IRS audit - auditor requires deferral elections before work is performed

[John Feldt ERPA CPC QPA]

Some participants who were eligible to defer into a 401(k) plan made no salary deferral elections until late in the plan year - mid-to-late December. At that time they elected to defer from their end of year bonus/commission (a large percentage of their pay for the year).

The IRS auditor stated something like this

"Deferral elections must be made prior to the time the employee earned the compensation. Employees A, B and C earned all but a few days worth of their bonus/commission compensation prior to the date the election to defer was signed. Deferring wages to the end of the year does not mean that you had not already earned the compensation. Thus it appears that Employees A, B, and C are not entitled to a deferral or match for the year. The deferrals, matching, and earnings need to be distributed. This will be subject to a closing agreement program..."

Any suggestions? I am especially curious as to just what code or reg the IRS auditor may be using to back up their assertion - I assume they must back up their comments with something official, right?

[GBurns]

Ask the auditor for cites etc.

In probably seemingly similar cases that I have seen the auditor was right. In those cases the bonus/compensation was constructively received although not paid. If an employee had terminated before the end of the year, their bonus etc woould have been pro-rated and paid, hence, they had the option to receive cash making the whole arrangement a deferral of compensation arrangement.

Your facts and circumstances might be different, so you need to get the auditor to commit to a position so that you can properly defend.

[KJohnson]

The regs don't use a constructive receipt test they use a "current availability" test. The deferral election has to be made before "current availablity". If you have to either quit (to receive a prorated bonus) or wait until the end of the year to receive the bonus then I don't think it is "currently available" until it is actually payable. Here is the definition of currently available.

Current availability defined. Cash or another taxable benefit

is currently available to the employee if it has been paid to the

employee or if the employee is able currently to receive the cash or

other taxable benefit at the employee's discretion. An amount is not

currently available to an employee if there is a significant limitation

or restriction on the employee's right to receive the amount currently.

Similarly, an amount is not currently available as of a date if the

employee may under no circumstances receive the amount before a

particular time in the future. The determination of whether an amount is

currently available to an employee does not depend on whether it has

been constructively received by the employee for purposes of section

451.

[Guest Sieve]

Under most all circumstances, KJohnson is right &the IRS auditor is wrong. Unless, of course, a portion of the bonus or commissions could have been demanded and paid prior to year-end.

Look at Ex. 1 at Treas. Reg. Section 1.401(k)-1(a)(3)(vii), where an annual bonus that is payable on Jan. 30 with regard to the prior year is considered currently available on Jan 30 and thus is subject to deferral as a result of a bonus deferral election.

Also, a deferral election prior to Jan 1 is considered to apply to all amounts paid after Jan 1, not earned after Jan 1. So, in Ex. 2, a deferral election made before a payday is considered valid for amounts paid on the next payday, not just for amounts earned after the election.

[Guest mjb]

Some participants who were eligible to defer into a 401(k) plan made no salary deferral elections until late in the plan year - mid-to-late December. At that time they elected to defer from their end of year bonus/commission (a large percentage of their pay for the year).

The IRS auditor stated something like this

"Deferral elections must be made prior to the time the employee earned the compensation. Employees A, B and C earned all but a few days worth of their bonus/commission compensation prior to the date the election to defer was signed. Deferring wages to the end of the year does not mean that you had not already earned the compensation. Thus it appears that Employees A, B, and C are not entitled to a deferral or match for the year. The deferrals, matching, and earnings need to be distributed. This will be subject to a closing agreement program..."

Any suggestions? I am especially curious as to just what code or reg the IRS auditor may be using to back up their assertion - I assume they must back up their comments with something official, right?

It appears that the IRS agent is attempting to demonstrate that the employees are accrual basis taxpayers. Under IRS rules employees are cash basis taxpayers unless they keep books and records of acccunts which allow them to file returns as an accrual basis taxpayer. (I have never known any common law employee to file tax returns as an accrual basis taxpayer.) Under reg 1.451-1(a) a cash basis taxpayer includes an an amount in gross income when it is actually received (e.g., currently available as defined under the 401k regs), not as it is accrued. For the purpose of this discussion I am ignoring constructive receipt. Therefore, a bonus that is earned for 2008 but is paid in 2009 is taxable income for 2009 and is eligible for deferral anytime in 2009 as long as a deferral election is in effect before the payday that preceeds the payday when the bonus payment is currently available .

GBurns: Please state the statutory or regulatory provision under which the auditor's interpretation would be correct including any "probably seemingly similar cases" that you are aware of. You also dont seem to know the difference between constuctive receipt and accrual basis taxpayer.

[GBurns]

There is a relationship/difference between an accrual basis taxpayer and a cash basis tax payer, but what is the relevance knowing the difference between " constuctive receipt and accrual basis taxpayer" ?

