While many important functions of employee benefit planning are typically completed well in advance of the end of the year, there are a few important matters that still require attention amidst the holiday plans. Benefit planners should be thinking about three things in particular:
- Documenting all applicable employer tax deductions related to compensation and benefit plans
- Reviewing any nonqualified compensation plans for possible tax issues
- Preparing to meet all end-of-year ERISA reporting requirements
Employer deductions for compensation and benefit plans
Compensation planning is simple and is sometimes not even thought of as a form of employee benefit planning. However, the tax rules for the timing of a corporation’s deduction for compensation are more complicated than one might expect, primarily because the IRS sees potential for abuse in compensation payment situations.
IRS Publication 334, Tax Guide for Small Business, has a simple explanation of the IRS position on the employer’s tax treatment of employee pay and benefits. IRS Publication 17, Your Federal Income Tax, covers the tax treatment from the employee side of both these publications are available free from the IRS and are revised annually.
Under the usual tax accounting rules for accrual method taxpayers, an item is deductible for an accounting period if that item has been properly accrued, even if not actually paid. Accrual occurs, for tax purposes, in the taxable year when all events have happened that legally require the corporation to pay the amount—the so-called “all events” test. Usually, the all events test is satisfied as soon as the employee has performed all the services required under the terms of the employment contract. Because of the apparent potential for abuse of compensation arrangements, particularly for closely held businesses, there are specific rules for deducting compensation payments that override the usual accrual rules in some cases.
If the company uses the cash method of accounting, deductions for compensation cannot be taken before the year in which the compensation is actually paid.
No employer, whether using the cash method or the accrual method, can take a deduction for compensation for services that are not rendered before the end of the taxable year for which the deduction is claimed. Any compensation paid in advance must be deducted pro rata over the period during which services are actually rendered.
Timing of corporate deductions for compensation payments
The tax rules for timing of deductions distinguish between current compensation and deferred compensation. If the compensation qualifies as current compensation, then the employer can deduct it in the year in which it is properly accrued to the corporation under the tax accounting accrual rules. If the amount qualifies as deferred compensation, then Code section 404 and related regulations do not permit the employer corporation to deduct it until the taxable year of the corporation in which, or with which, ends the taxable year of the employee in which the amount is includable in the employee’s income. For example, if an employer sets up a deferred compensation arrangement in 2013 for work performed in 2013 with compensation payable in 2014 and taxable to the employee in 2014, the corporation cannot deduct the compensation amount until 2014.
Whether an amount is considered current or deferred compensation depends on the type of employee:
For a regular employee — an employee who is not a controlling shareholder or otherwise related to the employer corporation — the IRS takes the position that a plan is deferred compensation if the payment is made more than 2½ months after the end of the taxable year of the corporation. In other words, there is a 2½ month safe harbor rule. For example, if a calendar year accrual method corporation declares and accrues a bonus to an employee before the end of 2013, the employer is entitled to a 2013 deduction for the bonus as long as the bonus is paid before March 15, 2014. The employee would include this bonus in income for 2014. However, if the bonus was paid on April 1, 2014 — beyond the 2½ month limit — then the employee still includes the amount in income for 2014, but the employer’s deduction is delayed until 2014.
If the employee is related to the corporation (directly or indirectly owns more than 50% of the corporation), then according to Code section 267 the 2½ month safe harbor rule does not apply. Deductions and income are matched in all cases. So, if a calendar year accrual method corporation declares and accrues a bonus to its controlling shareholder before the end of 2013, but pays it on February 1, 2014, the corporation cannot deduct the bonus until 2014.
Taxation can be avoided or deferred by various types of non-cash compensation plans. Some examples of plans that defer taxation, usually until cash is actually received by the employee are:
- nonqualified deferred compensation plans;
- qualified pension, profit sharing, ESOP, 401(k) and similar plans;
- Stock option and restricted stock plans
Compensation options that are completely tax-free (no taxation, either currently or deferred) include such plans as:
- health and accident plans (provided that certain nondiscrimination and eligibility requirements are met)
- disability income plans of certain types
- dependent care and educational assistance plans (subject to certain maximum limits on amounts that may be excluded from income by employees)
- group term life insurance up to $50,000 (unless the plan discriminates in favor of key employees)
- the pure death benefit amount from any life insurance plan, even if the premium is currently taxable
Where the employer may lose a deduction for cash compensation due to a reasonableness of compensation problem, part of the compensation might be provided in a form that is both tax-deferred to the employee and deduction-deferred to the employer. The reasonableness of compensation issue does not arise until the year in which the employer takes the deduction, so deferring the deduction can be helpful.
