Payroll in Practice: 10.5.20

Practitioners’ questions are answered by a payroll and tax consultant who also is an enrolled agent licensed to practice before the Internal Revenue Service.

Question: Several of our executives recently deferred a portion of their salaries under a nonqualified deferred-compensation plan. There is an understanding that, upon payment, they also would receive interest on the amount deferred. Is the interest taxable and is the interest considered supplemental wages?

Answer: Earnings on deferred compensation, including interest, is taxable income to the employee. In some cases, the interest is treated as additional compensation and included along with the deferred compensation as supplemental pay. However, the interest payment may be just interest and not included in wages. In that case, it would be reported on Form 1099-INT, Interest Income, and would not be subject to the supplemental wage withholding rules.

The Internal Revenue Service’s “Nonqualified Deferred Compensation Audit Techniques Guide” provides guidance as to taxation of nonqualified deferred compensation.

In the compliance section, “Interest Credited to Amount Deferred,” the guide discusses the taxation of earnings on deferred compensation.

In general, when Social Security and Medicare taxes owed on the deferred compensation have been paid, interest earned on the deferred compensation after the taxes were paid is not included in wages. However, the interest rate must represent a reasonable rate of return. If the rate of return does not fall within the guidelines discussed in the audit guide, the interest may be considered compensation rather than interest.

A main benefit of a deferred compensation plan is the deferment of tax payments on the compensation to a later tax year. For there to be a tax deferral, there must be a written plan. If the deferral is not made according to a plan, but the executives simply ask that it be paid in the following year, the deferred amounts are constructively received at the time of deferral. All taxes are due at the time the employee obtains control over the disposition of the compensation and has constructive receipt.

Deferred compensation becomes taxable for tax purposes under the Federal Insurance Contributions Act when the services are performed or when there is no substantial risk of forfeiture of the employee’s right to receive the deferred amounts, whichever occurs later. For example, the deferred amount would be subject to FICA taxes at the time of deferral unless the employee is required to perform substantial future services in order to have a legal right to the deferred amount.

When all the required services have been performed the employee obtains a legal right to the deferred amount, that is, the amount becomes vested, and is subject to FICA taxes. Additionally, any earnings on the deferred amount up to the date of vesting, also are subject to FICA taxes as additional employee compensation.

Nonqualified deferred compensation plans are funded or unfunded, although most are intended to be unfunded because of the tax advantages unfunded plans afford participants. Whether a plan is funded or unfunded does not affect when FICA taxes apply. However, depending on the arrangement, funding may trigger constructive receipt and liability for payment of income taxes.

Question: We are to pay accrued vacation pay to the personal representative of an employee who died. I know we pay the hours through payroll because the vacation was accrued while the employee was employed, but I am not sure how to run a payment to the trustee through payroll. Should I run the check through with a special deduction for the payment to the personal representative so that the net amount of the paycheck is zero and then have accounts payable issue a check for the net amount?

Answer: The payment of accrued vacation pay is essentially a wage payment. However, the payment is subject to a special set of rules referred to as wages in respect to an employee who died.

Wages paid under this process generally are wages that were not considered as constructively received by the employee before the date of death. Wages constructively received before the date of death, including a check that was prepared, but not delivered, are treated the same as wages paid before death.

Assuming the date of death occurred in 2020 and payment of the accrued vacation pay had not been prepared before that date, the accrued vacation are wages for the former employee. The payment should be made through payroll to report and compute Social Security and Medicare wages and taxes and reported on the 2020 Form W-2, Wage and Tax Statement.

When the wages are paid during the same year the employee died, the former employee’s wages are subject to taxes under the Federal Insurance Contributions Act (FICA) as well as the Federal Unemployment Tax Act (FUTA).

However, if paid in a subsequent year, the payment is exempt from FICA and FUTA taxes. For example, if the employee died before Jan. 1, 2020, any wage payment made in 2020 is not subject to Social Security and Medicare taxes and a W-2 is not required for federal tax purposes.

Whether paid in the year of death or a subsequent year, the amount paid should not be included in income tax wages on the W-2. The payment, while still taxable income, is exempt from income tax withholding with respect to the employee. The employee’s income tax liability cuts off on the date of death and anything that was not constructively received by that date should not be included in the employee’s income for income tax purposes.

Instead, the income tax liability attaches to the recipients of the funds. The employer should obtain a Form W-9, Request for Taxpayer Identification Number and Certification, from the payee. The employer is required to obtain the payee’s name, tax ID number, address, and entity type to avoid backup withholding of income tax as well as to obtain the information required to issue correct and complete information return, usually a Form 1099-MISC.

If the employer does not have the payee’s name and tax ID number before making the payment, the employer is required to backup withhold 24%of the gross wages. Gross pay for this purpose includes withheld FICA and any other deductions. If the payee information is obtained before payment, income tax should not be withheld.

The amounts of wages and backup withholding, if any, are reported on Form 1099-MISC. The wages are reported in Box 3, Other Income. Backup withholding, if any, would be reported in Box 4, Federal Income Tax Withheld.

In summary, if paid during the year the employee died, the employer will issue two information returns:

• Form W-2 made out to the decedent, including the former employee’s Social Security number, reporting all Social Security and Medicare wages and taxes for wages earned and paid during the year; and

• Form 1099-MISC made out to the payee, including the payee’s tax ID number, that reports the income tax wages paid in respect of the decedent in Box 3 and any backup withholding in Box 4. The Box 3 amount will be the gross income tax wages that were not constructively received before the date of death while the payment amount will be for the net pay after deductions for Social Security and Medicare taxes, federal, state, and local income taxes (if any), and any other deductions that may be involved.

The payee may be required to issue nominee information returns to the ultimate beneficiaries. For example, when the recipient is the employee’s estate or trust, the estate or trust would issue Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., to each beneficiary showing each beneficiary’s share of the income.

By Patrick Haggerty

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.