Last week, the Treasury Department released the “Green Book,” formally known as the General Explanations of the Administration’s Revenue Proposals. Among its proposals, the Green Book includes a new proposal that could signal stepped-up enforcement of section 409A, as well as a new tool for the IRS. Section 409A, adopted almost two decades ago, represented a significant shift in the tax treatment of non-qualified deferred compensation plans. Prior to its adoption, these plans often relied on traditional concepts of constructive receipt to determine when it was required that a plan participant recognize income. Section 409A overlaid those principles with significant new rules regarding the time that an election to defer compensation must be made, as well as limitations on the time and form of payment of deferred compensation.
Failure to comply with the section 409A requirements results in substantial tax penalties. First, income that is deferred is includible in income when it is no longer subject to a substantial risk of forfeiture. Second, the amount includible in income is subject to a 20% additional tax, on top of regular income taxes. Finally, the employee is subject to a “premium interest tax.” This premium interest tax is determined as the amount of interest that would have been accrued at the underpayment rate plus one percentage point if the deferred compensation had been includible in gross income for the year in which amounts were first deferred or vested. In other words, the service provider must calculate the hypothetical amount of tax that would have been owed in the year of deferral had the amount not been deferred, and then determine the amount of interest owed for the period between that year and the year in which it was actually included in income.
Section 409A is somewhat odd in that a 409A failure may be the result of a service recipient’s error, but the tax consequences fall almost entirely on the service provider (absent an indemnification from the employer). Under current law, the service recipient’s liability is limited to withholding income taxes on the amount includible in income as a result of the failure and potential penalties for failing to report the failure on an information return provided to the service provider (Form W-2, if the service provider is an employee; Form 1099-NEC, if the service provider is an independent contractor).
The Administration’s proposal would require employers to withhold the 20 percent additional tax and the premium interest tax on deferred compensation included in an employee’s income due to a section 409A failure. Section 3402(a) would be amended to include the 20 percent additional tax and the premium interest tax. The proposal would be effective after December 31, 2022.
The proposal would represent a powerful tool for the IRS if it seeks to increase enforcement of section 409A. Currently, the IRS can only assess the employer for the income tax due on an amount includible in income under section 409A and a potential information reporting penalty. However, if Congress adopts the proposal, an employer could be held liable for the additional 20% tax and premium interest tax related to a section 409A failure. It is unclear how an employer (or the IRS, on audit) would determine the amount required to be withheld, as the premium interest tax cannot be determined without a full review of the employee’s personal tax return for the year of deferral (and potentially intervening years, depending upon the employee’s tax situation). It remains to be seen whether Congress will adopt it, but the proposal is expected to raise nearly $7 billion during the 10-year budget window. As a result, it is a proposal that is worth watching.