Non-qualified Deferred Compensation Plans of Tax-exempt and Governmental EntitiesJuly 20, 2017
Non-qualified deferred compensation plans maintained by tax-exempt or state or local governmental entities, other than certain “eligible” deferred compensation plans, are subject to special, and often surprising, federal income tax rules under Internal Revenue Code (“Code”) section 457(f). These plans, commonly known as “ineligible 457(f) plans,” or just “457(f) plans,” offer tax-exempt and governmental employers the ability to compensate their senior officers and high level management employees on a basis that is generally unrestricted in terms of who is covered by such plans and the amount of compensation provided.
Compensation deferred under a 457(f) plan is includible in the plan participant’s taxable income on the later of the date when the participant obtains a legally binding right to the compensation or the date the right to receive the compensation is no longer subject to a “substantial risk of forfeiture.” Thus, depending on the terms of the 457(f) plan or arrangement, amounts may be taxable to the participant in a taxable year prior to the taxable year in which the amount is paid.
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Deferred Compensation – Special Fica Tax RulesApril 18, 2017
FICA taxes (technically consisting of “social security taxes” and “regular and additional Medicare taxes”) apply to wages paid by an employer to its employees with respect to their employment with the employer. The definition of “wages” for this purpose is quite broad and includes, with limited exceptions, all remuneration for services. FICA taxes imposed on an employee’s wages are shared by the employee and employer. The employee’s portion of FICA taxes is withheld from the employee’s wages.
General Timing/Special Timing FICA Tax Rules
In general, wages are subject to FICA taxes when the wages are actually or constructively paid (known as the “general timing rule”). However, compensation in the nature of “nonqualified deferred compensation” (“NQDC”) is subject to a different FICA tax timing rule. NQDC is subject to FICA tax and must be “taken into account” for FICA tax purposes as of the later of (i) when the services are performed, or (ii) when there is no substantial risk of forfeiture of the rights to such NQDC (i.e., when the amount “vests”). This rule, which accelerates the FICA tax applicability date, is known as the “special timing rule.” Once an amount of NQDC is taken into account under the special timing rule, neither such amount nor any future earnings attributable to that amount is later treated as wages subject to FICA tax. This avoidance of the imposition of FICA tax at the later time of payment, where the wage amount was previously taken into account at an earlier date pursuant to the special timing rule, is known as the “nonduplication rule.” Due to the impact of the nonduplication rule, the application of the special timing rule generally results in a smallar amount of FICA tax payable than would be the case if FICA tax was paid pursuant to the general timing rule.
Recent FICA Tax Ruling
In a recent IRS Chief Counsel Memorandum (AM2017-001, 12/19/2016) (the “GCM”), the IRS addressed the impact of failing to initially pay FICA tax on NQDC pursuant to the special timing rule. If an employer fails to initially report and pay its FICA tax liability with respect to NQDC in accordance with the special timing rule, but amends its employment tax returns and pays any additional FICA taxes attributable to such compensation within the applicable statute of limitations, then the favorable nonduplication rule applies. However, if such amendment and adjustment of FICA taxes due is not made before the statute of limitations period closes, the FICA tax will apply pursuant to the general timing rule.
In this GCM, the IRS was asked if it would enter into a binding closing agreement with an employer to allow the employer to pay FICA tax in a taxable year prior to the year of payment of NQDC, even though the statute of limitations had run with respect to the taxable year for which the special timing rule would have otherwise applied to such NQDC. Such closing agreement would enable the employer (and affected employees) to benefit, to some extent, from the application of the nonduplication rule in calculating the FICA tax due. The IRS concluded that, as a matter of tax policy, a closing agreement in such instance would not be appropriate in determining the amount of FICA tax owed where the statute of limitations period had closed, and accordingly, the general timing rule for determining FICA tax due on the NQDC would apply.
The above analysis and IRS ruling in the GCM highlight the important need for employers to be diligent and compliant with the special timing rule as applied to the reporting and payment of FICA taxes on NQDC.
