TAM Clarifies Tax and Withholding Consequences of Early Retirement Incentives and Failed Section 457 Plans (Posted on May 10, 1999 by )


Carol V. Calhoun, Counsel
Venable LLP
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Washington, DC 20004
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Carol V. Calhoun

Technical Advice Memorandum (“TAM”) 199903032 (October 2, 1998) provides new guidance on the tax and withholding rules which apply to nonqualified deferred compensation and severance plans of governmental and other tax-exempt employers. Under the rules set forth in the TAM, many plans which employers have thought of as severance plans would be treated as deferred compensation plans, subject to unfavorable tax rules. Moreover, benefits under such plans would potentially be subject to tax at three different times: to income taxes when the taxpayer is eligible to receive the benefits, to FICA (Social Security and Medicare) taxes upon termination of employment, and to income tax withholding as they were paid to the employee. Given that governmental employers whose deferred compensation plans failed to meet the new funding requirements of Code Sec. 457(g) by January 1, 1999 will be subject to these rules, they come at a particularly timely moment.

The provisions which the Internal Revenue Service (“IRS”) was called upon to interpret related to Code Sec. 457(f), Code Sec. 3121(v)(2), and Code Sec. 3402. Code Sec. 457 provides in general that if an eligible employer (a governmental employer, or a tax-exempt employer other than a church) maintains a nonqualified “deferred compensation plan” which does not meet the requirements of Code Sec. 457(b), each participant will have to include the present value of the compensation deferred under the plan in income for tax purposes in the first taxable year in which there is “no substantial risk of forfeiture” of the benefits under the plan. However, the statute exempts a bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plan from these rules.

Code Sec. 3121(v)(2), which applies to taxable as well as tax-exempt employers, similarly provides that any amount deferred under a nonqualified “deferred compensation plan” is subject to FICA taxes as of the later of when the services are performed, or when there is “no substantial risk of forfeiture” of the benefits.

For example, suppose that a nonqualified governmental deferred compensation plan does not meet the requirements of Code Sec. 457(b). Suppose further that in 1999, $5,000 is put into the plan on behalf of Participant A, and that Participant A will receive that amount plus interest upon termination of employment, regardless of how long Participant A remains in the employ of the employer. Participant A will have to include the $5,000 on her 1999 tax return, and her employer will have to count it as wages for purposes of FICA taxes, even though she does not receive the $5,000 in 1999, and may not receive it for many years to come.

Code Sec. 3402 governs the employer’s income tax withholding obligation. It states that wages are subject to income tax withholding when the employer makes payment of such wages to the employee. Unlike Code Sec. 457 and Code Sec. 3121(v)(2), Code Sec. 3402 contains no special rules for nonqualified deferred compensation.

TAM 199903032 dealt with a public school district in State X. The school district maintained a plan which provided for benefits to teachers hired before 1988 if those teachers retired after attaining a combination of age and service totaling 73 (“rule of 73”). The benefits were equal to whatever amount was necessary for the teacher to reach a $26,000 guarantee, after subtracting the school district’s matching contributions to another deferred compensation plan, plus interest thereon. (The other deferred compensation plan was one that met the requirements of Code Sec. 457(b).) The plan would not pay any benefits, however, if the teacher were fired for cause.

The school district argued that teachers who had attained the rule of 73, but had not retired, should not be taxed on their benefits. The IRS considered three arguments in favor of this position, as follows:

  • The plan was a severance plan, not a deferred compensation plan, and therefore was not covered by Code Sec. 457(f) or Code Sec. 3121(v).
  • If the plan was a deferred compensation plan, the benefits under it were subject to a substantial risk of forfeiture, and thus not subject to tax until the teacher retired, because they would diminish (and in some cases be eliminated) as the school district continued to make matching contributions to the other deferred compensation plan.
  • If the plan was a deferred compensation plan, the benefits under it were subject to a substantial risk of forfeiture, and thus not subject to tax until the teacher retired, because the teacher would lose them if the teacher were fired for cause.
With respect to Code Sec. 457, the IRS rejected all three arguments. It held that because the benefits were payable upon a voluntary as well as involuntary termination of employment, they constituted deferred compensation benefits rather than severance benefits. It held that the reduction in benefits as a result of the school district’s matching contributions was meaningless, because the employee would still get the $26,000 total, although some of it would come from the other plan. And it held that the fact that a teacher who was fired for cause would not receive benefits did not represent a “substantial risk of forfeiture.”

With regard to Code Sec. 3121(v)(2), however, the IRS took a different approach. It held that the plan was a deferred compensation plan, and that benefits were not subject to a substantial risk of forfeiture, within the meaning of Code Sec. 3121(v)(2). However, citing regulations under Code Code Sec. 3121(v)(2), it held that FICA taxes would not apply until the amount of the benefit became “readily ascertainable;” i.e., when the teacher terminated employment.

