oversight

Social Security: Taxing Nonqualified Deferred Compensation

Published by the Government Accountability Office on 1990-03-15.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

     United   States   General   Accounting   Office

     Report to the Chairman, Subcommittee ’
     on Social Security, Committee on Ways
     and Means, House of Representatives

,.
””
                                                       ,,’.
     T&g                     N---w

     Deferred
     compensatpemation
        United States
GAO     General Accounting Office
        Washington, D.C. 20548

        Human Resources Division

        B-23641 1

        March 15, 1990

        The Honorable Andrew Jacobs, Jr.
        Chairman, Subcommittee on Social Security
        Committee on Ways and Means
        House of Representatives

        Dear Mr. Chairman:

        You asked us to determine whether self-employed taxpayers use
        deferred income arrangements that achieve similar income tax treat-
        ment as plans called “nonqualified deferred compensation plans” used
        by employers and employees. These nonqualified plans are basically
        employer IOUs to pay employees future benefits in return for current
        services. You asked how the imposition of the social security tax on
        employees using these kinds of plans differs from its imposition on self-
        employed taxpayers for similar types of income. You also asked several
        questions about the nature and effects on social security tax revenues
        resulting from changes in the taxing of nonqualified deferred income for
        employees.

        Simply stated:

      . Employees currently participating in nonqualified plans to defer income
        are subject to social security tax on the deferred amount in the year
        income is earned.
      . Self-employed taxpayers who defer income through contractual
        arrangements with their customers or clients pay social security tax on
        the deferred amount in the year income is received.

        The difference in tax treatment between these two categories of workers
        can be traced to the enactment of section 3121(v)(2) of the Internal Rev-
        enue Code, which changed the social security tax treatment of nonquali-
        fied deferred compensation for employees.

        The effect of this difference in social security tax treatment depends on
        whether an individual’s other earnings are above or below the social
        security wage base ($51,300 in 1990) in the year the deferred income is
        earned. Generally, those earning above this maximum taxable amount
        are better off if the deferred amounts are considered taxable in the year
        earned. Since they must pay the maximum tax anyway, no additional
        tax results from recognizing the deferred income promise. In contrast,
        those with earnings below the wage base in the year the deferred



         Page 1                     GAO/HRD90.82 Taxing Nonqualified Deferred   Compensation
B-236411




income is earned are generally better off if the deferred income is sub-
ject to the tax in the year received. They are going to have to pay addi-
tional social security taxes at some point, and would probably rather
pay later than sooner.

Section 3121(v)(2) of the code resulted in different social security tax
treatment of employee income deferred through nonqualified plans than
self-employed income deferred through contractual arrangements with
customers, On one hand, the different treatment can be viewed as bur-
densome by some of the self-employed because their inability to recog-
nize for social security purposes deferred income earlier ultimately can
increase their social security tax payments. On the other hand, the dif-
ferent treatment can be helpful to some self-employed individuals who
may need additional quarters of coverage to be eligible for social secur-
ity benefits.

Self-employed taxpayers do not seem to make extensive use of contrac-
tual arrangements to defer income. We were unable to determine the
specific reasons why they do not use these arrangements more often.
One possible reason is that self-employed persons may experience risks
in collecting payments substantially later, especially from customers
with whom they have not had continuous business relationships. Also,
there have been a number of tax decisions involving the deferral of
income by self-employed taxpayers where the Internal Revenue Service
(IRS) or federal courts held that taxes had to be paid on alleged deferred
income before payments were actually received. Such conditions may
discourage the self-employed from using contractual income deferral
arrangements more often.

Four groups of self-employed professionals (medical doctors, ministers,
insurance agents, and directors of corporations) who use deferred
income arrangements that achieve similar income tax treatment as non-
qualified deferred compensation are discussed in appendix IV. It is pos-
sible, however, that other self-employed professionals also defer income.
Further, if the code is changed to provide the same social security tax
treatment for income deferred under contractual arrangements with
customers, higher income self-employed taxpayers willing to assume the
associated risks may have a financial incentive to increase use of these
deferral arrangements.