Code Section 403(b) Tax-Deferred Annuity Plans - UpdateApril 3, 2017
Internal Revenue Code (“Code”) section 403(b) tax-deferred annuity plans (“403(b) plans”) are retirement plans for employees of public schools and universities, certain tax-exempt charitable organizations, and churches. 403(b) plans operate in a manner similar, but not identical, to Code section 401(k) plans. Thus, contributions to a 403(b) plan may be made via employee salary deferrals (on a pre-tax or after-tax (including Roth contributions) basis) and employer matching and nonelective contributions. Such contributions, other than after-tax or Roth employee contributions, are not taxable to the plan participant until distributed to the participant at a later date, usually after the participant terminates employment.
403(b) Contribution Limits
The opportunity to make elective salary deferral contributions under a 403(b) plan must be made available generally to all employees eligible to participate in the plan (known as the “universal availability rule”). Favorably, 403(b) plans are not subject, unlike 401(k) plans, to special nondiscrimination testing requirements applicable to elective pre-tax salary deferral contributions. Employer matching contributions and employee after-tax contributions, if such contributions are permitted by the plan, are subject to nondiscrimination testing rules similar to the rules that apply under 401(k) plans. Church-sponsored 403(b) plans are generally exempt from nondiscrimination requirements.
Salary deferral contributions to a 403(b) plan are subject to an annual dollar limit ($18,000 (plus $6,000 in “catch-up” contributions for participants over age 50) for 2017). It is important to note that such dollar limit applies on an individual basis to the aggregate salary deferral contributions made by an employee under all 403(b) plans and 401(k) plans for a calendar year (e.g., where an individual was covered by and contributed to two or more employer 403(b) and/or 401(k) plans for a given calendar year). Thus, such salary deferral dollar limit does not apply on a plan by plan basis. Employer nonelective contributions are subject to the general limit on annual contribution allocations (known as the Code sec. 415 “annual addition” limit). Further, 403(b) plans are funded through annuity contracts issued by an insurance company or a custodial account invested exclusively in mutual funds.
403(b) Plan Documentation
Since 2009, 403(b) plans are required to maintain a written plan document that reflects all applicable legal requirements. 403(b) plan documents, either in the form of a “preapproved plan” document (i.e., prototype or volume submitter plan) or an “individually designed plan,” must be updated periodically to reflect changes in applicable law governing 403(b) plans.
403(b) Plans – Remedial Amendment Period
In accordance with recent IRS guidance (IRS Revenue Procedure 2017-18), sponsors of 403(b) plans, for which a written plan document was adopted by December 31, 2009 or as of its later effective date, will be permitted to adopt plan amendments to correct or update plan terms on a retroactive basis effective as of the later of January 1, 2010 or the plan’s effective date, provided the corrective or updated plan, terms are adopted by the plan sponsor by means of (i) adopting, on or before March 31, 2020, a compliant preapproved 403(b) plan document that has a favorable opinion or advisory letter issued in 2017, or (ii) amending an individually designed 403(b) plan to reflect such corrective or updated plan terms by March 31, 2020. If the time deadline for adopting such retroactive 403(b) plan amendments is not met, the plan will need to be corrected pursuant to the IRS’s voluntary plan correction program (known as the “Employee Plans Compliance Resolution System”), which program generally requires a formal plan filing with the IRS and payment of a compliance fee. It is important to note that currently only prototype and volume submitter 403(b) plans can be submitted to, and approved by, the IRS for compliance in the form of documentation with applicable 403(b) rules. Individually designed 403(b) plans may not be submitted for approval by the IRS.
While there is ample time to retroactively correct noncompliant provisions under a 403(b) plan, it is not too early to review your 403(b) plan document to determine if it reflects all required plan terms and to thereafter periodically review the plan to ensure any future 403(b) plan document changes are adequately and timely adopted. Lastly, it must be remembered that the extended remedial amendment period described above for making 403(b) plan document changes does not extend the otherwise applicable effective date for complying with any such 403(b) plan provisions in operation.
