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August 12, 2015 in Tax Info, Compliance

IRS Audit Guide Spotlights Deferred Comp Plans

Many employers have struggled for years with the intricacies of nonqualified deferred compensation (NQDC) plans. Now the IRS has published an updated audit guide for these plans that can help companies avoid a time-consuming, expensive audit.

NQDC plans are elective or non-elective arrangements between employers and high-ranking staff, typically to supplement benefits from a qualified retirement plan. The deferred compensation is invested and can grow without tax erosion until a specified date, typically when employees retire.

NQDC plans must be unfunded. Essentially employees have only the employer’s unsecured promise to pay the benefits. Employers may track the benefits in a bookkeeping account, in investments or in a trust that remains a part of the company’s general assets. The trust would be subject to the claims of creditors in the event of insolvency, so employees run the risk that company funds could be siphoned away by creditors.

Deferred Amounts

Deferred amounts must be treated as wages for payroll tax purposes when services are performed or there’s no longer a substantial risk of forfeiture, whichever comes later. This applies to both Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) withholdings. Once a deferred amount is taken into income, the amount and the income attributable generally can’t be treated as FICA or FUTA wages again.

IRS auditors frequently zero in on the deductions employers claim for NQDC plans. The recently published, updated Nonqualified Deferred Compensation Audit Techniques Guide (ATG) says that employers must be able to show that the deducted deferred comp amount matches the amount reported on W-2 forms filed for the year. The deduction may be limited to $1 million for publicly held corporations.

Auditors must verify that an employer made a Schedule M adjustment to Form 1120 reflecting the deferred comp that was expensed on the company’s books but wasn’t deducted because it wasn’t included in an employee’s taxable income.

Generally, the current year’s deferrals should be adjusted on Schedule M. The ATG notes that the non-deductible amount could be obscured if the company netted the current year’s deferrals against distributions made during the year.

In addition, auditors should verify that an employer:

  1. Made appropriate Schedule M adjustmentsin prior years for distributed amounts it deducted in the current year, and
  2. Didn’t claim a deduction in the year the employee deferred the income and another deduction in the year it paid the deferred comp.

Proper Accounting for Taxes

The guide tells auditors they should follow these steps to determine that an employer properly accounted for payroll taxes:

  • Verify that current year distributions excluded from FICA wages were taken into account in prior years,
  • Confirm that the deferred comp amount is included in FICA and FUTA wages for the year in which the services are performed unless it is subject to a substantial risk of forfeiture, and
  • Analyze the database of W-2 forms, if available, to see if there are discrepancies between Social Security wages and Medicare wages. Generally, Social Security wages plus 401(k) contributions will equal Medicare wages. With an NQDC, large differences can occur. Excess Medicare wages generally represent current year deferrals of income, while shortages indicate current year distributions.

Employer matching contributions should be taken into account for FICA and FUTA taxes at the later of either:

  1. When the services were performed creating the right to the employer contribution, or
  2. When the contribution is no longer subject to a substantial risk of forfeiture.

In addition, a business can’t take a tax deduction for matching contributions until the amounts are included in an employee’s income.

Due to the complexity of NQDC plan rules, it’s easy to get tripped up. The updated ATG can provide insights that may help your business avoid an audit. You can find the entire ATG here.