You also asked us to describe (1) the origin and development of section
3121(v)(2), (2) its effect on social security tax revenues, and (3) any
problems that have arisen from its implementation. You indicated that


 Page 2                    GAO/lDllMO-82 Taxing Nonqualiiied Deferred Compensation
                            B23Mll




                            this information would be useful in deciding if social security taxes
                            should be imposed similarly on the self-employed and employees.


                            The social security tax is imposed on employment-related earnings and
Background                  self-employment earnings in order to finance the social security Old Age
                            and Survivors’ Insurance and Disability Insurance programs as well as
                            part of the Medicare program. It is imposed on all earnings up to the
                            social security wage base, which is $51,300 in 1990, except for amounts
                            specifically excluded from taxation by the code.


Deferred Compensation       Deferred compensation plans refer to compensation arrangements in
                            which employers pay in the future for current services provided by
Plans Can Be Qualified or   employees. Employers offer deferred compensation plans to provide
Nonqualified                work incentives or retirement income or to limit employees’current
                            income tax liability.

                            Under the tax code, deferral plans are either “qualified” or “nonquali-
                            fied” for special income tax treatment.’ To be qualified, the deferral
                            must be made under a plan meeting numerous code requirements. Some
                            of these requirements, such as the requirement that the plans cannot
                            favor employees who are officers or shareholders or only the highly
                            compensated, are designed to encourage employers to allow all employ-
                            ees to participate in plans. Other requirements are intended to protect
                            the interests of employees who participate in such plans. For example,
                            employers must place amounts promised to employees in trusts that are
                            restricted to the sole purpose of paying benefits.

                             Nonqualified deferred compensation plans are ones that have not met
                             code qualification requirements. Nonqualified deferrals may be offered
                             to employees to provide the same type of benefits as qualified deferrals.
                             However, nonqualified deferred compensation arrangements frequently
                             fail code requirements for qualification because employers do not estab-
                             lish trusts to pay amounts promised to employees.




                             ‘Essentially, the special income tax treatmentallows (1) employers to deduct their contributions to
                             the trust fund of a qualified plan as current expenses even though the amounts have not been paid to
                             employees and (2) employees to defer paying income taxes on these amounts and any investment
                             earnings until the amounts are paid to them.



                             Page 3                             GAO/HRMC32        Taxing Nonqudifkd     Deferred Compensation
                            B-236411




How Section 3121(V)(2   1   Section 3121(v)(2), enacted as part of the Social Security Amendments
                            of 1983, changed the tax year in which employee earnings under non-
Changed Taxing of           qualified deferred compensation plans are subject to the social security
Nonqualified Deferred       tax. Before this provision became law, amounts owed to employees
Compensation                under nonqualified plans were subject to the tax in the year received,
                            but payments made under these plans could escape taxation if they met
                            one of several code exclusions. For example, some of these exclusions
                            made specific retirement-related payments not subject to the social
                            security tax. After enactment of section 3121(v)(2), income under these
                            plans was subject to the social security tax either in the year services
                            were performed or in the year that conditions’ required for payment
                            were met.


Self-Employed Can Defer     Self-employed taxpayers can defer income in various ways. They can
Income                      use qualified arrangements comparable to those used by employees, or
                            they can enter into contractual arrangements with their customers to
                            delay receipt of payment for goods or services. If the contractual
                            arrangement meets certain tax code prerequisites, self-employed tax-
                            payers defer recognition of the income and the social security taxes until
                            they receive payments from customers. This is the same way deferred
                            income from nonqualified plans was treated for employees before enact-
                            ment of section 3121(v)(2).


Tax Advantages Can Arise    The tax year in which the social security tax is imposed on deferred
From Income Deferrals       income can be important to taxpayers because the social security wage
                            base limits the amount of wages subject to this tax in a given year. If
                            taxpayers are assessedthe tax on deferred amounts in a year in which
                            they have other income exceeding the wage base, they pay no social
                            security taxes on the deferred amount.

