IRS Releases Nonqualified Deferred Compensation Audit Techniques Guide

The headline looked promising: “IRS Updates its Audit Technique Guide for Nonqualified Deferred Compensation Plans.” Finally, the IRS might provide additional guidance on its audit approach to 409A issues. However, despite the first update since 2005, the new Audit Technique Guide (ATG) leaves the impression that 409A is only a minor concern for the IRS auditors of nonqualified deferred compensation plans. However, maybe that is the message IRS is trying to send to us, to wit, in your obsession with 409A, don’t ignore all of the other rules that apply to nonqualified deferred compensation plans.

Considered in this spirit, the ATG does highlight a few other areas where the IRS apparently continues to see problems, including:

  • The Timing of FICA and FUTA Tax Withholding (also see our blog from January, “Unfortunate Court Decision Holding Employer Liable for Legal, But Not Optimal, Tax Withholding”). Deferred amounts are taxable for FICA and FUTA at the later of when the services are performed creating the right to the amounts or when the amounts are no longer subject to a substantial risk of forfeiture. Employer matching contributions are taken into account for FICA and FUTA taxes.
  • Violations of the Contingent Benefit Rule. A 401(k) plan may not condition any other benefit (including participation in a NQDC) upon the employee's participation or nonparticipation in the 401(k) plan. The ATG suggests that IRS reviewers will be “looking for a provision that limits the total amount that can be deferred between the NQDC plan and the IRC § 401(k) plan,” and “any NQDC provision which states that participation is limited to employees who elect not to participate in the § 401(k) plan.”
  • Constructive Receipt. If the employee may borrow, transfer, or use the amounts as collateral, or there may be some other signs of ownership exercisable by the employee, which should result in current taxation for the employee.

The ATG also highlights some of the reporting and recordkeeping issues in the weeds, including verifying that:

  • The amount of deducted deferred compensation matches the amount reported on the Forms W-2 that were furnished and filed for the year.
  • A Schedule M adjustment was made to the Form 1120 for the amount of deferred compensation expensed on the employer's books but was not deductible because the compensation was not includible in income by the employees.
  • The employer made appropriate Schedule M adjustments in prior years for amounts distributed and for which the employer took a deduction in the current year.
  • For current year distributions that are excluded from wages for FICA taxes, that these amounts were taken into account in prior years.
  • Current year distributions are reported in Box 1 as wages on Form W-2 and are also reported in Box 11.
  • Income tax withholding was made as required at the time the funds are distributed to employees, and reported in Box 2.