United States: Guidance Issued On Reporting And Wage Withholding Under Code § 409A

Internal Revenue Code § 409A provides, among other things, that all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met. Under Code § 6051, amounts deferred under a nonqualified deferred compensation plan must be reported annually on Form W-2 (Wage and Income Tax Statement) or Form 1099 (Miscellaneous Income), as appropriate. In addition, Code § 6041 requires payers to report on Form W-2 or 1099 amounts includable in income under a deferred compensation plan—either by its terms or as a result of a violation of Code § 409A.

Recently issued IRS Notice 2006-100 provides important new rules clarifying the reporting and wage withholding treatment of deferred compensation arrangements for 2005 and 2006. While this guidance provides some welcome relief (e.g., the requirement that 2005 deferrals not be reported is extended to 2006), there is a premium placed on compliance for other purposes (e.g., the waiver of certain late filing and payment penalties). This client advisory explains the key features of this recent guidance and the steps that plan sponsors need to take in response.

The American Jobs Creation Act of 2004, which added Code § 409A, imposed the following reporting and wage withholding requirements:

• Employers and other service recipients must report all deferrals for the year under a nonqualified deferred compensation plan on IRS Form W-2 (Wage and Tax Statement) or Form 1099-MISC (Miscellaneous Income), regardless of whether the deferred compensation is includible in gross income under Code § 409A(a).
• The term "wages," for the rules regulating the withholding of income at the source, includes any amount includible in the gross income of an employee under Code § 409A.
• Amounts not "wages" for withholding purposes must nevertheless be reported in the year otherwise includible in gross income under Code § 409A.

In Notice 2005-1, the IRS issued the following interim rules relating to reporting and wage withholding requirements:

• Annual deferrals under a nonqualified deferred compensation plan should be reported in box 12 of Form W-2 using code Y.
• Amounts included in gross income by virtue of Code § 409A should be reported in box 1 of Form W-2 as wages paid to the employee, and in box 12 of Form W-2 using code Z.
• Deferrals by or on behalf of nonemployees (e.g., independent contractors) should be reported in box 15a of Form 1099-MISC.
• Amounts includible in gross income of nonemployees under Code § 409A should be reported in boxes 7 and 15b of Form 1099-MISC.

The IRS provided the following additional guidance on reporting and wage withholding in Notice 2005-94 for the 2005 calendar year:

• Reporting requirements were waived with respect to annual deferrals of compensation.
• No reporting was required of amounts includible in 2005 income by reason of failure to comply with the Code § 409A requirements.

NOTE: These amounts are referred to as amounts that the "employee neither actually nor constructively received" during the year. Under generally applicable tax rules, an amount is included in income in the year in which it is received, actually or constructively. But an amount that is neither actually nor constructively received can nevertheless be subject to tax under Code § 409A if, for example, the plan under which the compensation is deferred contains a term that contravenes the requirements of Code § 409A or if the plan is operated in a manner that violates Code § 409A.

• The notice made clear that "future published guidance may require an employer or payer to file a corrected information return and to furnish a corrected payee statement for calendar year 2005 reporting any previously unreported amounts includible in gross income under § 409A."
• The IRS will not assert penalties with respect to amounts includible in gross income under Code § 409A if the amounts are timely and properly reported in accordance with future guidance.

Treatment of 2005 and 2006 Annual Deferrals

Employers are not required to report amounts deferred during 2005 and 2006 under a nonqualified deferred compensation plan subject to Code § 409A in box 12 of Form W-2 using code Y. Nor is a payer required to report amounts deferred during the year under a nonqualified deferred compensation plan in box 15a of Form 1099-MISC.

Reporting of and Withholding on Amounts Includible in Gross Income

For income tax withholding purposes, the term "wages" includes any amount includible in gross income of an employee under Code § 409A, and the payment of these amounts is treated as having been made in the taxable year in which the amount is includible in gross income. Thus, an employer is required to report such amounts as wages paid on line 2 of Form 941 (Employer’s Quarterly Federal Tax Return) and in boxes 1 and 12 (using Code Z) of Form W-2. Where the employee has received other regular wages from the employer during the calendar year, amounts includible in gross income under Code § 409A are treated as "supplemental wages," subject to withholding at the rate of 25% for amounts less than $1,000,000 and 35% for amounts exceeding $1,000,000.