                            For example, assume that for tax year 1990, an employee taxpayer had
                            $51,300 (the wage base) in social security-covered income and the
                            employer promised to pay an additional $10,000 later under a nonquali-
                            fied deferral plan. The plan is designed to pay the taxpayer $10,000
                            after retirement, when presumably the taxpayer will have no other
                            earned income. Under current rules, the taxpayer would recognize
                            $61,300 as social security-covered wages for tax year 1990, but the tax
                                                           --
                            ‘Employees may risk forfeiture of benefits if payment is conditioned upon future events For exam-
                            ple, a common provision provides for an employee to forfeit benefits if the employee begins working
                            for a competitor.



                            Page 4                              GAO/HRD90-82 Taxing NonqualIfied Lkf’erred Compensation
                     B236411




                     would be imposed on only $51,300-the wage base. Since the remaining
                     $10,000 was recognized for social security tax purposes in 1990, it
                     would not be subject to this tax when received.

                     Assume a self-employed taxpayer also earned $61,300 in 1990. Of this
                     amount, the self-employed taxpayer deferred $10,000 under a contrac-
                     tual arrangement with a customer to receive the deferred amount at a
                     time the taxpayer presumably would have no other earned income.
                     Under current rules, the self-employed taxpayer would pay the social
                     security tax on the entire $61,300. The social security tax would be
                     imposed on $51,300 in 1990 and on the deferred $10,000 when it is
                     received.

                     The tax advantage decreases, however, when current income is below
                     the wage base. For example, if an employee taxpayer received a $10,000
                     deferred income promise and had current 1990 income of only $31,300,
                     the employee taxpayer would have to pay taxes on the entire $41,300 in
                     1990. In contrast, the self-employed taxpayer defers taxes on the entire
                     $10,000 until payment is received.


                     The Congress enacted section 3121(v)(2) as part of the Social Security
Origin and           Amendments of 1983. It was intended to conform the social security tax
Development of       treatment of income deferred under nonqualified plans to income
Section 3121(V)(2)   deferred under qualified plans.

                     Specifically, the Congress was concerned that employees could avoid
                     paying the social security tax on wages they contributed to 401(k) plans
                     (qualified deferral plans) and therefore control the amount of their
                     wages subject to social security tax. To rectify this condition, the Con-
                     gress decided to tax employee wage contributions to 401(k) plans at the
                     time the amounts were earned. It was hoped that taxing these employee
                     wage contributions would prevent the possible erosion of the social
                     security wage base in the future. In considering nonqualified deferred
                     compensation, it was felt that amounts associated with these plans
                     should be taxed. It decided that the tax should be imposed on these
                     amounts when earned just as in the case of wage contributions to 401(k)
                     plans. Detailed information on the origin of this section of the code can
                     be found in appendix I of this report.




                     Page 5                    GAO/HlUb3082 Taxing Nonqualified Deferred Compensation
                                           -
                     8236411




                     The effect of section 3121(v)(2) cannot be measured because of limited
RevenueEffect of     reporting on nonqualified plans. Although neither IRSnor the Social
Section 3121(V)(2)   Security Administration (SSA) has data to determine the revenue effect,
                     representatives at both agencies believe that the provision has had mar-
                     ginal effects. IRSofficials believe that the trust funds have lost some rev-
                     enues, while SSArepresentatives believe the trust funds have gained
                     some. Appendix II contains details on their rationales.


                     IRSofficials believe the code’s broad definition of nonqualified deferred
Problems in          compensation plans makes it difficult to distinguish the type of pay
Implementing         arrangements covered by section 3121(v)(2). They are concerned by
Section 3121(V)(2)   positions taken by some taxpayers who used this provision. Officials
                     said IRS has devoted extensive time to developing regulations for section
                     3121(v)(2), but higher priority tax legislation and technical problems
                     have delayed completion. Appendix III discusses in greater detail the
                     regulatory problem arising from enactment of the provision.


                     Our work was performed between July and December 1989 at IRSand
Scopeand             SSAheadquarters in Washington, D.C., and Baltimore, respectively. It
Methodology          consisted primarily of interviewing agency representatives; reviewing
                     available guidance, such as SSApolicy statements, IRS revenue rulings,
                     and court decisions; and contacting various representatives of the self-
                     employment and financial services community. Appendix V provides
                     more information on our scope and methodology.

