United States: Withholding Judgment: IRS Issues Guidance On Reporting And Withholding For Nonqualified Deferred Compensation

On December 1, 2006, the IRS issued Notice 2006-100, which addresses reporting and withholding with respect to nonqualified deferred compensation subject to section 409A of the Internal Revenue Code (the Code). Most significantly, the Notice provides that 2006 deferrals under arrangements that comply with section 409A do not need to be reported on Form W-2 or Form 1099-MISC. However, the Notice does require reporting and withholding with respect to deferrals under arrangements that fail to comply with section 409A. Also, the Notice provides guidance with respect to the procedures for reporting, withholding and calculating the amounts taxable for non-409A-compliant arrangements.

The American Jobs Creation Act of 2004, which added section 409A to the Code, also amended the Code to require that:

• Employers and payers (e.g., companies paying independent contractors) report deferrals under nonqualified deferred compensation plans that comply with section 409A on a Form W-2 or Form 1099-MISC, as applicable;

• Employers and payers report amounts includible in income under arrangements that do not comply with section 409A on a Form W-2 or Form 1099-MISC, as applicable; and

• Employers withhold income taxes on amounts includible in income under arrangements that do not comply with section 409A.

Notice 2005-1 and the proposed regulations under section 409A provided initial guidance with respect to reporting and withholding under section 409A, and Notice 2005-94:

• Waived employers’ and payers’ reporting obligations for 2005 for deferrals under 409A-compliant arrangements;

Suspended (but did not permanently waive) employers’ and payers’ reporting obligations for 2005 for amounts included in income under arrangements that do not comply with section 409A, unless such amounts were actually or constructively received by the employee under such an arrangement;

• Waived employers’ withholding obligations for 2005 for amounts included in income under arrangements that do not comply with section 409A, unless such amounts were actually or constructively received by the employee under such an arrangement (e.g., an arrangement fails to comply with section 409A by allowing an impermissible accelerated payment); and

• Permitted plan participants¹ to delay reporting and paying taxes with respect to amounts included in income under a non-409A-compliant arrangement, without penalty, if the participant later reports and pays taxes in accordance with subsequently issued guidance.

Employers and other payers have been awaiting guidance on the suspended 2005 reporting and tax payment rules, as well as guidance on reporting and withholding for 2005 and 2006, and Notice 2006-100 provides that guidance.

The Notice confirms that the 2005 reporting requirements for deferrals under 409A-compliant arrangements are waived, and the Notice extends that waiver to include deferrals made in 2006.

If an arrangement fails to comply with section 409A, amounts are includible in income under such arrangement unless the amounts are subject to a substantial risk of forfeiture or have been included in income previously. With respect to amounts includible in income under a non-409A-compliant arrangement for 2005 or 2006, the Notice provides that employers and payers must report for 2005 and report and withhold for 2006.

Reporting for 2006 must be made by the usual deadlines (generally, February 28, 2007 for returns and January 31, 2007 for payee statements). Employers and payers who suspended reporting for 2005 under Notice 2005-94 are now required to file an original or corrected information return or payee statement (Form W-2 or 1099-MISC) reporting any previously unreported amounts includible in gross income under section 409A for 2005. Such returns and payee statements must be filed by the deadlines applicable for 2006.

The Notice provides the following additional rules and procedures for reporting and withholding for 2005 and 2006.

Mechanics of Reporting and Withholding. Employers must report amounts includible in income under non-409A-compliant arrangements in box 1 of Form W-2 and box 12 of Form W-2 using code Z. Employers must also report such amounts on line 2 of Form 941. Furthermore, the Notice provides that employers must withhold income taxes from such amounts under the supplemental wage withholding rules (assuming the employee received other regular wages during the year). The Notice provides that the income tax withholding requirement does not include the 20 percent additional tax under section 409A, so employees may need to make estimated tax payments to avoid tax penalties. Payers of non-employees (e.g., independent contractors) must report amounts includible in income under non-409A-compliant arrangements in box 7 and box 15b of Form 1099-MISC. Amounts previously reported on a 2005 Form W-2 or Form 1099-MISC (or a corrected version of those forms) need not be reported again in 2006.

For purposes of income tax withholding and reporting (in particular, on Form 941, for which the actual date the amount is includible in income is relevant), amounts that a plan participant actually or constructively receives during 2006 under a non-409A-compliant arrangement are considered a payment of wages when actually or constructively received by the participant. Accordingly, employers must withhold income tax at that time and report such amounts as wages on Form 941 in that calendar quarter.

