General Audit Steps
I. Examining Constructive Receipt and Economic Benefit Issues
Issues involving constructive receipt and economic benefit generally will present themselves in the administration of the plan, in actual plan documents, employment agreements, deferral election forms, or other communications (written or oral and formal or informal) between the employer and the employee. The issues may also be present in related insurance policies and annuity arrangements. Ask the following questions and request documentary substantiation where appropriate:
- Does the employer maintain any qualified retirement plans?
- Does the employer have any plans, agreements, or arrangements for employees that supplement or replace lost or restricted qualified retirement benefits?
- Does the employer maintain any nonqualified deferred compensation arrangements, or any trusts, escrows, or separate accounts for any employees? If yes, obtain complete copies of each plan including all attachments, amendments, restatements, etc.
- Do employees have individual employment agreements?
- Do employees have any salary or bonus deferral agreements?
- Does the employer have an insurance policy or an annuity plan designed to provide retirement or severance benefits for executives?
- Are there any board of directors’ minutes or compensation committee resolutions involving executive compensation?
- Is there any other written communication between the employer and the employees that sets forth “benefits,” “perks,” “savings,” “severance plans,” or “retirement arrangements”?
When reviewing the answers and documents received in response to these questions, look for indications that –
A. the employee has control over the receipt of the deferred amounts without being subject to substantial limitations or restrictions. If the employee has such control, the amounts are taxable under the constructive receipt doctrine. For example, the employee may borrow, transfer, or use the amounts as collateral, or there may be some other signs of ownership exercisable by the employee, which should result in current taxation for the employee; or
B. amounts have been set aside for the exclusive benefit of the employee. Amounts are set aside if they are not available to the employer’s general creditors if the employer becomes bankrupt or insolvent. Also confirm that no preferences have been provided to employees over the employer’s other creditors in the event of the employer’s bankruptcy or insolvency. If amounts have been set aside for the exclusive benefit of the employee, or if the employee receives preferences over the employer/service recipient’s general creditors, the employee has received a taxable economic benefit. Also verify whether the arrangements result in the employee receiving something that is the equivalent of cash.
C. As part of the Pension Protection Act of 2006, IRC § 409A(b) was also amended to prohibit the contributions of funds to a Rabbi trust during certain restricted periods. These restricted periods generally refer to periods during which the sponsoring employer also sponsors a single-employer defined benefit plan that is “at risk,” meaning the plan is underfunded as defined by the regulations under the qualified plan rules. Per IRC § 409A(b)(3)(B), “at-risk status” is defined in IRC § 430(i). Therefore the examiner may want to determine if the employer maintains any qualified retirement plans.
II. Audit Techniques
Interview the company personnel that are most knowledgeable on executive compensation practices, such as the director of human resources or a plan administrator.
Determine who is responsible for the day-to-day administration of the plans within the company. For example, who processes the deferral election forms and maintains the account balances?
Review the deferral election forms and determine if changes were requested and approved.
Review the executive compensation disclosures in Securities and Exchange Commission filings such as the corporation’s proxy statements and exhibits to Form 10-K. These can be located by performing an Edgar search for the company’s “DEF 14A” filings. Also, review the notes to the financial statements. If the stockholders are asked to vote on a compensation plan, the proxy for that particular meeting will have an exhibit of the plan as an attachment containing detailed disclosures.
Determine whether the company paid a benefits consulting firm for the executive’s wealth management. Review a copy of the contract between the consulting firm and the corporation. Determine who is administering the plan. Determine what documents are created by the administrator and who is maintaining the documents.
Review the ledger accounts/account statements for each plan participant, noting current year deferrals, distributions, and loans. Compare the distributions to amounts reported on the employee’s Form W-2 for deferred compensation distributions. Determine the reason for each distribution. Check account statements for any unexplained reduction in account balances. Any distributions other than those for death, disability, or termination of employment need to be explored in-depth, and Counsel may need to be contacted.
III. Examining the Employer’s Deduction
The employer’s deduction must match the employee’s inclusion of the compensation in income. The employer must be able to show that the amount of deducted deferred compensation matches the amount reported on the Forms W-2 that were furnished and filed for the year. In addition, the employer’s deduction may be limited by IRC § 162(m).
Verify that a Schedule M adjustment was made to the Form 1120 for the amount of deferred compensation expensed on the employer’s books but was not deductible because the compensation was not includible in income by the employees.
Generally, the current year’s deferrals should be adjusted on the Schedule M. Note that the employer may have netted the current year’s deferrals against distributions made during the year. This might obscure the amount that is not deductible. In the year the deferred compensation is paid, the employer will make an adjustment on the Schedule M for a deduction that was not expensed on its books that decreases taxable income.