                                               -
                     As agreed with your office, we did not obtain written agency comments
                     on a draft of this report. However, in meetings with IRS and SSA repre-
                     sentatives, we sought their views on a draft of this report and refined it
                     accordingly. Agency representatives expressed general agreement with
                     its content.

                     As agreed with your office, unless you publicly announce its contents
                     earlier, we plan no further distribution of this report until 30 days from
                     its issue date. At that time, we will send copies to the Commissioner of
                     Social Security, the Commissioner of Internal Revenue, congressional
                     committees with oversight responsibilities for IRS and SSA operations,
                     and other groups with an interest in this matter. We also will make cop-
                     ies available to others upon request.




                     Page 6                        GAO/HRB96-82 Taxing Nonquallfied Deferred Compeneation
B-236411




If you have any questions or would like additional information, please
call me on (202) 2756193. Other major contributors to this report are
listed in appendix VI.

Sincerely yours,




Joseph F. Delfico
Director, Income Security Issues




 Page 7                   GAO/HR.B90-82 Taxing Nonqualified Deferred Ccmpem&ion
Contents


Letter                                                                                                   1
Appendix I
Origin and              Recommendations of the Kational Commission on Social
                            Security Reform
Development of          Congressional Action Expands Commission’s Proposal                             11
Section 3121(V)(2) of
the Internal Revenue
Code
                                              -~
Appendix II                                                                                            14
Effect of Section       Limited Reporting and Accounting Requirements Prevent
                             Measurement of Revenue Effects
                                                                                                       14
3121(V)(2) on Social    IRS and SSA Representatives Believe the Effects Were                            15
Security Revenues            Marginal
Cannot Be Measured
Appendix III                                                                                            17
Implementation          Purpose of IRS Guidelines
                        Reasons Delaying IRS Regulations
                                                                                                        17
                                                                                                        18
Problems Arising
From the Enactment
of Section 3121(V)(2)
Appendix IV                                                                                            21
The Use of Deferred     Deterrents to Income Deferral Found                                            21
                        Use of Deferred Income Arrangements by the Self-                               24
Income by Taxpayers         Employed
Subject to Self-        Potential for Others to IIave Deferral Arrangements                             25
Employment Tax
Appendix V                                                                                              26
Scopeand
Methodology



                        Page 8                     GAO/HRD-90-82 Taxing Nonqualified Deferred Compensation
                                            -
                        Contents




Appendix VI
Major Contributors to
This Report




                         Abbreviations

                         IRS       Internal Revenue Service
                         SSA       Social Security Administration


                         Page 9                    GAO/HRD90-82 Taxing NonqualifIed Deferred Compensation
Appendix I

Origin and Development of Section 3121(V)(2)
of the Internal RevenueCode

                       Section 3121(v)(2) of tG Internal Revenue Code was enacted by the
                       Social Security Amendments of 1983. It was one of many provisions in
                       the amendments and, in the overall context of the law, a relatively
                       minor feature. Most of the amendments, including this provision, were
                       developed from recommendations made by the National Commission on
                       Social Security Reform. The Commission was appointed to help find a
                       solution to serious financial problems faced by the social security pro-
                       grams in the early 1980s. The Commission’s recommendation to tax
                       employee wage contributions to employer-sponsored 401(k) plans
                       (qualified deferral arrangements) appears to have been the basis of sec-
                       tion 3121(v)(Z).


                       The Social Security Amendments of 1983 were designed primarily to
Recommendations        address serious short- and long-range financing problems facing the Old
of the National        Age and Survivors’ Insurance program. Since 1975, program expendi-
Commission on Social   tures had exceeded revenues, resulting in an estimated short-term reve-
                       nue shortfall of $150 to $200 billion. The shortfall was so severe that it
Security Reform        was anticipated that SSA would be unable to pay benefits on time begin-
                       ning in July 1983. The social security programs also faced a long-range
                       deficit over the next 75 years.

