After an almost two-year delay, the IRS has now indicated that the tax reporting and withholding requirements imposed by Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), are effective immediately with respect to deferred amounts that became includible in income in 2005 or 2006. In Notice 2006-100, the IRS has not only rescinded the reporting and withholding moratorium granted by Notice 2005-94, it has also provided useful guidance for both employers and taxpayers regarding their new compliance responsibilities.[1] Notice 2006-100 will not be the final word on reporting and withholding from the IRS but is instead intended to serve as interim guidance as we enter the 2006 tax reporting season.
Background
Having previously dealt with the basic and many of the substantive requirements imposed by Section 409A,[2] we will limit our summary here to the key issues relevant to Notice 2006-100. In general terms, Section 409A is intended to impose significant restrictions on deferred compensation arrangements of all sorts by limiting the timing of elections to defer compensation by “service providers” (i.e., employees, directors, or contractors), the timing and form of subsequent payments of deferred compensation, and the timing of subsequent changes to either. Violating any of these broad requirements (or any of the more specific requirements included in the proposed regulations and other guidance) not only triggers income tax on the deferred amounts but also triggers an additional 20% income tax and interest at a prescribed rate. For employers and other service recipients, Notice 2006-100 addresses the reporting and withholding implications associated with violations of Section 409A during 2005 and 2006, while for taxpayers (i.e., employees and contractors), the Notice provides guidance for reporting the resulting includible income and paying the additional tax and related interest.
Prior Guidance on Tax Reporting
Notice 2005-1,[3] the initial guidance the IRS issued under Section 409A, explained the specific reporting and withholding obligations for employers and other service recipients. Under this guidance, reporting is required for annual deferrals made by employees and contractors under arrangements subject to Section 409A on Form W-2 or Form 1099-MISC, respectively. In addition, previously-deferred amounts that become includible in income during a particular year as a result of Section 409A must also be reported on either Form W-2 or Form 1099-MISC, and, for employees, these amounts are subject to withholding. Deferrals and includible amounts are also subject to reporting by employers on their quarterly Form 941 filings.
Temporary Suspension of Tax Reporting Obligation
The reporting and withholding obligations under Section 409A for 2005 were previously suspended by Notice 2005-94 with the caveat that revised reporting and other corrective action might be required in the future under subsequent IRS guidance. While Notice 2005-94 did not excuse individual taxpayers from the requirement to report and pay tax on amounts includible in income under Section 409A in 2005, it did provide that the IRS would not assert penalties for failure to report such amounts and pay such taxes until future guidance is issued; despite this administrative forbearance, interest accrued on any underpayments resulting from a taxpayer’s failure to include taxable amounts on his or her 2005 tax return.
Notice 2006-100 supersedes Notice 2005-94 and requires reporting and withholding for amounts that became includible in income in 2006 and, as necessary, requires corrective reporting and withholding for any such amounts that became includible in income in 2005. Notice 2006-100 also requires remedial action by individual taxpayers who did not report includible amounts in 2005.
Tax Reporting and Withholding Now Required
In broad terms, Notice 2006-100 provides that “deferred amounts” that become includible in income as a result of Section 409A in 2005 or 2006 must be properly reported by both employers and taxpayers, generally by the deadlines that apply to wages paid on December 31, 2006 (employers) or the due date for individual tax returns for 2006 (employees and contractors). Employers and other service recipients are not required to report deferred amounts that are not includible in compensation under Section 409A for either 2005 or 2006, although the specific guidance provided in Notice 2005-1 indicates that reporting for such deferrals will eventually be required.
Amount Includible in Income
For reporting and withholding purposes under Section 409A, the crucial piece of information for employers and other service recipients is the amount includible as income for the relevant tax year as a result of Section 409A. Notice 2006-100 indicates that the includible amount is equal to (1) the portion of the total “deferred amount” that, as of December 31, 2006, is not subject to a substantial risk of forfeiture and that has not been previously included in income in a prior year; plus (2) any deferred compensation payable or made available in calendar 2006. The “deferred amount” at issue is determined using the rules set forth in Notice 2006-100 based on the type of deferral arrangement at issue. These rules apply to the non-qualified deferred compensation benefits of both employees and independent contractors. Deferred amounts that were earned and vested prior to January 1, 2005 are not generally subject to Section 409A and should be excluded from this determination.