ESOPs Offer Significant Benefits For Business OwnersMarch 3, 2017
Let’s say you are an owner of a successful privately-held company and you would like to cash out the substantial value reflected in your business. In addition, you would like to find an appropriate buyer for your company, a person that will carry on the business legacy you built and will continue to treat your employees in a manner similar to the way you treat them. A buyer in the form of an “employee stock ownership plan” (“ESOP”) may be the answer.
What Is An ESOP?
An ESOP is a tax-qualified retirement plan that is designed to be primarily invested in the company’s stock. Thus, since ESOPs must hold “company stock,” ESOPs must be maintained by corporations for federal income tax purposes (e.g., regular C corporations or Subchapter S corporations). LLCs and partnerships are not eligible to maintain ESOPs.
Favorable Tax and ERISA Benefits
As a tax-qualified retirement, company contributions to the ESOP, within IRS-prescribed limits, are tax deductible by the company. Moreover, ESOPs are uniquely allowed to borrow money from the company or other third parties to enable the ESOP to fund the purchase of company stock. Thus, an ESOP’s purchase of stock from a company owner can effectively be financed with fully tax deductible dollars, even the amounts applied by the ESOP to repay the principal on the loan used by the ESOP to purchase the owner’s shares.
Special ESOP Gain Deferral Rules
Special provisions in the Internal Revenue Code permit an owner (or owners) selling stock in a privately-held domestic C corporation to an ESOP to defer the recognition of the gain on the sale if certain tax law requirements are met. Such requirements include (i) the ESOP must own at least 30% of the company’s stock immediately after the sale, and (ii) the selling shareholder timely reinvests the ESOP sale proceeds in stocks and/or bonds of U.S. operating corporations. Thus, a company owner can liquidate his or her ownership interest in the company and pay no federal income tax upon a sale of stock to an ESOP, and at the same time favorably diversify his or her wealth among a portfolio of U.S. corporate stocks and bonds. In addition, the sale of stock to the ESOP effectively sells such portion of the company to the company’s employees through their participation in the ESOP, thus allowing the employees to obtain a vested equity stake in the future appreciation in the value of their company. Such “skin in the game” for employees can provide a powerful basis for increasing employee commitment and productivity for the betterment of the company and its owners.
As the above discussion indicates, the use of an ESOP to facilitate the sale of a privately-held company owner’s stock may prove to be a “win-win” result for the company owner, the company, and its employees.
Brach Eichler Benefits ReviewJanuary 26, 2017
2017 QUALIFIED PLAN LIMITS
Qualified retirement plans, such as Internal Revenue Code sections 401(k) and 403(b) plans, pension and profit sharing plans, individual retirement accounts (IRAs), and health flexible spending accounts (Health FSAs) are subject to various dollar limits on the amount of contributions that can be made or benefits that may accrue under such arrangements. Most of these dollar limits are adjusted annually by the IRS for changes in the “cost of living.”
For 2017, some of the key dollar limits affecting the above plans, IRAs and Health FSAs are as follows:
While the above benefit and contribution limits should be, as applicable, reflected in the plan documents for such plans and accounts, and in the operation of such arrangements, it is important to remember that the elective deferral and, as applicable, related catch-up contribution limits apply on an individual basis. Thus, if you change jobs during calendar year 2017 and participate in two or more employer-provided 401(k) and/or 403(b) plans, you are entitled to a maximum aggregate elective deferral and catch-up contribution limit under all such plans for 2017 of $18,000 in elective deferrals and $6,000 in catch-up contributions (i.e., one set of elective deferral and catch-up contribution limits apply per individual per calendar year).
