Compliance August 25, 2021

A Reminder of What IRS Examiners Will Look for Regarding NQDC Plans

An updated audit technique guide discusses the doctrines of constructive receipt and economic benefit, as well as IRC Section 409A, to explain when NQDC deferrals are included in employees’ income.

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The IRS has issued an updated nonqualified deferred compensation (NQDC) audit technique guide for its agents that discusses the issue of when amounts deferred into NQDC plans are includable in employees’ gross income and deductible by plan sponsors.

The guide discusses the constructive receipt doctrine for unfunded plans, which states that income, although not actually reduced to a taxpayer’s possession, is constructively received in the taxable year in which it is credited to the taxpayer’s account, set apart for the taxpayer or otherwise made available to the taxpayer. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

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The IRS notes that whether an employee has constructively received an amount does not depend on whether he withdrew funds, but whether he could have withdrawn funds without substantial limitations or restrictions.

For funded plans, under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, he will be taxed at the time of receipt of the property when it is either transferable or not subject to a substantial risk of forfeiture. The taxpayer does not include the value of the property in income until the property is no longer subject to a substantial risk of forfeiture or the property becomes transferable.

The IRS notes that under Treasury regulations, a substantial risk of forfeiture generally exists when the transfer of rights in property is conditioned, directly or indirectly, upon the future performance of substantial services.

According to the guide, Internal Revenue Code (IRC) Section 409A provides comprehensive rules governing NQDC arrangements that apply in addition to the doctrines of constructive receipt and economic benefit. Section 409A provides that all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent that they’re not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are met.

The IRS notes that if Section 409A requires an amount to be included in gross income, the statute imposes substantial additional taxes, which are assessed against the employee/service provider (including an independent contractor) and not the employer/service recipient.

Employers must withhold income tax on any amount includible in the employee’s gross income under Section 409A. However, the employer is not required to withhold the additional taxes. Generally, employers must withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee.

In addition, NQDC deferral amounts are taken into account for Federal Insurance Contributions Act (FICA) tax purposes at the later of when the services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts in a later calendar year. In other words, amounts are subject to FICA taxes at the time of deferral, unless the employee is required to perform substantial future services to have a legal right to the future payment.

Regarding employer tax deductions for amounts deferred into NQDC plans, the guide says they are deductible by the employer when the amount is includible in the employee’s income.

The guide tells IRS agents that a NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. The examiner should also address if deferred amounts were properly taken into account for employment tax purposes.

The agency notes that a NQDC plan that references the employer’s 401(k) plan may contain a provision that could cause disqualification of the 401(k) plan. Regulations provide that a 401(k) plan may not condition any other benefit (including participation in a NQDC) upon the employee’s participation or nonparticipation in the 401(k) plan. Examiners will look for any NQDC plan provisions that limit the total amount that can be deferred between the NQDC plan and the 401(k) plan, as well as any which state that participation is limited to employees who elect not to participate in the 401(k) plan.

Compliance August 25, 2021

Retirement Plan Sponsors Have Ultimate Responsibility for Operational Compliance

Indemnification clauses in service provider contracts, PEPs and 3(16) administrators can reduce plan sponsors’ fiduciary burden, but none offer complete protection, attorneys say.

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Two law firms have issued reminders that plan sponsors are ultimately liable for any plan operational errors, even if they rely heavily on recordkeepers and third-party administrators (TPAs) for day-to-day plan administration.

In an article, Carol Buckmann, an employee benefits and ERISA [Employee Retirement Income Security Act] attorney and a co-founding partner of Cohen & Buckmann P.C., notes that whether it’s a failure to use the correct definition of compensation in determining benefits, calculate vesting service correctly or make required minimum distributions (RMDs) to eligible participants, plan sponsors might be surprised to learn that they are responsible for the issue—not their service provider.

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“ERISA requires that every plan have a legal administrator and designates the plan sponsor as the default administrator when no other person has been appointed,” Buckmann explains. “This means that if the agreement doesn’t make the recordkeeper the fiduciary plan administrator, plan sponsors remain responsible for the recordkeeper’s mistakes found on audit or by a court, even if they just did what the recordkeeper told them to do or were unaware of the recordkeeper’s actions.”

Buckmann suggests that plan sponsors review their service agreements. Most often, the arrangements with recordkeepers contain disclaimers that the recordkeeper is not performing services as a fiduciary, which means it is not assuming the legal responsibilities of a plan administrator as defined in ERISA, she says.

A blog post from law firm Haynes and Boone says one way to mitigate a plan sponsor’s liability is through indemnification agreements with service providers, or contractual agreements in which one party agrees to pay for potential losses or damages not caused by the another party. However, the firm notes, the default language in service provider contracts often provides indemnification only for the service provider’s “gross negligence,” but not its “ordinary negligence,” leaving the employer responsible for correcting and paying for errors caused by the service provider that do not amount to gross negligence or intentional misconduct. In addition, many contracts with service providers contain a limitation of liability—often a multiple of the amount paid to the service provider under the contract.

Haynes and Boone suggests plan sponsors understand the extent to which they are still liable for the negligent acts or omissions of their plans’ service providers before entering into contracts with them.

Buckmann echoes these points in her article. She says, “While plan sponsors can try to negotiate more favorable indemnification provisions, they will always provide limited protection.”

However, Buckmann also suggests plan sponsors consider hiring a 3(16) plan administrator. She says 3(16) administrators vary in the tasks that they are willing to assume, so a best practice would be to issue a request for proposals (RFP) for an administrator and compare not only the cost of the services provided, but also their scope.

Buckmann notes that joining a pooled employer plan (PEP) is another option to mitigate plan sponsors’ liabilities.

None of these options offer complete protection from liability for plan sponsors, Buckmann says, “but outsourcing administration can materially restrict a plan sponsor’s liability exposure.”

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