The IRS has instructed employers to start reporting taxable deferred compensation for 2005 and 2006 and to withhold on the 2006 amounts. Deferred amounts that are not taxable under Code Sec. 409A do not have to be reported.
The IRS had been holding off on these requirements until the initial confusion over Code Sec. 409A, which was enacted in the American Jobs Creation Act of 2004, had abated. The latest guidance lifts the earlier suspension of reporting for 2005 amounts and requires reporting and withholding for all deferred comp taxable in 2006. Both 2005 and 2006 amounts must be reported on Form W-2 for employees or Form 1099-MISC, for independent contractors, and on Form 941, Employer's Quarterly Federal Tax Return, by the deadline for the 2006 tax year.
New requirements
If a deferred compensation plan does not comply with Code Sec. 409A, all amounts deferred for 2005 and for 2006 must be included in income, unless the amounts are subject to a substantial risk of forfeiture. Amounts that were previously included in income for 2005 do not have to be reported again for 2006.
Calculating the taxable amount
The new guidance explains how to calculate the total amount deferred and taxable under the plan as of December 31, 2006 (or as of December 31, 2005 in the case of deferred comp taxable in 2005).
Account balance plans. An account balance plan is a deferred compensation plan under which a principal amount is credited to an individual account, income on the principal amount is credited to the account, and the amount payable to the employee is based solely on the balance of the individual account. The taxable amount is the entire account balance as of December 31, 2006.
Nonaccount balance plans. Under a nonaccount balance plan, the amount deferred for a period equals the present value of the additional future payments to which the employee has a legally binding right. The deferred amount is the present value of all future payments as of December 31, 2006, as if the employee had obtained all of the rights on December 31, 2006.
Stock rights. The deferred amount equals the fair market value of the underlying stock on December 31, 2006, less the sum of the exercise price and any amount paid by the employee. The stock right is treated as immediately exercisable on that date.
Other deferred amounts. The amount deferred must be determined under a reasonable, good faith method that reflects reasonable assumptions as to the timing or amount of any payment. An assumption that produces the lowest potential value will be presumed not to be reasonable, unless overcome by clear and convincing evidence.
Date of payment
Amounts included in income for 2006 that are actually or constructively received by the employee are treated as paid when received by the employee, for reporting, withholding and depositing income tax. Amounts that were not received by the employee are treated as paid on December 31, 2006. If the employer did not withhold because the employee did not receive the amounts, the employer may withhold on subsequent wages by January 31, 2007, recover funds from the employee by that date, or pay the withholding on behalf of the employee (with appropriate gross-up adjustment).
Employee responsibilities
Employees and independent contractors must calculate their reportable income in the same manner as the employer. If the employer calculates an incorrect amount, the employee is responsible for calculating and reporting the correct amount. Taking into income the amount reported by the employer is not sufficient compliance.
2005 amounts. If an employee is taxable on amounts for 2005, that individual must file an amended return and pay any taxes due. Provided the return is filed by the due date for the individual's 2006 return, the IRS will not seek to impose penalties on the income. If the employee fails to report a taxable amount for 2005, the employee cannot treat the amount as previously included in income.
Pre-2005 amounts. An employee is taxable on amounts deferred before January 1, 2005 if the plan is materially modified after October 3, 2004. When calculating the 20 percent penalty on taxable amounts, the employee may treat these amounts as deferred on January 1, 2005.
IR-2006-185, Notice 2006-100
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