirees net benefits. Indemnification protection under 3102(b) does not help when employer failed to apply 3121(v)(2). Because the application of the special timing rule of 3121(v)(2) is exceedingly complex, it is not uncommon for employers to make mistakes in the application of this rule. Miller & Chevalier Chartered 24

25 Davidson v. Henkel (cont d) The decision in Henkel may open the door to employees who feel aggrieved by their employer s mistakes to sue under ERISA for recovery of their lost tax benefits. Thus, the decision highlights a very real threat facing a sponsoring employer of a top-hat plan if it fails to administer the plan in a manner that results in the most beneficial tax treatment. Takeaway for employers: Review the FICA tax procedures being applied to your nonqualified deferred comp arrangements. Miller & Chevalier Chartered 25

26 FICA Tax Exam Activity and Issues Exam activity with FICA taxes within executive compensation has not slowed. Supplemental pension benefits remains an easy target for exam Timing of FICA tax withholding and deposit Calculation of benefits Focus on when benefit becomes reasonably ascertainable Defined contribution arrangements (salary and bonus deferral) Far more common than pension arrangements Often complex vesting schedules Review of earnings and permissible investments RSU and equity compensation Retirement vesting Valuation issues Miller & Chevalier Chartered 26

27 409A DEFERRED COMPENSATION

28 409A Exam Activity 2009 IRS issued very broad IDRs IRS describes new limited audits Limited scope Limited employees Used for training purposes Focus of IRS deferred compensation audit technique guides: Funding Income inclusion FICA Deductions Miller & Chevalier Chartered 28

29 409A Exam Activity 409A issues can arise in other contexts: Stock option deductions 162(m) 280G Deduction review Compliance monitoring outside of IRS: Due diligence Outside auditors Outside counsel Miller & Chevalier Chartered 29

30 162(m) Exam Activity Review of Schedule M-3 on Form 1120 IRS desire to review basic information: Covered employees Shareholder disclosure Timely grants Timely certification Deduction timing Miller & Chevalier Chartered 30

31 Tax Withholding and Reporting Blog Excellent resource for in-house counsel and professionals in tax, accounts payable, and payroll roles who must stay up-to-date on the ever-shifting requirements of federal and state tax withholding and reporting issues. Covers not only the substantive requirements of the law, but also information on related penalties, penalty abatement, IRS audit trends, and other topical developments in these areas. Miller & Chevalier Chartered 31

32 Critical Issues Series: FICA Tax and FATCA Available now from Thomson Reuters: Critical Issues Series: U.S. Information Reporting and Withholding at the Source FATCA The first Critical Issues Series title, U.S. Information Reporting and Withholding at the Source FATCA, by Marianna G. Dyson and Michael M. Lloyd, addresses FATCA information reporting and withholding requirements. Critical Issues Series: U.S. Information Reporting and Withholding at the Source FICA Provides a thorough discussion of the requirements for imposing FICA taxes, which do not always harmonize with the requirements for imposing Federal income tax withholding on wages. The authors also offer practical solutions for special FICA tax challenges faced by employers, such as situations involving signing bonuses, severance pay, sick pay, tips received by employees, cross-border compensation, and employment-related settlements, to name a few. Miller & Chevalier Chartered 32

33 For Further Information Marianna G. Dyson Anthony G. Provenzano Miller & Chevalier Chartered 33