There are several types of compensation strategies and benefit plans that can present issues that require some degree of end-of –year planning.
Bonus plans can be informal or even oral. There are no taxes or other legal requirements for a written plan or for filing anything with the government. However, a written plan is often desirable, and in that case employer and employee might want to consult with an attorney experienced in handling employee compensation matters.
Bonus payments are deductible under the same rules as other forms of cash compensation. A bonus, together with other compensation, cannot be deducted unless it constitutes (a) a reasonable allowance for (b) services actually rendered. Factors indicating reasonableness — the first part of the test — are listed above, as well as the fact that no deduction is permitted for compensation in excess of $1,000,000 paid to certain top executives of publicly held corporations, along with certain other limitations.
Bonuses can be very large if they are based on profits or earnings and the company has a very good year. For example, suppose a sales manager receives a $400,000 bonus in addition to his regular $100,000 base salary, under a sales-target bonus formula. Although $500,000 of compensation might, as a general rule, be considered unreasonably high for this type of sales manager, this arrangement might be sustained by the IRS for two reasons:
- Reasonableness of compensation is often tested in accordance with circumstances existing when the bonus agreement is entered into rather than when the bonus is actually paid.
- In testing the reasonableness of a bonus, both the IRS and the courts will usually take into account the element of risk involved to the employee. That is, an employee presumably had a choice between a relatively lower amount of guaranteed compensation and a higher amount of contingent compensation. So the two should be deemed equivalent for purposes of testing reasonableness. For instance, a sales manager who receives a $100,000 base salary and a bonus of 10% of the gross sales increase in 2013, producing a $400,000 bonus for 2013, probably could not at the beginning of 2013 have negotiated a contract for $500,000 of guaranteed compensation without bonus. The reasonableness of the bonus contract should be based on the reasonableness of the equivalent fixed salary agreement that the sales manager could have negotiated, not on the $500,000 total resulting from taking a chance and then having a good year.
It is important to plan ahead when using bonuses as an employee benefit technique. If reasonableness might become an issue, decide upon a bonus formula well in advance of the time the bonus is paid. (Preferably, in advance of the year in which the bonus will be earned). In other words, a formula for determining a bonus for year-end 2013 should be determined in writing before the beginning of 2013 to help support the reasonableness of the amount.
The timing of income to the employee and deductions to the corporation are governed by the rules discussed in detail above with regard to cash compensation. Since bonuses are often payable after the end of the year in which they are earned, the “2½ month safe-harbor rule” is important for bonus planning. Under this rule, an accrual method corporation can deduct a compensation payment that is properly accrued before the end of a given year, so long as the payment is made no later than 2½ months after the end of the corporation’s taxable year. For example, for a calendar year accrual method corporation, a bonus earned for services completed in 2014 can be deducted by the corporation for 2014, so long as it is paid on or before March 15, 2015. Note, however, that the 2½ month rule does not apply to payments to employees who own or control (50% or more) the corporation under Code Section 267(b). For those employees, the corporation must pay the bonus during its taxable year in order to deduct it during that taxable year.
For regular employees who can make use of the 2½ month safe harbor technique, the ability to move taxable income into the employee’s next taxable year is a significant advantage of the bonus form of compensation. For example, a bonus might be earned (and deducted by the corporation) in 2013, paid on March 15, 2014, and the employee could defer the payment of tax to April 15, 2015 (the employee’s due date for the 2014 tax return.)
A severance pay plan is an agreement between employer and employee to make payments after the employee’s termination of employment.
Under Treasury Regulations section 1.162-7, severance payments are deductible by the employer if: (a) the payments are compensation for services previously rendered by the employee, and (b) the payments are reasonable in amount.
Severance payments made pursuant to a written plan or agreement, which is entered into while the employee is still actively at work, should be considered compensation for services in most cases. The promised severance benefits in such a case are considered part of the employer’s pay/benefit package, which compensates the employee for services. However, if there is no written plan or agreement in place prior to termination of employment, the IRS could argue that the payment is something other than compensation — such as a gift, a dividend, a buyout payment for the employee’s interest in the business, or whatever other characterization might fit the particular facts of the situation. Planners should counsel clients to try to avoid this result by adopting formal severance plans, policies, or agreements.
The reasonableness test which applies to severance pay arrangements is the same test that applies to all forms of compensation payments.
If the severance pay plan is unfunded (i.e., no assets are placed beyond the reach of the employer’s creditors), severance payments are taxable to the recipient as compensation income in the year actually or constructively received under Treasury Regulations section 1.61-2(a).
