The IRS Will Be Looking At Deferred Compensation Plans

The IRS recently launched a limited audit effort to gauge how well nonqualified deferred compensation plans are complying with the tax Code. My understanding is that the number of companies to be contacted will be less than 100. The IRS will use this effort to refine its audit techniques in three areas of nonqualified deferred compensation:

1. Initial election to defer compensation
2. Subsequent election to defer compensation
3. Eventual payment of said compensation

Before proceeding further, let’s define the “nonqualified” part of this term. Someone is deferring compensation. Perhaps someone (say, Tom Brady) is earning $15 million this year, but some or all of it will not be paid until some future date. It happens all the time, and the IRS has limited “preapproved” ways to do so. The classic way is stock options, for example.

Deviate in any way from the IRS-preapproved road, however, and the plan is referred to as “nonqualified.” I use nonqualifieds on a common basis, as they allow more flexibility in their planning and implementation than qualifieds. There is no connation of good or bad to being “nonqualified.”

The IRS is looking at Section 409A, a particularly nasty Code section.

What was the purpose of Section 409A? Let’s go back to 2000 and 2001. We are now talking about Enron, an energy and commodities company headquartered in Houston and one of the most scandalous business frauds of all time. Enron executives pushed their way to the front of the line by accelerating the payout of their deferred compensation before the company went under. You may recall that the average employees were blocked-out of their 401(k)s, with the result that they saw their retirement dwindle if not evaporate while company fat cats, like Kenneth Lay and Jeffrey Skilling,  walked away with wheel barrels full of cash.

How did it evaporate? There were two primary drivers:

(1)  Enron made its 401(k) matching contribution with company stock. Then it put in a lockdown, preventing employees from selling that stock until age 50.

(2)  Enron decided to transfer the administration of its 401(k). Unfortunately, this occurred during the period the stock collapsed, and employees were preventing from selling their stock even if they could and wanted to.

The truth of the matter is that many companies, not just Enron, use their own stock to fund a 401(k). For example, Coca Cola employees keep more than 80% of their 401(k) assets in Coca Cola stock. At Proctor & Gamble, the percentage is over 90%.

So what we have is an issue of corporate 401(k) matching, as well as an issue of the interregnum between plan administrators. That was not sufficient for Congress, which loves nothing more than a good scandal (unless it is their own, of course). In response, Congress passed Sarbanes-Oxley in 2002. It then passed the American Jobs Creation Act – containing Section 409A – in 2004.

Congress was after deferred compensation.  

Section 409A starts off easy enough: it applies to any “plan” that provides for the “deferral of compensation” to “service providers.” A “plan” does not need to be reduced to writing, and “”service providers” can included independent contractors as well as employees. “Deferral” means any payment (to which a service provider has a legally binding right) that may be received in a future tax year.

            STEP ONE: Carpet bomb. Look for survivors later.

The IRS had to start excluding something, otherwise this thing was going to dragnet everything- think accrued sick leave or accrued vacation pay - into its wake. Remember: any compensation not paid IMMEDIATELY could potentially detonate this tax trap.

It didn’t matter how much money you made, either. This thing was not limited to the big wigs. Section 409A swept up the small and large alike.

How ridiculous does this go? A number of years ago the IRS decided that schoolteachers were violating Section 409A by deferring their salary over 12 months rather than being paid over the 9 months comprising a school year. Let that sink in: the IRS felt driven to protect Americans from the rapaciousness of schoolteachers wanting to budget their salary over 12 months.

NOTE: The IRS received so much bad press that it was forced to reverse its position. That was fine, but a more cogent question was whether the law was so deeply flawed that its logical progression inevitably led to absurd results.

Therefore, the IRS gave us a few exceptions, including:

·       “Short term deferrals”

o   This means being paid by March 15 of the following year

·       Qualified plans, which means pension and profit-sharing plans, including your 401(k)

o   Obvious

·       Certain welfare plans, such as vacation and sick leave plans

o   Obvious

·       Grants of incentive stock options (ISOs) and employee stock purchase plans (ESPPs)

o   Have their own rules

·       Options to buy the stock of the service recipient, but only if the exercise price is not less than the market value of the stock on the date of grant

o   This means that – if you work at P&G and can buy P&G stock through a plan, you had better pay full retail price. If P&G gives you a discount – say you buy for 90 cents on the dollar – the IRS sees this as a “feature for the deferral of compensation.”

