Unintended Tax Consequences
How salary containment options can trigger them.
November 12, 2009
Over the course of the recent economic downturn, employers have become increasingly aggressive in reducing personnel costs. More compassionate business owners who have minimized layoffs have often implemented other labor-related cost-cutting measures, including benefit reductions, contracted work schedules, salary freezes, salary roll backs, deferred bonuses and/ or deferred raises.
While on its face, these arrangements seem to present no problem other than a potential deferral of the employer’s tax deduction, there are a number of potentially unintended consequences to both the employer and the employee for certain of these programs. The full tax ramifications may adversely impact both parties and offset a material portion of the employer’s projected economic savings. Furthermore, the employer may find that he has created a significant morale issue with his employees.
IRC Section 409A was enacted under the American Jobs Creation Act of 2004 and generally became effective on January 1, 2005. Section 409A was adopted in the wake of various corporate accounting scandals (namely ENRON) in which corporate executives cashed out much of their deferred compensation just prior to their companies’ bankruptcy filings. Congress, wary of future abuses of deferred compensation plans, crafted Section 409A with the goal of strictly regulating these plans without abolishing them entirely. Section 409A also contains “triggers” on taxable income deferred from prior years if the deferred compensation plan is materially modified.
Noncompliance with Section 409A guarantees hefty penalties. In the four years after Section 409A became effective, however, the IRS granted transition relief through December 31, 2008: deferred compensation plans were to be amended in light of a “good faith, reasonable interpretation” of Section 409A. That relief window has now passed so taxpayers must exercise extreme care to avoid the tax landmines contained in 409A.
Overview — Taxes and Penalties for All
The key provisions of Section 409A are as follows:
Certain states may also impose some form of penalty.
In some cases, employers will agree to pay the Section 409A-related taxes assessed on their employees’ income (prior to actual receipt); however, such reimbursement can result in additional taxable income and payroll taxes for the employee.
The Three-Part Test to Avoid Section 409A Treatment
The employer’s deferred compensation plan can side-step the onerous 409A provisions by meeting all three of the following three test.
This is known as the distribution requirement.
ExemptionsThe following plans are automatically exempt from the Section 409A Web:
Therefore, with proper planning, employers can avoid the application of Section 409A by either structuring the deferred compensation to fall within one of the seven exemptions or by meeting the three-part test detailed above.
Generally Accepted Accounting Principles (GAAP) IssuesStatement of Accounting Standards No 5 — Accounting for Contingencies provides guidelines for financial statement disclosures of contingent liabilities, including deferred compensation.
ConclusionWith the relative frequency of these types of deferred compensation plans during the current recession, both public and private companies must be careful to structure their deferred compensation in a manner to minimize the exposure to the 409A and GAAP accrual rules.
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Blake Christian, CPA/MBT, is a tax partner in the Long Beach, California office of HCVT, LLP. Christian is also co-founder of National Tax Credit Group, LLC.