Employers should be aware of the constructive receipt issue concerning severance payments.
Example. Suppose employee Bob Cratchit is terminated on December 24, 2013 and is entitled to an immediate severance benefit of $350 (two weeks’ pay). Bob asks his employer to give him a tax break by paying the severance benefit on January 2, 2014, and the employer does so. Technically, Bob has run afoul of the constructive receipt doctrine; he should report the $350 severance benefit in 2013, because he had an unrestricted right to receive the payments in 2013.
While the IRS may sometimes overlook small constructive receipt issues in situations like the Cratchit example, they will be alert to constructive receipt where substantial amounts are involved.
Example. Suppose an executive severance pay plan provides a severance benefit of 1½ years’ salary, payable over a 2-year period. If the executive has no option but the 2-year payment, the payments will be included in income as they are received. However, if the executive can choose, at the time when he severs employment or thereafter, to accelerate the payment schedule to one year (without risk of forfeiting the benefit), then the entire amount must be reported as received in that one year, even if the executive actually chooses to and does receive it over a 2-year period. Careful drafting of the agreement is essential to avoid such unexpected tax results.
A severance pay plan is considered to be funded if assets are set aside beyond the reach of the employer’s creditors (typically in a trust) solely to pay plan benefits to employees. Severance pay plans funded through welfare benefit trusts or voluntary employees’ beneficiary associations (VEBAs) are of current interest among compensation planners. If severance pay benefits are funded, the value of the benefit is taxable to the employee in the first year in which he no longer has a substantial risk of forfeiting the benefit. This could result in taxation before the employee has actual or constructive receipt of the benefits. For example, suppose a funded plan provides severance benefits, payable in two equal annual installments, upon the employee’s involuntary termination, death, or disability. Unless the plan provides a substantial risk of forfeiture that continues after termination, death, or disability, the full value of the benefits will be taxable in the year in which the employee terminates, dies, or becomes disabled, even if actual payment is spread over two years.
If the severance payment is characterized as a parachute payment, the employer’s deduction may be limited and the employee may be subject to penalty. In general, parachute payments are severance payments that take effect upon changes in business ownership.
In general, the tax consequences of a severance pay plan (whether or not it is governed by ERISA, as discussed below) are similar to those of a nonqualified deferred compensation plan.
Treasury Regulations section 31.3121(v)(2)-1 provides guidance on the Social Security tax treatment of nonqualified deferred compensation. According to the regulations, certain welfare benefits are not treated as deferred compensation for FICA purposes. In particular, the IRS believes that severance pay in general is not subject to the special timing rule for nonqualified deferred compensation, contained in Code section 3121(v)(2)(A), which provides that any amount deferred shall be taken into account for FICA purposes, as of the later of: (1) when the services are performed; or (2) when there is no substantial risk of forfeiting the rights to the amount deferred. Thus, severance benefits are generally subject to Social Security and Medicare taxes when received.
Restricted stock plans
The employer’s tax deduction for compensation income to the executive under a restricted stock plan is deferred until the year in which the employee is substantially vested and includes the amount in income. Under Treasury Regulations section 1.83-6(a)(1), the employer’s tax deduction occurs in the employer’s taxable year in which, or with which, the taxable year of the employee in whose income the amount is includable ends. This is the usual rule for the timing of an employer’s deduction for deferred compensation payments. As with other types of compensation, the employer is required to withhold and pay tax and in order to meet certain informational requirements.
Nonqualified compensation plans
Nonqualified plans present two issues which have specific end-of-year planning needs that may slip through the cracks: issues related to taxation of the employer for nonqualified plans, and payment of FICA taxes.
Taxation of the employer
For a nonqualified deferred compensation plan, the employer does not receive a tax deduction until its tax year that includes the year in which the compensation is includable in the employee’s taxable income under Code section 404(a)(5) and related regulations. This rule seems to apply even to amounts credited as “interest” on unfunded deferred compensation by an accrual-basis employer. If the plan is unfunded, the year of inclusion is the year in which the compensation is actually or constructively received. For a formally funded plan, compensation is included in income in the year in which it becomes substantially vested, as discussed earlier.
Payments under a deferred compensation plan, like other forms of compensation, are not deductible unless the amounts meet the reasonableness test. The same issues can arise with respect to deferred compensation as with regular cash compensation or bonus arrangements.