                       In December 1981, the President appointed a bipartisan group, the
                       National Commission on Social Security Reform, to review all options to
                       address the financing problems and develop a plan to insure the fiscal
                       integrity of the social security trust funds while maintaining full social
                       security benefits for recipients. It was hoped that the Commission could
                       recommend a package of corrective measures that would be acceptable
                       to the Congress and the administration.

                       On January 20, 1983, the Commission issued its report, which contained
                       numerous recommendations for both limiting the future growth in
                       expenditures and increasing revenues. Estimates prepared for the Com-
                       mission showed that the proposals would (1) reduce the short-range
                       revenue/expenditure gap by $168 billion for 1983-89 and (2) substan-
                       tially reduce the long-range deficit.

                       One change recommended by the Commission concerned the taxing of
                       certain deferred compensation, which we believe was the forerunner of
                       section 3121(v)(2). The Commission was concerned that current law
                       allowed employees to contribute amounts from their wages to 401(k)
                       plans beyond those contributed by employers. For tax purposes, these



                       Page 10                   GAO/HRD90-32 Taxing Nonqualified Deferred Compensation
                                                       -
                          Appendix I
                          Origin and Development   of Section
                          31210(Z) of the InternIll Revenue Code




                          additional contributions were treated the same as employer contribu-
                          tions, which were excluded from the social security wage base. This
                          allowed employees to avoid paying the social security tax on their wage
                          contributions.

                          A perception existed that there was no difference between employees
                          saving part of their compensation through a 401(k) plan and saving
                          through other types of available arrangements, such as passbook sav-
                          ings accounts. In both cases, employees were choosing to save a portion
                          of their incomes. As wages employees saved through traditional
                          arrangements, the amounts were subject to social security tax at the
                          time earned. The Commission recommended in effect that the law be
                          amended to make wages that employees contributed to 401(k) plans sub-
                          ject to social security tax when earned.

                          In discussing this recommendation, the Commission stated that the pro-
                          posal would not produce significant additional tax revenue because few
                          plans that allowed for employee contributions had been put into effect
                          yet. However, since the enactment of tax laws designed to encourage
                          employers to establish qualified plans (such as 401(k) plans), participa-
                          tion in such plans had been steadily increasing. The Commission was
                          concerned that elective wage contributions to 401(k) plans would
                          increase considerably and feared that if its recommendation was not
                          followed, the social security wage base could possibly be undermined,
                          causing considerable decreases in social security tax revenue.

                           The President, the Speaker of the House, and other members of the
                           House and Senate leadership endorsed the Commission’s package. The
                           Congress used the Commission’s recommendations as a starting point for
                           its deliberations about the problems facing the social security programs.


                           Shortly after the C&imission’s report was issued, the House and the
CongressionalAction        Senate considered the proposals and expanded on them under bills
Expands COIlUTliSSiOn’S    H.R. 1900 and S.1, respectively. As passed by the House, H.R. 1900
Proposal                   included a provision to cover not only employee wage contributions to
                           401(k) plans, but also employee wage contributions to (1) “cafeteria”
                           plans authorized under section 125 of the code’and (2) tax-sheltered


                           ‘Under a cafeteria plan. an employee may chooseamong a variety of fringe benefits offered under
                           the employer’s plan. Deferred compensation cannot be included in such a plan except for 401(k)
                           PhlS.



                           Page 11                           GAO/‘HRD-90-82 Taxing Nonqualified Deferred Compensation
Appendix I
O&in and Development of Section
31210@) of the Internal Revenue Code




annuities authorized under section 403(b) of the code.?The bill required
that employee wage contributions to these types of qualified deferral
plans be added to the employee’s taxable social security wage base in
the year the wages were earned. There was no provision in the House
bill concerning the taxing of nonqualified deferred compensation.

The Senate bill reported out of the Finance Committee contained similar
provisions to tax employee wage contributions made to 401(k) plans,
cafeteria plans, and tax-sheltered annuities when earned. It also had the
effect of providing that all amounts related to nonqualified deferred
compensation plans be subject to social security tax in the year the
wages were received. The Finance Committee said it did not believe that
favored social security tax treatment should be extended to plans that
did not qualify for tax-favored treatment under income tax rules.