I do not recall whether "constructive receipt" or "currently available" (as pointed by KJohnson) or both, was the argument by the auditors, nor would it have made any sense to make notes of any cites etc given back then.

What we do not know from the OP is the nature of the money.. Apparently some is bonus but according to the OP some is commission. Commission by its nature would be earned during the year as each sale was made.

We also do not know what happens when someone terminates during the year.

There is nothing in the OP that makes this clearly an issue of end of year bonus, which would be necessary for the positons taken by mjb and Sieve. The OP says bonus/commission.

[K2retire]

But what if the bonus/commission is not payable until the client pays his bill to the employer? In that case the work may be done months before the payment becomes due. And if the client defaults it might never become due.

There are many assumptions here.

[jpod]

If the agent was pointing to facts that suggested there was earlier "current availability," you might have a problem, but that does not appear to be the case here. The agent either doesn't know the rules or doesn't care because he likes his own rules better (unfortunately the latter is all too common). Give the agent copies of the provisions of the regs. that set forth the current availability rule, and the definition of current availability. If the agent doesn't back off, request to speak with his manager.

[John Feldt ERPA CPC QPA]

I'll see if I can find more information about the nature of the compensation and if it could have been demanded at an earlier time without having to quit to get paid.

[GBurns]

J4FKBC

Getting paid if quitting is as important as getting paid by demanding.

***************

K2retire

Therein lies 1 of the big problems. Surely payments are not all made all at the end of the year, some might even be early. So under a commission due on payment scheme, some commission would be earned before year end even if not paid out to the employee as yet.

Another problem is the recognition of defaults. Recognition of income would come before default, long before. So are the company's books not closed periodically ? What happens if subsequently collected by litigatiion or otherwise ?

I hope there will be clarification.

[KJohnson]

"An amount is not currently available to an employee if there is a significant limitation or restriction on the employee's right to receive the amount currently"

I would consider quitting in order to get the money "early" a significant limitation...

[John Feldt ERPA CPC QPA]

"Getting paid if quitting is as important as getting paid by demanding."

If an employee enters a plan January 1, 2009, gets paid monthly at the end of the month, they sign their first salary deferral election on January 27, 2009 (the payroll cutoff date for January 31st), then does the IRS agent argue that they can only defer on 5 days worth of pay for January? They could have been paid on the 26th if they had quit on the 25th. How do you see this?

edited to add: ok - I see KJohnson's reply

[K2retire]

K2retire

Therein lies 1 of the big problems. Surely payments are not all made all at the end of the year, some might even be early. So under a commission due on payment scheme, some commission would be earned before year end even if not paid out to the employee as yet.

Another problem is the recognition of defaults. Recognition of income would come before default, long before. So are the company's books not closed periodically ? What happens if subsequently collected by litigatiion or otherwise ?

I hope there will be clarification.

In the situation I was thinking of, bonus was paid monthly. It was a percentage of the amount billed to the client and paid at the end of the month in which the client paid the employer. I left that position in October 2005 and received my final bonus payment (for work completed in 2005) January 31, 2007. Ignoring the separation from service for a moment, this auditor apparently believes that the 2007 bonus payment should be subject to the 2005 deferral election? That makes no sense.

[GBurns]

Using your scenario, the auditor is saying that you cannot use a January 25, 2007 deferral election on that January 31, 2007 payment, you have to use something earlier.

[John Feldt ERPA CPC QPA]

Using your scenario, the auditor is saying that you cannot use a January 25, 2007 deferral election on that January 31, 2007 payment, you have to use something earlier.

So, if an employer allows employees to enter the plan immediately on date of hire, would you seriously say that they must complete an election on their hire date in order to allow a full deferral from their first paycheck (which might be actually paid a few weeks later)? Any election made after their hire date would not be early enough to satisfy the IRS?

I know it differs from the original post, but I think the same principle applies.

added on edit: Look at 1.401(k)-1(a)©(1).

[Guest Sieve]

Look at the examples from the regs that I cite in post #4. The deferral election simply has to be made prior to the date the amounts would otherwise be paid pursuant to the employer's normal payroll practices.

[GBurns]

My Post #14 says "Using your scenario" in response to K2retire.

[John Feldt ERPA CPC QPA]

Okay. We'll see how the IRS responds.

[GMK]

In some cases a company will have a policy to allow a cash advance, at the employee's request and prior to the regular paydate, where the advance amount can be up to the amount earned but not yet paid. This would seem to make your earnings currently available before the regular paydates, even if you never take a pay advance. Yes?

In the other cases, if no one can get their bonus/commission earlier than the one day (probably after all the numbers are in), then the bonus/commission looks very unavailable until that day.

KJohnson's post #3 seems to say it all.