Account Balance Plans.[4] The deferred amount includible in an employee’s or independent contractor’s income for an account balance plan is effectively the entire vested account balance (as adjusted by any earnings or losses credited to such amount) that is subject to Section 409A as of December 31, 2006, in addition to the vested account balance of any other account balance plan that is aggregated with that plan (also adjusted by earnings and losses). In general, an individual’s account balances in all account balance plans maintained by the same service recipient (e.g., the employer) are aggregated for purposes of Section 409A.
Non-Account Balance Plans with Reasonably Ascertainable Amounts.[5] The deferred amount that is vested under a non-account balance plan (such as a non-qualified defined benefit plan) together with the vested benefits of all aggregated non-account balance plans where the amount deferred is “reasonably ascertainable” equals the present value of all future payments to which the employee or contractor has a legally binding right as of December 31, 2006, calculated as if the employee or contractor secured the legally binding right on December 31, 2006. A deferred amount is “reasonably ascertainable” on the first date when the amount, form, and commencement date of payments are known, and the only actuarial or other assumptions regarding future events or circumstances necessary to determine the amount are interest and mortality.
Stock Rights.[6] The vested deferred amount for a stock right, together with the vested amounts under any aggregated stock rights, is equal to the amount an employer or contractor would be required to include in income if the stock right were immediately exercisable and exercised on December 31, 2006. Generally, this means that the deferred amount as of December 31, 2006 is equal to the fair market value of the underlying stock less the exercise price and any other consideration paid by the employee or contractor.
Other Deferred Amounts. For deferred amounts that do not fit into any of the preceding categories, Notice 2006-100 indicates that such amounts must be determined under a “reasonable, good faith application of a reasonable, good faith method.” This would generally require the use of reasonable, good faith assumptions with respect to any contingencies as to the timing or amount of payments. The IRS notes that the use of an assumption resulting in the amount deferred being the lowest potential value of the future payment will be presumed to be unreasonable absent clear and convincing evidence to the contrary. Further, if a deferred amount consists of interests in various types of deferral arrangements, the amount of each segregable portion must be determined using the appropriate rules.
Service Recipient Reporting Requirements
Employers and other service recipients are generally required to report includible amounts as “wage” payments for employees on Form W-2 and as “non-employee compensation” for contractors on Form 1099-MISC. Includible amounts made available to employees are also reportable on the employer’s Form 941.[7] Amounts reportable under the Notice are treated as “supplemental wages” for purposes of determining the appropriate withholding amount.[8] Withholding is not required on the amount of any additional 20% tax due as a result of violating Section 409A.
For purposes of amounts not eligible for relief under Notice 2006-33, employers and other service recipients must make a reasonable good faith application of a reasonable good faith method to determine the amount includible in income for reporting purposes.[9] These amounts are treated as wages paid on the date of the deemed transfer of property under Section 83.
For tax reporting, withholding, and remittance, amounts includible in income in 2006 that are either actually or constructively received in 2006 are treated as wage or compensation payments when they are received by the employee or contractor at issue. Amounts includible in income in 2006 that are not actually or constructively received during 2006 are treated as wage or compensation payments as of December 31, 2006.
Employee Reporting Requirements
An employee or contractor is required to report as income any deferred amounts that become includible in income in 2006 under Section 409A. Moreover, if a service provider has not yet reported deferred amounts that became includible in 2005, he or she must submit corrected returns and pay any additional tax due.[10] If the service provider follows the requirements set forth in Notice 2006-100, the IRS will not attempt to assess any penalties (other than underpayment penalties associated with deferred amounts that were not reported on the taxpayer’s 2005 tax return). For corrected 2005 returns, the service provider must submit the return and pay any additional taxes no later than the due date for his or her 2006 tax return in order to avoid further penalties. If a service recipient fails to report and pay the appropriate taxes for 2005 or 2006, he or she will be subject to additional income taxes and penalties based on the amount of the underpayment.