Related Practice: Labor and Employment
New Fiduciary Investment Advice RuleMay 17, 2016
On April 6, 2016, the U.S. Department of Labor (“DOL”) issued a final regulation (the “New Fiduciary Rule”) that redefines and significantly broadens the scope for determining who is treated as a fiduciary as a result of the provision of “investment advice” to plans covered by the Employee Retirement Income Security Act (“ERISA”), and their plan fiduciaries, participants and beneficiaries, and individual retirement accounts (“IRAs”), and IRA owners. The New Fiduciary Rule also includes two new prohibited transaction class exemptions and modifications to other current prohibited transaction class exemptions to reflect this new expanded definition of fiduciary investment advice. This article will focus on the new fiduciary investment advice regulatory rule. A future article will address the new and revised prohibited transaction class exemptions.
Related Practice: Labor and Employment
Employee Benefits - Topics of InterestJanuary 4, 2016
Nonqualified Deferred Compensation Arrangements
While many may know about qualified retirement plans, such as a 401(k) plan, and the rules governing such plans, it is likely that most people are not aware of the important tax rules that govern “nonqualified deferred compensation” (“NQDC”).
Broad Scope of NQDC
The first, and perhaps most important, thing to note about NQDC is its broad scope. NQDC covers generally any promise of compensation made in one taxable year for a payment of such compensation in a later taxable year. Thus, NQDC could include compensation in the form of bonuses, elective salary deferral (outside the context of a 401(k) plan), separation or severance pay, nonelective supplemental deferred compensation, stock rights (e.g., stock options; stock appreciation rights), taxable expense reimbursements, equity-based deferred compensation (e.g., restricted stock units), and many other forms of deferred compensation that may not be labeled as “deferred compensation.”
Code Section 409A
Under Section 409A of the Internal Revenue Code, and the IRS tax regulations and other guidance issued thereunder (“Section 409A” or “409A”), rules are prescribed that must be met to avoid violations that can result in the imposition of significant federal tax penalties. The essence of Section 409A is a roadmap of rules that are designed to limit the discretion of employers and employees to change the timing and form of payment of NQDC once the legally binding promise to pay such compensation is made. It is important to note that Section 409A also covers NQDC arrangements between independent contractors (e.g., consultants) and their “service recipients.”
Compliance With 409A
In practice, Section 409A requires that NQDC either (A) satisfy an exception from 409A (e.g., special exceptions from 409A apply to (i) compensation paid within a short period after the employee (or independent contractor) “vests” in the compensation, and (ii) separation pay that is payable only upon an involuntary separation from service, is limited in amount, and is paid within a prescribed time period, or (B) complies with the substantive rules of 409A (which rules require that the compensation be paid only upon certain permitted payment trigger events and that the time and form of payment of such compensation be set forth when the deferred compensation promise is made, subject to limited opportunities thereafter to change the time or form of payment).
409A Noncompliance Penalties
A failure to comply with Section 409A will often result in income inclusion for the employee (or independent contractor) in a taxable year prior to the year the amount is otherwise scheduled to be paid, and the imposition on the employee (or independent contractor) of an additional income tax penalty equal to 20% of the amount included in income, as well as, in some cases, an interest tax penalty equal to the product of the applicable interest rate on underpayments of federal income tax plus one percentage point and the additional income tax that would have been due had the deferred compensation been included in income, as applicable, in an earlier tax year when first vested. Employers (or “service recipients” with respect to independent contractors) may be subject to tax penalties for violations of 409A due to the failure to timely report and, as applicable, withhold and remit taxes with respect to amounts included in income.
Thus, the tax stakes are high for employees (and independent contractors) who are covered by NQDC plans or arrangements that fail to comply with Section 409A. Moreover, given the broad scope of what constitutes NQDC and the need to comply with Section 409A in both form of documentation and in operation, it is strongly recommended that employees (and independent contractors), and employers (and service recipients), take all steps necessary to ensure that their NQDC plans and arrangements comply with, or are otherwise exempt from, the requirements of Section 409A.