What happens if you are pulled into this thing?

·       The plan better be in writing

·       You better make a timely election to defer

·       Distributions to you may only be made upon occurrence of six IRS-approved events

·        You better not be able to accelerate your deferred benefits

What is a timely election? It is not what you may think. Timely in this context means “before you earn it.” For example, if your 2014 bonus is payable in 2015, you had better have your election in place in 2013.

What if you want to make a change to an existing deferral?

·       The payment must be deferred for at least another five years

o   So if you were to start in 2017, you can now start no earlier than 2022

·       And you better make this change at least 12 months before the payment was scheduled to be paid

What do you have to do to get to your money?

·       Death

·       Disability

Good grief! What else have you got?

·       Separation from service

This means you have to be fired. 

·       Change in control

This means that there is a change in ownership or control of the company. I suppose you could sell the company AND get yourself fired, just to be certain.

·       Unforeseen emergency

Think illness or accident or property loss. Even then, you have to show that expenses could not otherwise be met by insurance or your liquidation of other assets. Goes without saying that amount of distribution is limited to the amount needed for the emergency, plus taxes.

·       Date certain or fixed schedule

Finally, here is the heart of the matter. The IRS wants you to select when the deferred monies are to be paid and how (lump sum, series of payments) and then stick to it. It wants you to decide this way ahead of time, and then severely penalize you if later life events cause you to change in your mind.

What happens if you botch it?  Well, Section 409A will kick-in. 

·       There is tax on the distribution

·       There is interest (called a “stinger”) equal to the regular underpayment rate plus 1%

·       There is a 20% penalty

What if you take a distribution early? Bam – you have tax, interest and penalty.

What if you do not do anything wrong, but the company flubs the paperwork? Bam – you have tax, interest and penalty.

Can you say lawsuit?

That 20% penalty is not calculated as you would expect, either. A reasonable person would anticipate the penalty to be 20% of the tax, or possibly 20% of the tax plus the stinger. It is not, however. The penalty is 20% of the deferred balance, whether received by you or not. 

            STEP TWO: Bayonet the survivors.

What if you are in several plans simultaneously and one goes south? Does one plan contaminate the other? 

Of course it does.

STEP THREE: Repeat steps one and two. 

So what did Congress really accomplish with Section 409A?

·       Inability to distinguish publicly-traded from privately-owned

I scratch my head why Congress thinks that my auto mechanic down the street can get himself in the same trouble as a Humana or a General Electric.

Publicly-traded stock is almost like cash. These companies can buy other companies with it. They can pay employees with it. They can fund retirement plans with it. They can … well, they can play Enron with it.  

A privately-owned company however cannot.  Privately-owned companies are playing with their own money. Even the most reckless take a pause when reaching into their own wallet. A publicly-traded executive is closer to a Washington politician than any of the business owners I am likely to represent.

·       Crippling tax bombs for the unadvised

Change your deferral payment date 363 days – rather than 366 - before scheduled payout and risk tax annihilation. 

Does Congress expect that every businessperson can keep a tax attorney on retainer?

·       Yet another tax “industry”

There are advisors out there specializing in Section 409A. There has to be. You could endanger a large company by implementing a faulty plan. 

However, this is not quite the same contribution to the economy as Steve Jobs introducing the iPhone, is it?   

·       Insinuation into routine business transactions

We have a client who recently hired a business development manager. Their intention is to grow the company for 7 or so years, then sell out. It is their retirement program of sorts, I guess. The deal with the development manager includes deferred compensation, driven off year-over-year business growth and eventual sale of the company. What should be a routine tax matter now requires a Section 409A specialist, to be sure the employment package doesn’t blow up.

You want an alternative to 409A? How about this: all accelerations of executive deferred compensation (remember: Enron was only about acceleration) have to go to a shareholder vote. While we are at it, let’s lock down the executives for the same period as the rank-and-file are locked out of their 401(k)s.

And if Enron was caused by acceleration, why does 409A penalize additional deferrals? What is the point?