2006 Tax Credit for Employees. Notice 2006-100 offers some relief to an employee whose employer fails to withhold the full amount of taxes due on a deferred amount (or does not withhold at all) in the form of a tax credit for 2006.[11]
Determination of Deferred Amount. Service providers must use the same rules for determining the deferred amount includible in income as are applicable to employers and other service recipients. A service provider’s compliance with this requirement is determined independently of the service recipient.
Updated Reporting for 2005
To the extent an employer or other service recipient did not previously report a deferred amount that was includible in income under Section 409A in 2005 or 2006, it must now report such amounts or prepare corrected tax reporting forms. If a deferred amount was previously and accurately reported on Form W-2 or Form 1099-MISC (including corrected forms), no further reporting is required by Notice 2006-100. The failure to file or correct previously-filed reporting forms may subject the employer or other service provider to penalties under Sections 6721 and 6722. The original and/or corrected forms must be submitted by the deadlines applicable for reporting amounts includible in income in 2006 (i.e., corrected return filed by February 28, 2007 and wage statement by January 31, 2007). The original or corrected form must calculate the amounts includible in income using the rules described in Notice 2006-100.
An employer is not liable for any tax withholding or penalties for previously-unreported amounts provided it complies with the provisions of Notice 2006-100 to report and remit the applicable amounts. Further, an employer or other service recipient that fully and correctly complies with Notice 2006-100 will be not liable for additional income tax withholding or penalties or be required to file a subsequent corrected return or furnish a corrected wage statement as the result of future published guidance. The IRS reserves the right to reassess an employer’s compliance with the Notice and require appropriate corrections (including additional tax liability and penalties).
Clarifications for Grandfathered Deferral Arrangements
The amounts required to be reported by Notice 2006-100 are only those that are includible in income as a result of Section 409A. Deferred amounts held in so-called “grandfathered” arrangements (i.e., deferred amounts that were vested as of December 31, 2004 under arrangements that have not been “materially modified” after October 3, 2004) are not subject to Section 409A’s reporting requirements. Notice 2006-100 grants a further reprieve for grandfathered arrangements that have been or are materially modified by providing that the reporting and withholding requirements may be applied as if the deferred amounts were originally deferred on January 1, 2005 rather than the actual date of deferral (which might have been many years earlier).
Coordination with Transition Guidance
As noted above, the IRS recently issued Notice 2006-79 which, among other things, extends the final compliance date for the Section 409A regulations and extends the compliance transition rule that was originally set forth in Notice 2005-1. Unfortunately, the IRS did not indicate how the compliance extension provided by Notice 2006-79 is intended to interact with the reporting and withholding requirements described in Notice 2006-100. Pending further guidance from the IRS on this point, there appears to be a reasonable basis for concluding that the reporting and withholding requirements apply only to deferred amounts that are ultimately taxable under Section 409A. In other words, if an arrangement that does not currently comply with Section 409A is updated by the applicable compliance deadline (i.e., December 31, 2007), no reporting or withholding for 2005 or 2006 should be required simply because it was not updated prior to the deadline. However, if an arrangement is not timely updated to comply with Section 409A, penalties and interest could be assessed for the failure to comply with the reporting and withholding requirements in Notice 2006-100.
Interim Guidance Only
The IRS emphasizes that Notice 2006-100 provides interim guidance and that further clarifications and modifications to its requirements will be forthcoming as part of more general regulatory guidance to be issued under Section 409A. It is not clear whether the IRS intends to include this additional guidance in the final Section 409A regulations which are expected to be issued in 2007.
Footnotes:
1: An advance version of Notice 2006-100 is available through the IRS website at http://www.irs.gov/pub/irs-drop/n-06-100.pdf. Notice 2005-94 is also available through the IRS website at http://www.irs.gov/pub/irs-drop/n-05-94.pdf.
