Failure to deduct deferrals from bonuses

[Guest kodle]

Employees have deferral elections in place for bonuses, and the deferral elections were made prior to year in which bonus was earned. Employee must be employed on bonus payment date to receive bonus (so substantial risk of forfeiture). Bonuses paid at the end of March following the year in which earned. Emloyer's payroll system has a glitch, and no deferrals are deducted from the bonus payments. Employees get checks and cash them. Employer discovers error.

One position is that the bonus amounts are not, and were not, deferred and so are not subject to 409A, and so no violation of 409A. However, another position is that the deferral elections were improperly "revoked" because they were not irrevocable, and thus a violation of the initial deferral rules occurred and so the "not deferred" amounts are subject to the 409A penalty. Yet another position would be that the amounts WERE deferred but then the payment of those amounts was accelerated, again in violation of 409A.

Thoughts?

I am having trouble justifying a "correction" by asking the employees to return the amounts that should have been deferred (and I find no direct authority that this is a transaction that can be rescinded), since they now are in actual receipt of those dollars, but am wondering if anyone has tried that strategy. Thank you for what I know will be some interesting responses.

[Steelerfan]

If there is a true SRF up until the payment date, the short term deferral rules should take you out of 409A. Otherwise I would think you have a failure. But it's interesting that no employees said anything. If they had refused payment would CR have occured?

[jpod]

I'm assuming the bonus was paid, and the failure to defer, occured in March of 2007. If wages (and the bonus constiutes "wages") mistakenly paid are repaid to the employer in the same taxable year, they are not reportable as gross wages on the W-2. I believe this is covered in Pub 15. Therefore, if the employee repays (which he must, technically, due to his irrevocable election; he had no legal right to receive the money), he has preserved his tax deferral. I don't think the proposed 409A regs. address this situation, but it seems like the perfect solution.

[Guest mjb]

Provided the employees had validly executed deferral agreements to defer the comp, the deferrals can be repaid in the same year they were mistakenly paid. See Rev Rul 79-311

[Steelerfan]

Provided the employees had validly executed deferral agreements to defer the comp, the deferrals can be repaid in the same year they were mistakenly paid. See Rev Rul 79-311

Based on page 9 in the final regs, this question should be raised to the IRS. In light of the general rule (see the first paragraph on page 9) that any early payment would constitute an impermissible acceleration, there would seem to be sufficient doubt as to whether the prior IRS authority would constitute an exception to the 409A failure rules.

The example the IRS uses is "if a service provider has made an irrevocable election to defer an amount of his or her salary to a future year, that amount is treated as deferred compensation regardless of whether the service recipient actually pays such amount to the service provider during the year in which the services are performed."

I know that provision is probably not intended to cover mistakenly made payments, but it's enough to make me nervous about administrative failures and the consequences of messing up without any formal guidance as to correction methods.

[Guest mjb]

The example the IRS uses is "if a service provider has made an irrevocable election to defer an amount of his or her salary to a future year, that amount is treated as deferred compensation regardless of whether the service recipient actually pays such amount to the service provider during the year in which the services are performed."

Doesn't this example confirm that the employee can return the funds to the employer without any tax impact since the employee has no right to the funds under the irrevocable agreement. This was the premise in RR 79-311 for allowing the return of salary advances received by the employee to avoid taxation because the empoyee had no right to the funds.

[jpod]

Steelerfan: MJB and I were trying to suggest approaches to favorably resolve a problem that resulted from a mistake that already occurred. Using these approaches certainly seems better to me than simply giving up and paying the 20% tax plus the interest charge, etc. Therefore, I'm a bit confused by what you mean when you say these approaches "make you nervous."

[Steelerfan]

Doesn't this example confirm that the employee can return the funds to the employer without any tax impact since the employee has no right to the funds under the irrevocable agreement. This was the premise in RR 79-311 for allowing the return of salary advances received by the employee to avoid taxation because the empoyee had no right to the funds.

mjb: My understanding of this example is that it confirms that despite an irrevocable election to defer, if an employee receives a payment in that same year of deferral, for example, because he retires, then the amount is still "deferred compensation" in terms of reporting, etc. I don't see how it creates authority to pay back amounts. Unless I'm missing something big, it looks like the opposite to me--that once you receive payment, it retains it's character as deferred comp, and if you had no right to receive it, then a failure occurs unless an exception applies. It sounds like the RR you mention uses a breach of contract theory to provide tax relief, but will it hold water post 409A? Under your theory, which would be great, this provision creates a large "oops I made a mistake exception" to 409A, which I don't believe it does.

jpod: These approaches would be fine, but my concern is that they may not provide relief if the IRS assesses penalties after you've "fixed" the problem and you're a couple years down the road facing an audit. I certainly don't advocate giving up, but I think correction of failures has to be one of the next major 409A projects the IRS needs to take up (after they tell us how to report).