So the IRS is going to be looking at 50 – to 100 large companies to check on their 409A compliance. I suspect these companies will be fine, as they have the people, resources and advisors to navigate Section 409A. I would give you a different answer were the IRS to train its attention on privately-owned companies, however. 

News from Murmansk, Russia

At first, I thought the following to be from The Onion, the online humorous and satirical publication of society and current events. Best I can tell, however, it seems genuine.

There was a circus bus in Murmansk. There was a 6 ½-foot crocodile. The circus features a crocodile in one of its performances, perhaps something crazy like putting your head between the jaws of a crocodile.  The bus hit a pothole. A 264- pound woman accountant was sent flying (some pothole!). She landed on top of Fyodor, the previously mentioned crocodile.

Fyodor was sick after being body checked, and he missed his next circus appearance. Medical authorities evaluated Fyodor for injuries. He was thought to have symptoms of shock, but this was unconfirmed because – you now – Fyodor is a crocodile and cannot speak.

The woman accountant was reprimanded and told to wear her seatbelt in the future.

And there was the news on May 22, 2014, from Murmansk, Russia.

Here is the link:

Crocodile injured by falling accountant during circus bus accident in Russia  

Ode To Joy

Sabadell is a city in the Spanish province of Catalonia. Banco Sabadell was celebrating its 130th year anniversary, and it wanted to do something worthwhile and memorable for the citizens of the city. Banco Sabadell did.

This is an exceptional street performance. If it sounds familiar, it is because you are hearing Beethoven's Symphony Number 9 Ode to Joy.

We talk about tax here because we are a tax blog. However, tax is not life. Enjoy, and remember to laugh and smile as often as you can.

Dude, Free Dragon! and the Earned Income Tax Credit

I am looking at a report from the Treasury Inspector General for Tax Administration (TIGTA) dated March 31, 2014 and carrying the non-hummable title of

The Internal Revenue Service Fiscal Year 2013 Improper Payment Reporting Continues to Not Comply With the Improper Payments Elimination and Recovery Act.”

We have reviewed a number of previous TIGTA’a publications, and this one concerns the earned income credit. The initial idea behind it was laudable enough: it was intended to provide a floor to the most economically disadvantaged, while simultaneously diluting the disincentive as someone weaned off welfare and went back into the workforce.

Sounds good, right?

There is a card game called Magic: The Gathering. I have a number of friends who play, and one in particular who is a Tournament judge. Think of Dungeons and Dragons, translate it into a card game and you have Magic: The Gathering. The reason I bring it up is that there is a Magic card that allows one to put a dragon onto the board at no cost to the player. Dragons are as formidable as you would expect, so this is not insignificant in game context. The friends refer to it colloquially as “Dude, free dragon”!

The earned credit is the tax Code version of “Dude, free dragon”!

This credit was virtually built to be abused, and abused it has always been and will always be. One cannot turn down free dragons.

What does it take to power the earned income tax credit? It takes two things: earned income and a dependent child.

·        Earned income means that you have paid social security or self-employment tax on it. Workers compensation or unemployment, for example, will not power the EITC as one does not pay social security on either.

·       The other thing you need is a kid. Two is better than one. Three is better than two. Four is no better than three, so there is a limit to this escalation.

NOTE: There is a very limited credit for someone with little income and no children, but we will set that category aside for this discussion.

You need to have a job. Makes sense, if you remember what I said earlier about removing disincentives to return to work. A W-2 job is the easiest to understand.

Self-employment income will also do it. I suspect that any tax practitioner who has been around the block a few times has had or heard of an EITC client reporting self-employment income, likely with few if any expenses. The taxpayer is incentivized to lowball his/her expenses, as the credit can outstrip any additional taxes due from overstating his/her actual income. Alternatively, one might simply “make up” income, just to power the EITC.

You also need a kid. This is where it gets problematic, especially nowadays.  It can take the discipline of a sociologist to follow the convoluted trail of who-did-what-and-then-moved-in-with…. The bottom line is that a kid is the key to this ride. Having a kid, especially a kid you can “lend” out, becomes a commodity, and, like any commodity, the kid has value.