2: For additional discussion about Section 409A, please refer to our prior Legal Updates entitled
Deferred Compensation Plans to Undergo Major Changes Under American Jobs Creation Act of 2004, October 2004;
Deferred Compensation Update: IRS Issues Initial Guidance Notice 2005-1, January 2005; and
Deferred Compensation Update: IRS Issues Proposed Regulations Under Code Section 409A, October 2005, for a more detailed and technical discussion of Section 409A’s general requirements. Additional analysis of more specialized Section 409A issues can be found in the following Legal Updates:
Proposed Code Section 409A Regulations Prompt Reconsideration of Stock Valuations for Equity Compensation Programs, January 2006;
IRS Notice 2006-4 Provides Interim Relief from Section 409A Valuation Requirements for Stock Options, December 2005;
Upsetting the Apple Cart: New Deferred Compensation Rules Endanger Employment Agreements and Severance Plans, December 2005;
Tax Issues Arising Out of Stock Options Back-Dating Investigations, June 2006; and
IRS Extends Section 409A Compliance Date for Non-Qualified Deferred Compensation Arrangements, October 2006.
3: Notice 2005-1 is available through the IRS website at http://www.irs.gov/pub/irs-drop/n-05-01.pdf.
4: Per Section 1.409A-6(a)(3)(ii) of the proposed Section 409A regulations (cross-referencing Treas. Reg. § 31.3121(v)(2)-1(c)(1)(ii)), an “account balance plan” is a “nonqualified deferred compensation plan under the terms of which a principal amount (or amounts) is credited to an individual account for an employee, the income attributable to each principal amount is credited (or debited) to the individual account, and the benefits payable to the employee are based solely on the balance credited to the individual account.”
5: Per Section 1.409A-6(a)(3)(i) of the proposed Section 409A regulations (cross-referencing Treas. Reg. § 31.3121(v)(2)-1(c)(2)), a “non-account balance plan” is a nonqualified deferred compensation plan that is not an account balance plan and under which the amount deferred for a period equals the present value of the additional future payment or payments to which the employee has obtained a legally binding right under the plan during that period.
6: For purposes of Section 409A, a “stock right” is stock option or stock appreciation right.
7: For deferred amounts that are reportable as a result of Notice 2006-100, employers are directed to report these amounts on the Form 941 they submit for the quarter ending December 31, 2006.
8: Certain wage payments not made as part of the regular payroll process are subject to simplified supplemental withholding rules, at an employer’s election. The supplemental withholding rate for 2006 is 25% on amounts up to $1 million. Under regulations issued under the American Jobs Creation Act of 2004, a second supplemental withholding rate — 35% — is applicable for supplemental wage payments in excess of $1 million.
9: Notice 2006-33 offered limited transition relief through December 31, 2007 to deferral arrangements funded through offshore trusts or those with financial health funding triggers. Under this transition relief, assets that were set aside, transferred or restricted on or prior to March 21, 2006 are not treated as having triggered the income inclusion rules of Section 409A(b) if the funding vehicle involved is brought into compliance on or before December 31, 2007.
10: Notice 2006-100 points out that depending on the amount of the deferrals, a taxpayer could be required to make estimated tax payments in order to avoid penalties under Code Section 6654.
11: This tax credit will be available if the employer takes either of the following remedial actions. First, prior to February 1, 2007, the employer may withhold or recover from the employee the amount of the undercollection and report as “wages” any deferred amounts that were not actually or constructively received but that are includible in income in 2006 under Section 409A. Alternatively, the employer may pay the tax liability on the employee’s behalf and report the gross wage amount and withholding for the quarter ending December 31, 2006 (including the includible amount itself and any taxes associated with the employer’s payment of the employee’s tax liability). The remittance of any such tax payments will be considered to be timely if they are deposited by the due date for the employer’s Form 941 for the quarter ending December 31, 2006. This approach will avoid failure to deposit penalties under Code Section 6656.