Similar rules apply to nonemployees with respect to whom the service recipient must report amounts includible in gross income under Code § 409A as nonemployee compensation in boxes 7 and 15b of Form 1099-MISC.

Amounts Includible in Income in 2006
An amount is actually received in a year if the amount is due under, and paid out in the year in accordance with, the terms of the plan. Similarly, an amount might become subject to tax in a year but, by reason of an express plan provision or because the employer failed to make actual payment. Such a payment is constructively received. In either case, these amounts are considered a payment of wages in 2006 by the employer for purposes of reporting and withholding of income tax at source.

Amounts includible in gross income under § 409A(a) in 2006 that are neither actually nor constructively received (i.e., they are not scheduled for payment in 2006 but are included in income as a result of a Code § 409A violation) are treated as a payment of wages on December 31, 2006. If as of December 31, 2006 the employer does not withhold income tax from the employee on such wages, or withholds less than the amount of income taxes required to be withheld, the employer has two options:

1. The employer may withhold or recover from the employee the amount of the undercollection after December 31, 2006 and before February 1, 2007, and report the amounts as wages for the quarter ending December 31, 2006 on Form 941 and in box 1 of the employee’s 2006 W-2; or
2. The employer can pay the income tax withholding liability on behalf of the employee (without deduction from the employee’s wages or other reimbursement by the employee), and report the gross amount of wages and the income tax withholding liability for the quarter ending December 31, 2006 as well as the wages resulting from paying the income tax on the employee’s behalf on Form 941 and in box 1 of the employee’s 2006 Form W-2.

In either case, penalties for failure to timely deposit taxes will not be imposed.

The amounts included in income in a year follow the so-called "special timing rules" for withholding with respect to deferred compensation plans under Code § 3121(v). For account balance plans, the amount deferred as of December 31, 2006 is the account balance as of that date. For non-account balance plans (e.g., defined benefit arrangements), the amount deferred as of December 31, 2006 is the present value of the future payments to which the employee has obtained a legally binding right as of that date. But because equity-based plans are not subject to the Code § 3121(v) special timing rules, Notice 2006-100 contains a separate rule. Generally, the amount deferred under an equity-based plan equals the amount that the employee would be required to include in income if the stock right were immediately exercisable and exercised on December 31, 2006.

Amounts Includible in Income in 2005
Employers and other service recipients who relied on Notice 2005-94 for calendar year 2005 must file an original or a corrected information return and furnish an original or a corrected payee statement (Form W-2 or 1099-MISC) for calendar year 2005 reporting any previously unreported amounts includible in gross income under Code § 409A for calendar year 2005 by the 2006 filing deadline. Generally, this means the original or corrected information return must be filed by February 28, 2007, and the original or corrected payee statement must be furnished by January 31, 2007.

Other Deferred Amounts
For deferred amounts not addressed in Notice 2006-100, taxpayers are instructed to operate under a reasonable, good faith application of a reasonable, good faith method.

Offshore Trusts and Amounts Includible in Income under Code § 409A(b)

Code § 409A also includes provisions aimed at preventing offshore funding mechanisms and "financial health triggers." Where these rules are violated, income tax is accelerated and penalties imposed. Similar rules were added in the Pension Protection Act of 2006 to prevent funding of domestic rabbi trusts during a restricted period with respect to a funding of a single-employer defined benefit pension plan of the plan sponsor. Notice 2006-100 contains rules that coordinate the timing of inclusion of amounts that violate these rules.

Notice 2006-100 provides important clarifications with respect to the Code § 409A wage withholding and reporting rules. The delay in the reporting of deferrals is welcome relief, but certain other rules require immediate attention. The biggest challenge is identifying deferred compensation benefits that are neither actually nor constructively received, i.e., amounts currently included in income as a consequence of Code § 409A violations. Complicating matters is the regulatory definition of the term "plan" for Code § 409A purposes, under which individual plan participants are deemed to be covered under a single plan (but disaggregated by plan type, such as account and non-account balance plans). A Code § 409A violation in one plan with respect to a participant automatically triggers a violation of all plans of a similar type with respect to the participant. As a result, an unreported failure in one plan can have a ripple effect in other plans. This ripple effect will both increase reporting and withholding burdens and amplify the penalties for failing to comply.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.