[Guest mjb]

The premise expressed in RR 79-311, RR 75-531 and under the tax law is that a taxpayer who returns renumeration for services that he is not entitled to retain to the payor in the same year in which funds are paid is not deemed have received taxable income on such renumeration merely because it was subject to the taxpayer's dominion and control. Since the employees have executed legally binding agreements to defer the bonuses they had no right to the payments and the return of the bonuses to the payor in the same tax year would eliminate any income taxation. The language you cited in the 409A regs does not mandate a different outcome.

This situation is no different than that of a bank customer who withdraws funds belonging to another customer which were mistakenly deposited in his account and returns the funds when notified by the bank. The fact that the customer took the funds into his possession does not result in taxable income if the individual returns the funds after receiving notification from the bank.

[401 Chaos]

I agree with others that there is no clear answer in the final regulations and that the IRS needs to provide guidance as to self-correction in this area. From a policy perspective, I think the IRS should clearly prefer and allow for the return of the erroneously paid amounts without consequences. That would simply be putting everybody back in the position they would have been in had the mistake not occurred. To allow participants to keep these amounts would be a failure to comply with the irrevocable elections and arguably an accelerated distribution under 409A. Although not the intent in this case, it seems that allowing such administrative mistakes to go uncorrected could potentially give rise to the sorts of abuse the IRS is trying to avoid under 409A. For example, executive changes his mind about a previous deferral election and possibly arranges for an "administrative glitch" to avoid that deferral.

Now for the hard part--getting the participants to pay back those amounts. I suppose arguing to them that the payments were a 409A violation and that the 20% excise tax will be taken out of their paychecks may help get the money returned but some group will no doubt demand that the company help out with this payback by providing them an additional bonus since they may have already spent the money.

Good luck.

[Just Me]

"the 20% excise tax will be taken out of their paychecks"

Good luck in taking the 20% excise tax out of their paychecks. There is no requirement or authority under Section 409A for the employer to withhold this amount, and without a written agreement by the employee, it would likely violate your state's payroll laws.

[401 Chaos]

Perhaps so but I'm not convinced the Service is going to let employers off the hook in getting the 20% excise tax when they know there has been a violation.

[Guest mjb]

According to P12, IRS Pub 15-A "Employers must withhold federal income tax (but not the additional taxes) on amounts includible in in gross income under 409A. " The employees are required to pay the additonal taxes on the 1040.

[Just Me]

I agree. The employer cannot withhold the 20% excise tax because it has no authority to do so. My concern was primarily with the concept of threatening the employee with a 20% withholding taken from his wages (if he didn't pay over the amount that should have been deferred) where the employer has no right or authority to do so. I would hate to think that anyone is advising an employer to do such a thing.

[401 Chaos]

Alright, alright. You are both correct that the employer cannot / should not take the 20% from the paychecks. My apologies--it was an off-the-cuff response and not intended to be legal advice to anyone. Seems still though that you have to tell the employees that you will report it as a noncompliant distribution thus the IRS will be looking for the 20% excise tax from somewhere. My main point was just that the employer probably needs some hook or threat to the 20% excise tax piece in order to convince the employees to return the money (if that is what they decide to do).

[Guest mjb]

how about the most obvious hook - if not returned to the employer byyr end it will be taxed as wages under RR 79-311 and will be subject to penalites under 409A.

[401 Chaos]

I haven't read the RR so I may be missing something but was generally assuming that the bonus amounts had already been taxed as wages since they should be subject to normal payroll withholding. It seems to me the employer arguably has to unwind those prior tax withholdings and get the after-tax amounts back from the employees. Unfortunately, in my experience asking for (and getting) the money returned is never as easy as it sounds.

[Guest mjb]

I thought the general principal of the RR is that if the employee returns money that is mistakenly paid to him by the end of the yr then it is not taxable. If the employee returns it in the next year the employee has taxable income on funds in the year paid even if the employee had no right to the funds under the law. Are you saying that if the employee executes a deferral agreement under 409A but the funds are not withheld the employee will not be taxed on the renumeration that is not returned t the employer but will deemed deferred?

