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Tax, Reporting Rules for Nonqualified Deferred Compensation Plans

May 18, 2022, 8:30 PM

Payroll professionals should be aware of specific Internal Revenue Service reporting and tax requirements for nonqualified deferred compensation plans, two payroll professionals said May 10.

Nonqualified deferred compensation plans are elective plans that allow employees to defer compensation from one tax year to another and entitle them to that compensation, said Fred Basehore, Senior Director of Payroll Tax and Compliance at Guidehouse. Unlike qualified deferred compensation plans, which are regulated under Section 401(a) of the Internal Revenue Code, nonqualified deferred compensation plans are regulated under IRC Section 409A.

Nonqualified plans can vary, added Basehore, who is also a member of Bloomberg Tax’s Payroll Advisory Board. Some plans may lack contributions limits or be subject to forfeiture in certain circumstances. Other plans may be discriminatory or have employer contributions. Examples of nonqualified plans can include employment agreements, supplemental employee retirement plans, and salary reduction arrangements.

Highly compensated employees often use nonqualified plans to increase their retirement savings because they cannot meet their retirement needs from 401(k) plans due to contribution limits, said James Medlock, a payroll compliance educator at Medlock & Associates.

Nonqualified plans fail if they do not satisfy IRC Section 409A requirements, he added. Plan failure affects how employers report deferred wages and earnings on deferrals to the IRS.

Social Security, Medicare, and FUTA

Nonqualified plans allow employees to defer federal income taxes until the wages are received by the employee. However, Social Security, Medicare, and federal unemployment taxes are assessed on wages at the time the services are performed or when no substantial risk of forfeiture remains, whichever is later, Basehore said.

“Most of these folks with nonqualified deferred compensation plans are high-income individuals,” he said. “And it’s very likely that they’ve already reached the Social Security wage base limit on their regular paycheck, $147,000 for 2022. But as we all know, Medicare is 1.45% and there’s an additional Medicare tax of 0.9% for wages over $200,000.”

Payroll departments should review their payroll systems to ensure that taxes are being withheld on deferred earnings that the employee does not receive, he added. Withholding taxes on nonqualified plan contributions can be difficult because the employer must withhold taxes on wages that the employee has not yet received.

Employers may use the estimated method or the lag method when withholding taxes, Basehore said at the American Payroll Association’s 40th Payroll Congress.

The estimated method requires employers to withhold based on their estimate of the amount that will be in an employee’s nonqualified plan account at the end of the tax year. If employers underestimate the amount, they must correct it within three months and complete Forms W-2c and 941-X, he said.

The lag method allows employers to withhold within three months after the end of the tax year, he said. Employers do not need to correct withholding using the lag method because they already know the amount that was in employees’ nonqualified plan accounts at the end of the tax year.

Form W-2 Reporting Requirements

Nonqualified plan distributions are reported on Form W-2 in Box 1 as compensation, Medlock said. Any nonqualified plan deferrals will decrease the amount in Box 1.

Deferrals and distributions may also be reported on Box 11 of Form W-2, he added. However, nothing is reported in Box 11 if deferrals and distributions occurred in the same year.

“If we have a distribution and a deferral in the same year, the IRS doesn’t want us to report anything,” he said. “They don’t want us to put apples and oranges together and put it in the fruit salad on Form W-2. They want them to be kept separate. So if we have a deferral and no distribution, then it would be reported in Box 11. If we have a distribution with no deferral, it would be reported in Box 11.”

Payroll departments should make sure that nonqualified plan distributions are not subject to Social Security, Medicare, and FUTA taxes because the amounts were likely already taxed when the employee deferred the earnings, he added.

Employers do not have to complete Box 12 of Form W-2 with code Y, the code for nonqualified deferred compensation plans, because of IRS Notice 2008-115, Basehore said.

IRS Notice 2008-115 is interim guidance by the IRS that has not been finalized since it was issued in 2008, added Medlock. The interim guidance may change, but it is unlikely to do so.

If a nonqualified plan fails, employers must complete Box 12 of Form W-2 with code Z, the code for nonqualified plans that do not satisfy IRC Section 409A, Basehore said. Calculating the amount to include in Box 12 varies depending on the type of nonqualified plan and whether there are any stock rights or other deferred amounts.

To contact the reporter on this story: Emmanuel Elone in Washington at eelone@bloombergindustry.com

To contact the editors on this story: William Dunn at wdunn@bloombergindustry.com; Jazlyn Williams at jwilliams@bloombergindustry.com