On the other hand, amounts that a plan participant does not actually or constructively receive but that are nevertheless taxable to the participant in 2006 under a non-409A-compliant arrangement are treated as a payment of wages on December 31, 2006 for income tax reporting and withholding purposes. Given that the date of the Notice’s publication gives employers only a few weeks to address withholding before December 31, 2006, the Notice provides two options that allow a delay in withholding. One option permits actual withholding or payment by the participant to the employer after December 31, 2006 but before February 1, 2007. The other option allows the employer to pay the income tax withholding amount in early 2007, without a deduction from the participant’s wages or repayment by the participant, with a resulting increase in the participant’s income tax liability as a result of the employer’s payment on behalf of the participant.

Calculation of Amounts Subject to Reporting and Withholding. If a plan participant is required to include deferred amounts in gross income in 2005 or 2006 under a non-409A-compliant arrangement, the method for calculating the amount included in income depends on whether the compensation was deferred under an account balance plan, a non-account balance plan, a stock right, or some other deferred compensation method. The Notice imports from the section 3121(v) regulations the definitions of "account balance plan," "non-account balance plan," and "reasonably ascertainable" in the rules described below.

Account Balance Plans. If compensation is deferred under an account balance plan (for example, a defined contribution SERP), the amount includible in income is the account balance, including credited earnings or losses, that is treated as deferred wages on the last day of the relevant year (2005 or 2006), plus any amounts paid or made payable to the participant under the arrangement in that year. For example, if compensation deferred under a plan became subject to inclusion under section 409A on June 30, 2006 and the account balance subject to section 409A is $10,000 on December 31, 2006, the total amount deferred for 2006 would be $10,000 plus amounts paid or made available to the participant in 2006 (if any).

Non-Account Balance Plans – Amounts That Are Reasonably Ascertainable. If compensation is deferred under a non-account balance plan (such as a defined benefit SERP or excess benefit plan), and the amount deferred is reasonably ascertainable, the amount includible in income is calculated by determining the present value of all future payments to which the participant has a legally binding right, calculated as if the right to the payments vested on the last day of the relevant year (2005 or 2006), plus any amounts paid or made payable under the plan to the participant in that year. The amount deferred is "reasonably ascertainable" if the amount, form, and commencement date of the benefit payment is known on or before the end of that year.

Stock Rights. If a plan grants stock rights covered by section 409A (for example, discounted nonqualified stock options or stock appreciation rights), the amount includible in income is the amount that the holder would be required to include in income if the right was immediately exercisable and exercised on the last day of the relevant year (2005 or 2006). For outstanding stock rights, this means that the amount deferred will equal the fair market value of the underlying stock on the last day of the year, less the sum of the exercise price, plus any amount paid by the holder for the stock right.

Other Deferred Amounts. For amounts deferred under any arrangement not listed above, including a non-account balance plan in which the benefit amounts are not reasonably ascertainable, the amount includible in income must be determined under a "reasonable, good faith application of a reasonable, good faith method." If a portion of the deferred amount can be calculated using one of the methods above, the Notice requires calculation of that portion using such method, and calculation of the balance using a reasonable, good faith method.

Income Includible Under §409A(b). Generally, section 409A(b) requires inclusion of deferred compensation amounts transferred to a foreign trust, to a trust with a financial health trigger, or during a restricted period with respect to the employer’s pension plan (as provided under the Pension Protection Act). Notice 2006-33 provided transition relief for amounts otherwise includible in income in 2005 and early 2006 due to a failure to comply with section 409A(b). For amounts not covered under the transition relief and includible in income in 2006, employers and participants must use a reasonable, good faith method to calculate, report, and withhold the amount includible in income.

For 2006, deferred compensation plan participants must report and pay taxes on amounts included in income under non-409A-compliant arrangements. Plan participants who have not previously reported amounts includible in income in 2005 must file an amended return for 2005 and pay any taxes due on includible amounts by the due date for the participant’s 2006 return. As the IRS indicated in Notice 2005-94, any such reporting or payment made in accordance with the Notice will not be subject to tax penalties. In calculating includible amounts, participants must use the methods described above. Whether the participant has complied with the Notice is determined independently of whether the employer has complied with the Notice; therefore, participants are independently responsible for calculating any amounts includible in gross income.

The Notice emphasizes that the rules for reporting and withholding for 2005 and 2006 are on an interim basis only, and that the IRS is now in the process of formulating permanent rules for future years. The Notice states that an employer or participant who complies with the rules provided in the Notice for 2005 and 2006 will not be subject to additional tax withholding or penalties as a result of any future published guidance regarding the computation of amounts includible in gross income under section 409A. The Treasury Department and the IRS have requested comments regarding the issues raised in the Notice or otherwise related to the section 409A reporting and withholding requirements.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.