New Guidance on Reporting and Withholding Requirements for Deferred Compensation Plans
Last December, the Internal Revenue Service (“IRS”) issued a notice providing interim guidance on the reporting and withholding requirements applicable to deferred compensation plans subject to Section 409A of the Internal Revenue Code (“Code”). The guidance applies for calendar years 2005 and 2006. It extends through 2006 the waiver previously provided for reporting deferrals under such plans, but it requires reporting of amounts includible in income due to violations of Code Section 409A that occurred in 2005 or 2006 as well as withholding on such amounts for 2006.
Reporting of Deferrals
After Code Section 409A first became effective, the IRS issued guidance requiring employers to report annual deferrals under nonqualified deferred compensation plans on Form W-2 or 1099-MISC, as applicable. However, since the IRS has not yet provided guidance on how to calculate the amount of certain deferrals, it has continued to waive the requirement to report such deferrals for 2005 and 2006.
Reporting of Income
If a deferred compensation plan violates Code Section 409A, all vested amounts under the plan become immediately includible in income (and subject to a 20% tax penalty), even if such amounts have not been received by the service provider (whether an employee or independent contractor). An employer must report the includible amount in boxes 1 and 12 of the employee’s Form W-2 using Code Z in box 12; the amounts must also be reported on line 2 of Form 941. For non-employees, the amount that is includible in income must be reported in boxes 7 and 15b of the Form 1099-MISC. Although the IRS previously waived the requirement to report such income for 2005, employers and payors now must file original or amended returns for 2005 and furnish payee statements in the same manner as 2006 amounts are reported.
On a related matter, the new IRS notice provides guidance on determining the amount of deferred compensation that is includible in income. Generally, the amount includible in income is the amount actually or constructively received for the applicable year together with amounts that remain deferred as of the end of such year, excluding grandfathered amounts. The method for determining includible income depends on the nature of the underlying arrangement. For account balance plans, the amount is generally the vested account balance as of December 31; for non-account balance plans, however, the amount is based on the present value of future payments to which there is a legally binding right as of December 31. The amount with respect to stock rights (such as discounted options) is generally equal to the spread on the stock right as of December 31. For other arrangements, a reasonable, good-faith method must be used.
The new notice requires employers to treat amounts includible in gross income as a result of a Code Section 409A violation occurring in 2006 as wages for federal income tax withholding purposes. If the employee received other regular wages from the employer during 2006, the amount includible in gross income is treated as supplemental wages for purposes of determining the amount of income tax required to be withheld.
Amounts that are includible in gross income for 2006 but are not received by the employee during 2006 are treated as paid on December 31, 2006, and should be reported on Form 941 for the quarter ending on December 31, 2006. The notice also provides two methods to correct an employer’s failure to withhold income taxes from such amounts before December 31, 2006: the employer may either withhold the required amount or pay the income tax withholding liability on behalf of the employee by January 31, 2007.
Service Provider Requirements
The employee or independent contractor will be required to report as income and pay taxes due on amounts includible in income for 2006. For 2005, amended returns must be filed and taxes paid by the due date for the 2006 tax return (including extensions).
If you have any questions about these new requirements, please contact one of the attorneys on the Boult Cummings Employee Benefits and Executive Compensation Team .