Proposed Deferred Pay Rules Present Tax-Saving Opportunities

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Pending the implementation of final deferred compensation rules, proposed income inclusion provisions under Treasury Regulation Section 1.409A-4 include certain “gifts” on which taxpayers can rely, said Daniel L. Hogans, a partner with the law firm Morgan Lewis.

The income inclusion regulations are substantially complete, as are the regulations that address Section 457(f), Hogans said.

However, efforts to finalize complex guidance on the Affordable Care Act (Pub. L. 111-148) continue to “soak up capacity” at the Internal Revenue Service, delaying completion of the income inclusion rules and other projects, he said.

Until the Section 409A regulations are finalized, the proposed rules can be used to correct unvested amounts deferred under a plan in the year of failure before the amounts vest without disclosure, Hogans said.

Alternatively, employers that want greater certainty and are willing to follow expanded reporting requirements could subject their deferred pay programs to the IRS correction program, Hogans said during a presentation to the American Law Institute Continuing Legal Education series.

Renewed interest in deferred compensation was sparked by concern about sufficient retirement savings, the increase in the long-term capital gains rates, and the new 3.8 percent surtax on unearned income added by the Affordable Care Act, Hogans said.

Making Corrections

The formal program for correcting Section 409A operational failures was announced in Notice 2008-113, Hogans said.

With respect to the notice's reporting requirements, “nobody wants to attach a statement” about a failure to an individual tax return, he said.

Companies have the documents and records that IRS would need to examine, so it is unlikely that individual executives are at risk of an IRS audit, Hogans said.

Some common operational errors that are “small but pervasive” might fit under the final regulations' sections addressing administrative impracticability or disputed payments and refusals to pay relief, he said.

Overpayment errors do not necessarily require an administrative impracticability fix, Hogans said.


 

Proposed rules can be used to correct certain unvested deferred compensation, until Section 409A rules are finalized.

 

 


In cases where the overpayment would be less than the cost of correction, allowing the employee to keep the money might be the easiest course to action, he said.

Possible Fixes

Employers should examine the table of contents in Notice 2008-113, Hogans said. Special attention should be paid to section 3, which addresses eligibility, and sections 9 and 10, which address disclosure.

After having identified the relevant sections, employers can “focus on the fix” they want to make, he said.

More than one fix can apply, and each fix may have different consequences, Hogans said. So, it is critical to consider the effect of the different fix options that are available, he said.

IRS also is apparently going to overlay Section 409A rules on the Section 457(f) rules regarding definitions of bona fide severance pay plan and substantial risk of forfeiture, Hogans said.

There is concern that if the 409A rules do not overlay the 457(f) rules perfectly, then satisfying 457(f) plan rules and complying with the regulations would be difficult, he said.

Section 457A of the tax code also is relevant for participants with deferred compensation owed by a non-U.S. company, Hogans said.

Initially, Section 457A was intended to address the offshore deferrals of hedge fund managers in no-tax or low-tax jurisdictions, but the section's reach is broader and its effect on pass-through entities is difficult to calculate, he said.

Renewed interest in using restricted property regulated under tax code Section 83 to compensate employees working and paying taxes in the United States also is indicative of possible regulatory change, he said.

Under proposed regulations issued in May 2012, a substantial risk of forfeiting a deferred amount must arise from a substantial service requirement with a real risk that the goal will not be satisfied, Hogans said.

The proposed regulations also clarify that a Section-16 transfer restriction would not delay taxation under Section 83, he said.

State Tax Planning

Deferred compensation has a state tax planning component, and a critical aspect of state tax planning is ensuring that an employee can make the most of the federal exemption from state tax rules, Hogans said.

The ability to apply the federal exemption is important when a taxpayer earned income while living in a high-tax state, such as New York or California, but then retired to a jurisdiction with lower taxes, he said.

Substantially equal periodic payments made by an employer to a retired employee over the employee's life expectancy or for a period of at least 10 years are exempt from state source tax, Hogans said.

However, a typical 10-year installment plan might not satisfy the 10-year requirement if the participant receives the first payment a few months after retirement, followed by nine payments over a period of less than 10 years, he said.