The reasonableness issue is raised by the IRS in the year in which an employer attempts to take a deduction. For nonqualified deferred compensation, this is generally the year in which the employee includes the amount in income—that is, a year that is later than the year in which the services were rendered. Compensation can be deemed reasonable on the basis of prior service; however, it is possible that a combination of deferred compensation and current compensation received in a given year could raise reasonableness issues, particularly if the deferred amount is very large.
Note that publicly held corporations generally cannot deduct compensation in excess of $1 million per tax year to certain top-level executives.
If assets are set aside in a reserve used to informally finance the employer’s obligation under the plan, income on these assets is currently taxable to the employer. Consequently, the use of assets that provide a deferral of taxation can be advantageous. Life insurance policies are often used because their cash value build-up from year to year is not currently taxed. Death proceeds from the policy are also free of tax, except for a possible AMT liability.
If assets used to finance the plan are held in a rabbi trust, the employer’s tax consequences are much the same as if assets were held directly by the employer. For tax purposes, the rabbi trust is a grantor trust. A grantor trust’s income, deductions, and tax credits are attributed to the grantor (here, the employer) for tax purposes.
Social Security (FICA) taxes
Amounts deferred under nonqualified deferred compensation plans are not subject to social security taxes until the year in which the employee no longer has any substantial risk of forfeiting the amount, provided the amounts are reasonably ascertainable under Code section 3121(v)(2) and related regulations. The final regulations provide a twist to this special timing rule for certain amounts deferred that are not reasonably ascertainable at the later of (1) the time the services creating the right to the amount deferred are performed; or (2) when there is no substantial risk of forfeiting the right to the amount deferred. In other words, as soon as the covered executive cannot lose his interest in the plan, he will be subject to social security taxes. Conceivably, this could be earlier than the year of actual receipt.
For example, if the plan provides that benefits are payable at retirement, but the benefits become vested five years after they are earned, then the amounts deferred will enter into the social security tax base five years after they are earned. Note that this is neither the year in which they are earned nor the year they are paid, a circumstance that complicates tax compliance in this situation.
Although part of the social security taxable wage base — the OASDI part — has an annual upper limit ($117,000 for 2014), the Medicare hospital insurance portion is unlimited. The Medicare tax rate is 1.45% for the employer and the same rate for the employee. For higher paid executives, the inclusion of deferred compensation in the wage base during a year of active employment will not result in additional OASDI taxes if the executive’s current (nondeferred) compensation is more than the OASDI wage base, but additional Medicare taxes will be payable. This factor must be taken into account in designing nonqualified deferred compensation plans.
ERISA reporting requirements
The Employee Retirement Income Security Act of 1974 (ERISA) is broad legislation that imposes extensive reporting and disclosure requirements on a broad range of employee benefit plans. These provisions require various forms and information to be disclosed to plan participants or filed with the IRS or the Department of Labor.
Under ERISA, employee benefit plans are divided into two types — pension plans and welfare plans. These terms are defined broadly enough that it often makes sense to think of them in terms of their exceptions rather than their definitions. That is, an employee benefit plan should be considered covered by the provisions of ERISA unless there is a specific exemption in ERISA or the regulations interpreting ERISA.
Dependent care assistance plans
A dependent care assistance plan reimburses employees for daycare and other dependent care expenses or provides an actual daycare center or similar arrangement. If the program is properly structured, the daycare expenses are deductible to the employer under Code Section 162 and non-taxable to the employee under Code Section 129. The dependent care plan can be funded using employee salary reductions under a Flexible Spending Account (FSA).
The plan is considered a welfare benefit plan for ERISA purposes. This requires a written plan document, a Summary Plan Description (SPD) explaining the plan that is provided to employees, a designated plan administrator, and a formal claims procedure. Further, Section 129 requires that the employer provide each employee with an annual statement of the expenses incurred in providing the prior year’s benefits by January 31 of each year.
PBGC Form 1-ES
While most ERISA reporting is done through IRS Form 5500 and related documents, benefits administrators should not forget about PBGC Form 1-ES, Estimated Premium Payment (Base premiums for plans with 500 or more participants). As the title suggests, the form is required for administrators or sponsors of defined benefit plans with 500 or more participants that are subject to PBGC provisions. It must be filed within two months after the end of the prior plan year, and can be completed electronically through the PBGC website at www.pbgc.gov.
While most compensation and benefit planning work occurs long before the snow starts to fall, a little attention paid to the issues discussed above can save a few headaches in the New Year.
For more information about the employee benefit planning, see The Tools & Techniques of Employee Benefit and Retirement Planning, 13th Edition, from National Underwriter for a comprehensive source of information on the entire range of compensations strategies and employee benefit plans.