Where does a tax pro see this? Easy. How about two unmarried people who have a child together. One brings a child from a prior marriage. The facts make more sense if they maintain two households, but they wouldn’t be the first to live together and have two EITCs sent to the same address.

OBSERVATION: I am giving the IRS this one for free: check for two EITCs sent to the same address. You are welcome.

So you come to see me. You tell me that you are taking care of your on-and-off-girlfriend’s second daughter, because her mother is irresponsible and you have taken a liking to the girl. You are thinking of adopting, immediately after that around-the-world flight on a paraglider you are planning.  Coincidentally the kid also gives you an earned income tax credit. How am I to know whether this is really taking place, whether that the child is living with you and not with her mother, yada yada yada?

I will tell you what the IRS has said I am to do. Then I will tell you what I actually do.

The IRS keeps expanding what a tax preparer is to do when faced with an earned income tax credit.  Let’s go back to the Improper Payments Information Act that TIGTA referenced. This law goes back to 2002. TIGTA goes on to explain:

… the IRS’s estimates of Fiscal Year 2012 improper EITC payments were understated. They were based on an assumption that a provision in the American Recovery and Reinvestment Act of 2009 … that increased the EITC for certain taxpayers would expire at the end of 2010. However, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended the provision through 2012.”

Did you get that? The IRS did not update its 2012 estimates for a law passed in 2010. Amazing. Let a tax CPA do that and he/she will soon have no clients.

Let’s continue:

It was later extended through December 2017 by the American Taxpayer Relief Act of 2012.”

There is my second freebie to the IRS.

The EITC remains the only revenue program fund to be considered at high risk for improper payments.”

How much money are we talking about?

The IRS estimates that 22% to 26% of EITC payments were issued improperly in Fiscal Year 2013. The dollar value … was estimated to be between $13.3 billion and $15.6 billion.”

This is real money, even by Washington standards. So what was the IRS plan to deal with this?

The IRS announced a plan in January 2010 to register, license and create enforcement tools that would impact the paid preparer community more broadly.

Paid preparers assisted in the preparation of approximately 66 percent of all EITC claims paid in Tax Year 2008.”

Let me see if I get this right:

·       The IRS has a “Dude, free dragon” tax credit

·       People abuse “Dude, free dragon”

·       A normal person can hardly prepare his/her own taxes anymore, so he/she uses a preparer, therefore

·       Abuse of the EITC is the preparer’s fault

Right….

Let’s continue.

However, in January 18, 2013, a Federal Court enjoined the IRS from enforcing the regulatory requirements for registered tax return preparers.”

We discussed this in an earlier blog. The IRS was arguing that they could regulate preparers because of a Treasury decision having to do with government payment for horses after the civil war. The Federal Court said no; the IRS did not have legal authority and could not arrogate such authority to itself.

NOTE: Seems quaint reasoning, especially after six years of the current Administration, doesn’t it?

The IRS is miffed, sticks out its lip and pouts:

The Court ruling materially affects the basis on which the IRS planned to establish a baseline for meaningful reduction targets as previously indicated.”

So IRS Commissioner Koskinen is placing blame on the tax preparer community. If only the IRS could regulate preparers!

There is some truth to this. There are many grades of preparers. There are the classically-trained, such as tax attorneys and tax CPAs. There are also Enrolled Agents (EAs), many of which are quite good. Then we drop to people who have taken an H&R Block course. Then you have those that never even took the course. It is that last category or two that the IRS wants to reach, but they have been stymied.

In the meanwhile, you come into my office with an EITC. What does the IRS expect me to do?

Remember that the key is the kid. The IRS wants me to:

·       Review school records

·       Review health care records

·       Review child care provider records

·       Review social services records

And so on. If I don’t do this, I have to indicate to the IRS that I did not do so. On a form included with your tax return. The IRS reserves the right to later come to my office and review my files.

As much as I appreciate the opportunity to soothe my inner social worker, it seems a lot to ask for the few hundred dollars I may charge for that tax return.

So what do I do?

Easy. I do not accept a client with an EITC. Furthermore, I would also consider releasing an existing client who slips into the EITC, unless I know them well and have very strong confidence in their tax numbers. I have to, as the risk to me from that tax return is disproportionate.

I cannot afford to play “Dude, free dragon”!