On October 23, 2007, the IRS issued Notice 2007–89 (the “Notice”), which provides guidance related to the reporting and wage withholding requirements for non-qualified deferred compensation arrangements under Section 409A of the Internal Revenue Code of 1986 (the “Code”), as amended. The Notice provides similar information to that provided in Notice 2006–100, which included guidance on reporting and withholding on taxable non-qualified deferred compensation amounts includible in income in 2005 and 2006.
- Employers/Payers are not required to report nonqualified deferred compensation that is deferred in 2007 and not includible in income for the 2007 calendar year. The Instructions for Forms W–2 and W–3 and the Instructions for Form 1099–MISC released prior to November 1, 2007 do not reflect this rule, but have since been updated.
- Employers/Payers are required to report amounts includible in income in 2007 under Section 409A of the Code (“Section 409A”).
- Employers are required to withhold on amounts that are includible in income in 2007 under Section 409A.
- Section 409A’s 20% penalty tax need not be withheld for violations occurring in 2007.
Employer/Payer Reporting and Withholding Requirements
Employers and other payers are not required to report the amount of deferrals of non-qualified deferred compensation subject to Section 409A if such amounts are not taxable in the 2007 calendar year. However, amounts includible in gross income in 2007 under Section 409A must be reported and withheld upon by the employer (or other payer), as outlined below.
An employer/payer must report taxable amounts includible in gross income in 2007 under Section 409A as wages on the following IRS forms:
- Form 941: Employer’s Quarterly Federal Tax Return, Line 2.
- Form W–2: Box 1 and Box 12, using Code Z.
- Form 1099–MISC (for non-employees): Box 7 and Box 15b.
Employer Withholding Obligations
Amounts includible in gross income under Section 409A are considered to be “supplemental wages” for the purposes of determining the amount of income tax required to be deducted and withheld. Thus, for calendar year 2007, if the total amount of an employee’s supplemental wages exceeds $1,000,000, taking into account the amounts includible under Section 409A, then the employee’s supplemental wages in excess of the $1,000,000 threshold are subject to a 35% withholding rate. Any supplemental wages that are equal to or less than $1,000,000 are generally subject to a 25% withholding rate. See IRS Publication 15 for the withholding rules that govern supplemental wages.
Failure to Withhold by Employer
If an employer fails to withhold on amounts that were includible in gross income in 2007, but were not actually or constructively received, then the employer may use one of the two following methods to correct the under-withholding:
- Between December 31, 2007, and February 1, 2008, the employer may withhold or recover from the employee the amount of under-withholding, and report as wages for the quarter ending December 31, 2007, the amounts that were includible in income under Section 409A. These amounts should be reported on Form 941 and in Box 1 of the employee’s W–2 for calendar year 2007; or
- The employer may instead pay the income tax withholding liability on behalf of the employee and report the gross amount of wages and income tax liability for the quarter ending December 31, 2007. The reporting and withholding must include all amounts that were includible as income under Section 409A, and also include FICA, FUTA and income tax withholding resulting from the payment of income tax on the employee’s behalf.
Compliance Avoids Future Corrections to Reporting and Withholding
An employer (or other payer) who complies with the requirements of the Notice will not be liable for additional income tax withholding or penalties, or be required to file subsequent amended information returns, as a result of future published guidance. However, if it is later determined that the employer or other payer did not apply the rules of the Notice, any recalculation of these amounts will result in additional liability for any amount that is under-withheld.
Calculation of Amounts Includible in Income under Section 409A
If amounts are includible in an employee’s gross income and subject to Section 409A, such amounts are calculated as follows:
- Account Balance Plans
For account balance plans, the includible amount equals the credited account balance under the plan vested as of December 31, 2007, including any attributable income, gain or loss. The plan aggregation rules require that all account balance plans must be aggregated in determining this amount.
- Nonaccount Balance Plans
For nonaccount balance plans where the amount is reasonably ascertainable the includible amount equals the present value of all future payments to which the employee obtained a legally binding right, and in which the employee is vested, as of December 31, 2007. The plan aggregation rules require that all nonaccount balance plans must be aggregated in determining this amount.
- Stock Rights
The includible amount is the amount that the employee would be required to include in income if the vested stock right (e.g. a discounted nonqualified stock option right) was exercised on December 31, 2007. Specifically, this amount equals the fair market value of the underlying stock on December 31, 2007, minus the sum of the exercise price and any other amount the employee would have paid for such stock right (including any income tax includible in 2006).
- Other Deferred Amounts
The Notice provides that for any other deferred amounts not specifically addressed, the total amount deferred as of December 31, 2007 that is subject to Section 409A must be determined under a reasonable good faith standard. The plan aggregation rules require that all amounts not specifically addressed must be aggregated in determining this amount.
Section 409A(b) of the Code (“Section 409A(b)”) prohibits:
- the transfer of assets to an offshore trust;
- the restriction of assets to protect benefits in connection with a change in a company’s financial health; or
- the transfer of assets during a restricted period with respect to a single-employer defined benefit plan.
Where amounts have been transferred to a trust under an arrangement that triggers the income inclusion and additional taxes under Section 409A(b), and the transfer is not eligible for relief provided in prior guidance, then employers and payers must make a reasonable, good faith determination of the amount that is includible in income for purposes of reporting, including any associated earnings or income. Such amounts are treated as wages paid on the date the deemed transfer of property would be required to be included in income for purposes of withholding, depositing and reporting. For amounts includible in income under Section 409A(b) that were eligible for relief provided in prior guidance, but are includible in income under Section 409A(b) because the arrangement is not made compliant on or before December 31, 2007, the date of the deemed transfer of property is January 1, 2008.