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Blake Christian
Blake Christian

Unintended Tax Consequences

How salary containment options can trigger them.

November 12, 2009
by Blake Christian, CPA/MBT

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:

  • Compensation deferred under a nonqualified plan (whether written or verbal) that is not subject to a substantial risk of forfeiture by the employee and that fails to meet the three statutory requirements of Section 409A (see below) is includible in the employee’s gross income to the extent that the plan is not subject to a substantial risk of forfeiture and was not previously included in gross income.

  • This compensation is subject to two penalties to be paid by the employee:

    • Interest in the amount of the federal underpayment rate plus one percent.
       
    • An additional 20 percent income tax on top of the employee’s regular federal tax obligation.

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.

  1. In order for an employee to avoid subjection to these penalties, the salary reduction plan must provide that deferred compensation will be distributed only upon any one of the following six events:
    1. Separation from service.
    2. Disability of participant.
    3. Death of participant.
    4. A date or time specific provision.
    5. A change in ownership or effective control of the corporation.
    6. An unforeseeable emergency.

This is known as the distribution requirement.

  1. Additionally, if the employer provides an election to an employee as to whether or not he wants his compensation for a certain year deferred until a later year, that election must be made prior to the beginning of the year of deferral. Thus, an employee who wants his 2010 income deferred until 2011 would have to make that election before the end of 2009. This is known as the election requirement.
  1. The final requirement is the acceleration of benefit requirement. Simply put, an employee may not accelerate his payments under a deferred compensation plan.

Exemptions

The following plans are automatically exempt from the Section 409A Web:
  1. Vacation leave, sick leave, compensatory time, disability pay or death benefit plans.

  2. Medical reimbursement arrangements.

  3. Qualified plans, including Simplified Employee Pension (SEPs) and SIMPLE (Savings Incentive Match Plan for Employees) Plans.

  4. Short-term deferrals paid within two-and-one-half months after the end of the employee’s or employer’s tax year. Note that wages/bonuses and guaranteed payments to S Corp shareholders or partners/LLC members, respectively, are generally only deductible in the year paid.

  5. Nonqualified stock options that are not issued at a discount and do not have deferral features.

  6. Section 422 or Section 423 compensation.

  7. Section 83 restricted property plans.

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) Issues

Statement of Accounting Standards No 5 — Accounting for Contingencies provides guidelines for financial statement disclosures of contingent liabilities, including deferred compensation.

SAS No. 5 outlines three general categories of contingent liabilities, which will determine the proper financial statement disclosure.
  1. Probable Obligation to Pay the Contingency

    The future event or events are likely to occur in cases in which the amount of deferred compensation is reported as a current-year expense to the extent the liability can be reasonably quantified.
     
  2. Reasonable Possibility of Paying the Contingency

    The chance of the future event or events occurring is more than remote but less than likely — in such cases, the liability should be disclosed in the footnotes, but not necessarily reflected in the profit-and-loss (P&L) and balance sheet statements.
     
  3. Remote Probability of Payment

    The chance of the future event or events occurring is slight. In these cases, disclosure is generally only required if the liability is guaranteed in some manner.

Conclusion

With 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.