For years, many have thought that nonqualified (NQDC or NQ) plans to be a significant area of tax abuse and a potential source of tax revenue for the federal government. And, whether this is simply a much needed update or the beginning of a push, the language in the guide would seem to suggest where the IRS thinks there are problems.
Let's look at the paragraph headers in the guide as a means of determining where the focus is likely to be:
- Examining Constructive Receipt and Economic Benefit Issues
- Audit Techniques
- Examining the Employer's Deduction
- Employment Taxes
- Important Note [related to 401(k) plans]
- The American Jobs Creation Act of 2004 [the law that brought us Code Section 409A]
Constructive Receipt and Economic Benefit Issues
Here, the guide instructs auditors to look for assets set aside free from creditors for the benefit of employees. It also instructs these auditors to look to see how executives can use the benefits in these nonqualified plans. For example, if a SERP might be pledged as collateral, then the employee has enough control to have constructively received the benefit and is subject to current taxation, or was when the benefit was first constructively received.
For employers with any knowledge of NQDC plans or those who use counsel who work at all in this area, getting this right falls under the heading of basic blocking and tackling. So, while the IRS might be able to find some defects here, it would not seem to be a source of significant revenue.
In this section, frankly, I think that the IRS is grasping at straws. It asks auditors to interview personnel most knowledgeable about the plans. Further, the auditors are encouraged to review Forms 10-K and to learn whether the company uses a consulting firm to assist with its NQDC plans.
There seems to be little glue holding this section together. Instead, what I am seeing is that their may be a needle in a haystack and a fortunate auditor might find that needle. Other sections of the guide may prove more fruitful.
Examining the Employer's Deduction
Generally, the amount and timing of the employer's deduction must match the amount and timing of the executive's inclusion in income. Looking from the outside in, this would seem to be simple. But, corporate tax returns, especially for large corporations are quite complex. Similarly, a corporate executive is fairly likely to have a complex tax return. It's not unlikely that treatment of income from NQDC plans is nowhere near the top of the priority list for either the corporate tax department or for the executive's accountant.
In fact, in my experience, some corporate tax departments do not have significant familiarity with this type of plan (some have exceptional knowledge). Similarly, and perhaps more glaring, many personal accountants, again in my experience, just don't know much about nonqualified plans.
The Internal Revenue Code is a complex instrument. The instructions to government forms, especially if you include the various Publications that they reference, are quite confusing. If an accountant deals with particularly few NQDC plans, it would not be shocking to find that accountant confused by their tax treatment. Certainly, I would not expect them to confirm that the amount and timing of inclusion in income coincides with the corporate tax deduction.
This is the section that deals with FICA and FUTA taxes. Until the cap was removed from Medicare wages, this section would have been ignored. The reason is that although nonqualified deferred compensation is subject to these taxes when it is both vested and reasonably ascertainable (a technical term meaning that a knowledgeable person can figure out about how much it is worth), virtually all NQDC participants earned far more than the Social Security Wage Base each year. But, when the cap at the Wage Base was removed for Medicare taxes, new NQDC was necessarily subject to that tax.
The regulations on this topic are, in a word, confusing. Specifically for what are known as non-account balance plans (generally defined benefit SERPs), the guidance on how to perform calculations was likely written by someone who did not know what they were prescribing and the guidance on the actuarial assumptions to be used in those calculations is virtually nonexistent.
However, in my experience with this topic, the IRS does have strong opinion on what the Treasury Regulations mean and intend. That said, when the regulations under Section 3121(v) were issued, I co-authored a research memo on the calculation of the amount of FICA wages from NQDC plans (the focus was on non-account balance plans). To say that the authors went back and forth many times before agreeing on the intended methodology is an understatement. To think that similar authors at other actuarial consulting firms would reach exactly the same conclusion is no plausible. Add to that the various accounting and tax firms who might have their own opinions and you would certainly have a lack of consistency. About 15 years ago, however, one IRS examiner that I spoke with off the record said that there was just one consistent method available under the regulations.
Said differently, while I don't know how much revenue is potentially available, the calculation of employment taxes with respect to NQDC plans, and specifically non-account balance plans would not all meet with the approval of that particular examiner.
Important Note [related to 401(k) plans]
The coordination of qualified 401(k) plans and NQDC plans that provide for deferrals in excess of those allowed in the qualified plan seems like it should be simple. It's not. In particular, it's not if the two plans (qualified and nonqualified) are administered by different providers (or if one is administered externally and the other internally). Generally, these plans allow participants to defer amounts where IRS limits would otherwise preclude such deferrals. In the simple situations where the 401(k) plan passes nondiscrimination testing, this is pretty easy. But, when the plan is forced to refund deferrals due to test failure or when deferrals are restricted in hopes of making the testing work, things can go horribly wrong. Do the two separate administrators communicate with each other? It's doubtful.
There is likely not a lot of revenue for the government to find here, but there are probably a large number of very small problems.
The American Jobs Creation Act of 2004 [the law that added Section 409A to the Internal Revenue Code]
I've written about 409A here many times. If you are interested, go the little search box at the top of the page and type 409A. I'd be surprised if you get fewer than 25 hits in this blog, but I've not counted.
As is often said about relationships, it's complicated.
The regulations are long and were written in a fashion similar to the regulations under Section 3121(v). Frankly, I don't think the people who worked on the project did a bad job writing the regulations. They're not perfect, but they wouldn't have been perfect if you or I had written them either, so we must be careful with our criticism.
But, certain parts of the regulations that have lots of calculational elements where the calculations almost necessarily must be performed by actuaries were written by attorneys. I know some of those attorneys. They're smart people. And, they spent lots of time understanding the statute and developing regulations to enforce that statute. They could have done far worse.
The people that I know, however, who worked on the project are not actuaries. While they have some familiarity with actuarial calculations, they don't actually do them and I think they would tell you if you asked candidly that they have only a minimal understanding of them. Yet, for certain types of plans (mostly non-account balance plans), there is much in the way of actuarial calculations that determines potential tax liabilities.
Frankly, we don't know what was intended. We tend to reference the FICA regulations, but even there as I noted above, the regulations are not prescriptive.
Section 409A is a mess. I don't think anyone intends to violate it, but there are lots of people who don't get it right. Finding the violations is difficult, but if examiners do find violations, with those violations will come some fairly meaningful tax revenue.
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So, that's my take on where the IRS is headed and what value it has to them. Time will tell if I got it right for a change or not.