Finally, it held that although Code Sec. 457 governs the teacher’s income taxes, it does not determine the timing of the school district’s obligation to withhold income taxes. Under Code Sec. 3402, income tax withholding obligations arise only when wages are paid or made available to an employee. Thus, although the teacher would owe income taxes when she satisfied the rule of 73, the school district would not withhold income taxes on the benefits at that time.

Under the TAM, an employee could potentially be subject to tax at three different times on the same income. For example, suppose the teacher met the requirements of the rule of 73 in 1999 under the plan described in the TAM. Suppose further that the teacher retired in 2005, but elected to have the ultimate benefits paid in 2006. The deferred compensation plan would result in income taxes in 1999, in FICA taxes in 2005, and in income tax withholding in 2006

The IRS reasoning is likely to be controversial. The language of Code Sec. 457(f)and Code Sec. 3121(v)(2) is identical in all material respects. Thus, it is unclear how regulations under Code Sec. 3121(v)(2) could cause a delay in FICA taxation, without also causing a delay in the employee’s income taxes.

The holding that the income taxes are payable under Code Sec. 457 in a year different from the year in which the benefits are subject to income tax withholding under Code Sec. 3402 seems more justified by the statute, but defies common sense. Presumably, the teacher in our prior example will receive a Form W-2 at the end of 1999 in which the value of the deferred compensation will not be reported as wages for either FICA or income tax withholding purposes. She is then supposed to figure out for herself that the present value of the deferred compensation must be added to the amount shown on the W-2 to determine taxable income, determine what the present value of the deferred compensation is, and report that value on her 1999 tax return. And of course, the calculation of the present value requires assumptions about how long she will continue employment, what matching contributions will be made to the other deferred compensation plan in the future, and what interest rate she should be using to calculate the present value. One wonders whether teachers in that district will be required to have training in both mathematics and law in order to cope with these requirements.

Moreover, the IRS stated that the income tax withholding requirement would not apply in the year in which the amounts were deferred. The logical corollary to this is that income tax withholding would be required in the year in which the school district paid such amounts to the teacher. However, the amount subject to income taxes in such year would be reduced by the amount which the teacher included in income for tax purposes in the year of deferral. Thus, the school district would presumably be reporting on the teacher’s Form W-2, and withholding income taxes on, a much larger amount than the amount on which the teacher would be subject to income tax. Even if such a result is technically required by the statute, it does not make a lot of sense from a practical standpoint.

What does TAM 199903032 mean from the point of view of an employer? First, it makes clear that many arrangements which employers and employees have thought of as severance arrangements must be treated as deferred compensation. Second, it provides the reporting and withholding rules for an employer that sets up a nonqualified deferred compensation plan which does not comply with Code Sec. 457, or which ceases to be in compliance with Code Sec. 457 due to a failure to meet the funding requirements applicable to governmental deferred compensation plans effective January 1, 1999.

Footnotes:
1. See “Deadline for Amending Governmental Section 457 Plans Approaching,” Pension & Benefits Week ¶ 5, 10/19/1998.
2. A nonqualified deferred compensation plan for Code Sec. 457(f)purposes is a deferred compensation plan that does not meet the requirements of Code Sec. 401(a), Code Sec. 403(a), or Code Sec. 457(b), and that is not a funded plan taxable under Code Sec. 83 or a qualified governmental excess benefit arrangement described in Code Sec. 415(m). Similar rules apply for purposes of Code Sec. 3121(v)(2), except that salary reduction contributions to 401(k) or 403(b) plans are covered by the rules. Whether governmental excess benefit arrangements are subject to the Code Sec. 3121(v)(2) rules is the subject of continuing controversy.
3. Code Sec. 457(e)(11).
4. Contrast this with the situation for employees of taxable employers, which are not subject to income tax under Code Sec. 451 until the deferred compensation is paid or made available to them.
5. Code Sec. 457(f)(1)(B).
See “Deadline for Amending Governmental Section 457 Plans Approaching,” Pension & Benefits Week ¶ 5, 10/19/1998.
A nonqualified deferred compensation plan for Code Sec. 457(f)purposes is a deferred compensation plan that does not meet the requirements of Code Sec. 401(a), Code Sec. 403(a), or Code Sec. 457(b), and that is not a funded plan taxable under Code Sec. 83 or a qualified governmental excess benefit arrangement described in Code Sec. 415(m). Similar rules apply for purposes of Code Sec. 3121(v)(2), except that salary reduction contributions to 401(k) or 403(b) plans are covered by the rules. Whether governmental excess benefit arrangements are subject to the Code Sec. 3121(v)(2) rules is the subject of continuing controversy.
Code Sec. 457(e)(11).
Contrast this with the situation for employees of taxable employers, which are not subject to income tax under Code Sec. 451 until the deferred compensation is paid or made available to them.
Code Sec. 457(f)(1)(B).