[Steelerfan]

Based on recent statements by IRS (either Tackney or Hogans) the IRS would like to have a failure corrections program but does not have resources allocated to do it now. This leads me to believe that they will approach failure in a very strict manner due to the nature of the abuses this statute was intended to prevent (Enron). I think the correction method discussed herein is a reasonable method and would more likely than not be accepted by IRS. However as mentioned it is not without problems. First the executive may have spent or invested the money and there may be no liquid cash to pay back. And second if the executive is a Section 16(b) officer, it could be an extension of credit under SOX if the exec pays back in installments. It also seems obvious that the executive could not keep the money under any circumstance since it is definitely a failure and such "glitches" would start to occur more frequently suggesting collusion.

Based on the recent statements by IRS officials (unless you would be allowed to self correct by getting the $ back and report nothing) an amount accidentally paid is deferred compensation; there is no way to change it's character or undo a mistake under 409A. What should happen is that the amount should be reported as box 12 code z and the employer must withhold taxes and the employee must pay the penalty. Then the fun really begins, because you just caused all other amounts (if any) in any other similar plans (elective account balance plans) that the exec is in to be immediately taxed and subject to 20%. Does this remind anyone of a similar draconian penalty known as disqualification of a qualified plan (but only in relation to one executive). The IRS has never disqualified a qualified plan and will likely never let this draconian scenario occur--but it stresses the need for guidance. The reality is that the exectuive will be grossed up for any penalty taxes. Then, since it's the employer's fault (presumably), the executive will receive other bonuses to place him in the same position he should have been had the error not occurred. Meanwhile, the employer will figure out a way reduce everyone else's pay to cover this cost since it is clear under the laws of nature that the rank and file should pay for this type of mistake and executives should not have to spend any of the money they earn.

[401 Chaos]

MJB,

I was really just trying to make two points. The first point is that getting money back from employees is a pain. As to your specific question, it seems to me the employees should have already had income / withholding taxes withheld on the bonus amounts since they have already been paid to the employees, albeit erroneously. Thus, I think the employer has generally satisfied its tax / withholding requirements on these amounts and all that is left is to be paid is for the employee to pay the 409A excise taxes. (I wouldn't think there would be penalties and interest due since the employer presumably withheld income taxes owed at the time of payment and those amounts should have been timely paid.)

If an employer wanted to try and self-correct this situation (and I'm not saying that is allowed), it could be difficult to convince the employee to give back the money. The employees have already received it, presumably paid taxes on it, and many have likely spent it and therefore may not be able to pay it back easily or quickly. As you noted, the 409A tax piece is the employee's responsibility so seems the most the employer can do is point out that obligation if the money isn't returned as part of a self-correction. If the employer desires to try self-correction, seems they could notify the employees of the excise tax issue and the ability to avoid that by returning the money. Hopefully most employees would follow through with the excise tax payment on their own if they don't / cannot return the money as part of the self-correction and things get reported / taxed as Steelerfan describes.

Regardless of whether employees return the money or not, I would not be surprised if some employees don't complain and look for the employer to help them. They could say that because it was the employer's fault the amounts were paid incorrectly, the employer should give them extra amounts / bonuses now to help pay back the amounts previously paid if they want to self-correct. Alternatively, if there is no self-correction attempt or employees do not or cannot participate in one, it would not surprise me if the employees don't come looking for the employer to cover the 20% excise tax. Note, I'm not saying the employer has any obligation to cover those amounts--merely saying that I've seen employees make such arguments in similar situations.

My second point was that although self-correction is not expressly authorized, I think you could make an argument that it should be the preferred remedy here and, from a policy perspective, is better than treating the payments as Steelerfan notes and subjecting the employees to the excise tax. My rationale for that is that allowing employees to receive these amounts due to a mistake could give rise to abuses. The erroneous (early / accelerated) distribution of these amounts could, if mistakes are manipulated, be viewed the same as the old haircut provisions (although at 20% it would be a steep haircut to be sure).

[Steelerfan]

Just FYI this is what Tackney said about a correction program from a BNA Daily Tax Report dated April 19, 2007 (from an April 18 DC Bar association luncheon meeting)

"Resources Lacking for Corrections Program

Tackney addressed the issue of a Section 409A correction program that might be similar to the voluntary corrections program for qualified plans, a private letter ruling mechanism, or development of model plans.

Tackney said the service does not have the resources for these programs in the nonqualified plan area, but he suggested taxpayers ask for them. "Write us," Tackney said, "so that we will know how to prioritize our resources." "

I would recommend speaking to an agent before utilizing any correction method. At a minimum it seems the IRS should ASAP open up the letter ruling program under 409A to provide some guidance when something like this happens because it will of course happen (oh yeah alot!)