After taking a selfie, the photographer/subject can examine the resulting image before deciding to share it. If the image is not satisfactory, appropriate adjustments can be made before others have the chance to view it. This same principle applies to nonqualified deferred compensation plans (NDCPs) with all the complex rules governing them and the costly consequences of noncompliance. Why risk the executive or sponsor being subjected to the paparazzi-like blitz of an Internal Revenue Service (IRS) audit, which could capture an unflattering candid shot of the plan’s operation? Wouldn’t it make more sense to take a selfie of the plan (i.e., conduct a self-audit) so that any operational blemishes may be fixed before seen through the unforgiving lens of an IRS audit? Encouraging such selfies, the NDCP operational correction procedures issued by the IRS generally provide that the quicker any errors are caught and corrected, the better the chances are of minimizing or even eliminating negative tax results for the affected participants.
While the sponsor may incur some cost in conducting a self-audit of its NDCPs, failing to find and promptly correct operational errors could potentially be even more expensive. IRC Section 409A violations can result in substantial tax penalties for the affected participants. The nonqualified deferred compensation (NDC) in question becomes fully taxable as soon as the participant has a vested (nonforfeitable) right to receive it. Furthermore, a 20% additional tax penalty on the value of the NDC will be imposed at the same time and, under certain circumstances, an interest charge will be imposed. Beyond the 409A ramifications, there may be other tax penalties for under-withholding if, for example, the applicable Federal Insurance Contributions Act (FICA) tax is not paid when due.
Maintaining operational compliance and correct reporting of amounts deferred to and distributed from their NDCPs poses a significant challenge for many sponsors who, while well-versed in qualified plan administration, do not have the same level of expertise available internally when it comes to the various and sometimes subtle differences presented by NDCPs. Just three of the plethora of potential pitfalls:
(1) Timely distributions: Most distributions from qualified plans do not occur until a participant elects to commence the benefit. The sponsor typically starts the process by sending an election package requesting the participant to make an election on the timing and form of the distribution. If no such election is made, it’s not uncommon for the benefit to be deferred in the plan. In contrast, there’s considerably less flexibility regarding the participant’s ability to choose the timing and form of distribution in NDCPs. Once the distribution triggering event occurs, the 409A compliance clock begins ticking and failure to transfer the applicable funds to the participant on a timely basis produces a 409A failure. It’s essential for sponsors to accurately track these distribution dates and stress to participants the importance of making sure the sponsor always has up-to-date instructions on where to send payments (especially in cases where participants terminate employment long before payment is due). A self-audit can determine if the current procedures are ensuring that all distributions are commencing in accordance with the plan’s terms.
(2) FICA calculation: While federal and most state income tax rules typically permit participants in a 409A-compliant NDCP to defer taxation until distribution, FICA taxation timing rules may require earlier inclusion in income. One of the most common omissions occurs in defined contribution style NDCPs that feature both executive deferrals and employer allocations. FICA rules require amounts deferred under these plans to be taxed when vested. Employee deferrals are 100% immediately vested and thus generally processed correctly (i.e., they are run through payroll and FICA tax procedures at that time). However, because employer allocations are treated separately and often subject to a vesting schedule, they can be overlooked and not properly FICA taxed once vesting occurs. A self-audit ascertains whether or not deferred amounts are being FICA taxed when due.
(3) W-2 reporting and withholding: There are separate, specific instructions and guidance that apply to which boxes need to be completed and what amounts should be entered on W-2 forms in order to properly report NDCP deferrals and distributions. NDCP sponsors must be extremely careful to not only accurately communicate the terms of their NDCPs to their payroll providers but also to review a provider’s initial withholding/report setup for the plan. Failure to address this during the initial stages can result in a wide range of negative tax consequences for participants. In addition to possibly triggering 409A violations, if amounts are not accurately reported, the participant may be overtaxed, under-taxed, and/or have their Social Security benefits adversely affected. A self-audit can compare the amounts currently being reported on W-2 with the supporting plan materials (e.g., election forms, benefit statements, salary information) to assure proper agreement.
NDCP sponsors would need a photographic memory to retain every nuance of the 409A rules, the FICA tax implications, and the reporting/withholding requirements. The preceding information represents just a very small snapshot of some of the issues that illustrate the need to self-audit. However, it is important to note that if the sponsors do not have the internal expertise in these areas, they should strongly consider seeking consulting advice to identify any and all imperfections so as to make sure that their selfies produce a pretty plan picture.