By: Jay Mittelman
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 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:
Proper Accounting for Taxes
The guide tells auditors they should follow these steps to determine that an employer properly accounted for payroll taxes:
Employer matching contributions should be taken into account for FICA and FUTA taxes at the later of either:
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.