Verify that the employer made appropriate Schedule M adjustments in prior years for amounts distributed and for which the employer took a deduction in the current year. Determine that the employer did not take a deduction in the year the employee deferred the income and another deduction in the year the employer paid the deferred compensation to the employee. Many deferrals are for more than 5 years – ask the Team Coordinator if these Schedule M adjustments are still at the audit site. If the Team Coordinator does not have the Schedule M’s for the earlier years, ask the employer for them. If you determine that the employer deducted the compensation in the wrong year, consider if a change in accounting method is appropriate so as not to permit a double deduction.
IV. Employment Taxes
For current year distributions that are excluded from wages for FICA taxes, verify that these amounts were taken into account in prior years.
Examine Forms W-2 for proper timing of wage reporting. Income tax withholding is generally required at the time the funds are distributed to the participants, and is reported in Box 2. Current year distributions are reported in Box 1 as wages and are also reported in Box 11.
Deferred amounts are taxable for FICA (Social Security and Medicare) and FUTA at the later of when the services are performed creating the right to the amounts or when the amounts are no longer subject to a substantial risk of forfeiture. When the amounts are taken into account for FICA and FUTA purposes, the amounts are reported in Box 3 for Social Security wages (subject to the Social Security wage base) and Box 5 for Medicare wages. Unless the amount deferred is subject to a substantial risk of forfeiture, the amount deferred should be included in wages for FICA and FUTA purposes for the year that the services are performed creating the right to the amount.
If available, analyze the database of Forms W-2 for discrepancies between Box 1 wages and Box 5 Medicare wages. Generally, Box 1 wages plus 401(k) contributions will equal Medicare wages. If NQDC plans exist, large differences will occur. Excess Medicare wages generally represent current year deferrals of income, while shortages indicate current year distributions. TheKane-Kurz database, which is available on the under LB&I CAS web page “Tom Kane’s W-2/1099 File Analysis,” is programmed to analyze Forms W-2 and generate a report including this information.
Employer matching contributions are offered in some NQDC plans. Any employer contribution should be taken into account for FICA and FUTA taxes at the later of when the services were performed creating the right to that employer contribution or when the contribution is no longer subject to a substantial risk of forfeiture. Additionally, the employer cannot take a tax deduction for the matching contributions until the amounts are includible in the employees’ income.
V. Important Note
A NQDC plan that references the employer’s IRC § 401(k) plan may contain a provision that could cause disqualification of the IRC § 401(k) plan. IRC § 401(k)(4)(A) and Treas. Reg. § 1.401(k)-1(e)(6) provide that an IRC § 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. Review NQDC plans looking for a provision that limits the total amount that can be deferred between the NQDC plan and the IRC § 401(k) plan. Also look for any NQDC provision which states that participation is limited to employees who elect not to participate in the § 401(k) plan. Contact Employee Plans in the TEGE Operating Division or Counsel in TEGE if provisions such as these are encountered.
VI. The American Jobs Creation Act of 2004
Section 885 of the American Jobs Creation Act of 2004 added IRC § 409A to the Internal Revenue Code. Section 409A provides new and comprehensive rules governing NQDC arrangements. More specifically, § 409A provides that all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are satisfied. IRC § 409A is effective with respect to amounts deferred or vested in taxable years beginning after December 31, 2004. For plans in existence before 2005, it is effective with respect to amounts deferred in taxable years beginning before January 1, 2005, but only if the plan under which the deferral is made is materially modified after October 3, 2004. In other words, IRC § 409A may implicate exams starting with the 2004 audit cycle. Broad transition relief expired December 31, 2008. Effective as of 2009, all plans must be in compliance with the final regulations, both in form and operation. If IRC § 409A requires an amount to be included in gross income, the statute imposes a substantial additional tax which is assessed against the employee/service provider and not the employer/service recipient. Employers must withhold income tax on any amount includible in gross income under IRC § 409A. This section also provides that failed deferrals under a NQDC plan (deferrals that become includible in the employee’s income due to a violation of IRC § 409A) must be reported separately on Form W-2 (box 12 code “Z” Income under section 409A on a Nonqualified Deferred Compensation Plan) and Form 1099 (box 15b Section 409A Income), as applicable.
For current guidance, see final regulations; Prop. Reg. § 1.409A-4 and Notice 2008-115 for income inclusion, reporting, and withholding requirements; Notice 2007-34 for application to split-dollar life insurance arrangements; and Notice 2008-113 and Notice 2010-6 for self-correction programs for operational and document failures, respectively, both as amended by Notice 2010-80.
Tom Kerester – TaxConnections Ambassador In Washington D.C. Reports On IRS Releases
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