The IRS has issued an updated nonqualified deferred compensation (NQDC) audit technique guide for its agents that discusses the issue of when amounts deferred into NQDC plans are includable in employees’ gross income and deductible by plan sponsors.
The guide discusses the constructive receipt doctrine for unfunded plans, which states that income, although not actually reduced to a taxpayer’s possession, is constructively received in the taxable year in which it is credited to the taxpayer’s account, set apart for the taxpayer or otherwise made available to the taxpayer. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
The IRS notes that whether an employee has constructively received an amount does not depend on whether he withdrew funds, but whether he could have withdrawn funds without substantial limitations or restrictions.
For funded plans, under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, he will be taxed at the time of receipt of the property when it is either transferable or not subject to a substantial risk of forfeiture. The taxpayer does not include the value of the property in income until the property is no longer subject to a substantial risk of forfeiture or the property becomes transferable.
The IRS notes that under Treasury regulations, a substantial risk of forfeiture generally exists when the transfer of rights in property is conditioned, directly or indirectly, upon the future performance of substantial services.
According to the guide, Internal Revenue Code (IRC) Section 409A provides comprehensive rules governing NQDC arrangements that apply in addition to the doctrines of constructive receipt and economic benefit. Section 409A provides that all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent that they’re not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are met.
The IRS notes that if Section 409A requires an amount to be included in gross income, the statute imposes substantial additional taxes, which are assessed against the employee/service provider (including an independent contractor) and not the employer/service recipient.
Employers must withhold income tax on any amount includible in the employee’s gross income under Section 409A. However, the employer is not required to withhold the additional taxes. Generally, employers must withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee.
In addition, NQDC deferral amounts are taken into account for Federal Insurance Contributions Act (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. In other words, 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.
Regarding employer tax deductions for amounts deferred into NQDC plans, the guide says they are deductible by the employer when the amount is includible in the employee’s income.
The guide tells IRS agents that a NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. The examiner should also address if deferred amounts were properly taken into account for employment tax purposes.
The agency 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. Regulations provide 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. Examiners will look for any NQDC plan provisions that limit the total amount that can be deferred between the NQDC plan and the 401(k) plan, as well as any which state that participation is limited to employees who elect not to participate in the 401(k) plan.
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