During the Senate floor discussion, Senator Lloyd Bentsen offered an
amendment to the bill’s proposed social security tax treatment of non-
qualified deferred compensation plans. Its purpose was to correct what
he believed was an unintended result reached by the Finance Commit-
tee. The Senator said that many small employers used nonqualified
deferred compensation arrangements to provide their employees with
retirement income and that amounts distributed under such plans were
not subject to social security tax under the existing law. He said the
Committee’s proposed treatment would subject recipients to an added
social security tax burden when they were retired and receiving social
security benefits.

To avoid this result, Senator Bentsen proposed that nonqualified
deferred compensation be subject to social security tax either when
earned or when it was no longer subject to substantial risk of forfeiture.
He noted that this approach was similar to the treatment proposed by
the Commission for taxing employee-elected wage deferrals made to
401(k) plans. As such, he believed the proposal to tax nonqualified
deferred compensation addressed the underlying concern that the social
security wage base be preserved.

The Senate voted to amend the measure to reflect Senator Bentsen’s pro-
posal. The amendment was enacted as section 3121(v)(2) of the code as
part of the Social Security Amendments of 1983. Neither Treasury nor


‘Section 403(b) governs tax-exempt organizations’purchases of tax-sheltered annuities for
employees.



Page 12
                           -
Appendix I
Or&in and Development of Section
3121(V)(2) of the Internal Revenue Code




the Department of Health and Human Services commented on this provi-
sion during congressional deliberations.




 Page 13                         GAO/HRD-30.82 Taxing Nonqualified Deferred Compensation
Appendix II

Effect of Section 3121(V)(2) on Social Seeurity~
RevenuesCannot Be Measured

                                Information with which to measure the effect of section 3121(v)(2) on
                                the amount of social security tax revenues collected yearly is unavaila-
                                ble. No definitive assessment can be made because of limited (1) report-
                                ing to the government by employers about their nonqualified plans and
                                (2) accounting for tax revenues by type of compensation. Although IRS
                                and SSA do not have data to measure the effect of section 3 12 1(v)( 2) on
                                social security tax revenues, both believe any change in revenues was
                                marginal.

                                                           ~__-
                                The revenue effects of section 3121(v)(2) could be measured if the gov-
Limited Reporting and           ernment required detailed reporting on either all nonqualified plans or
Accounting                      the source of social security tax revenues. Such information is currently
Requirements Prevent unavailable.
Measurementof         For instance, detailed reporting on plans would include (1) the number
RevenueEffects        of plans in use, (2) the number of employees participating in these plans,
                                (3) a profile of the annual social security-covered wages paid to employ-
                                ees participating in the plans, and (4) the amount of compensation being
                                deferred for each of the plan participants. In addition, to measure tax
                                receipts under these plans before enactment of section 3 121(v)( 2). infor-
                                mation is needed on whether payments made under plans qualified for
                                the wage exclusions then existing in the code.

                                With this information, the amount of compensation subject to social
                                security tax both before and after enactment of section 3121(v)(Z) could
                                be determined. By comparing the two amounts, the net tax effects could
                                be assessed. However, employer reporting on nonqualified plans is
                                limited.

                                According to IRS officials, most nonqualified plans are exempt from
                                reporting because they are unfunded-plan participants have only the
                                employer’s promise to pay future benefits. IRS officials said reporting to
                                federal agencies is not required in cases where nonqualified plans are
                                unfunded. When employers establish nonqualified plans, they often do
                                not set aside funds restricted for the sole purpose of paying benefits.
                                Instead, employers’ liability for the future payment of deferred wages is
                                c*ontingent on their ability to pay when the benefits are due.

                                 Employers report only limited information to IRS,the Department of
                                 Labor, and the Pension Benefit Guaranty Corporation on the number of
                                 nonqualified plans and the number of plan participants. These agencies
                                 receive reports for nonqualified plans that are funded. However, these


                                 Page 14                  GAO/HRB90-82 Taxing Nonqualified Deferred Compensation
                                                               ---
                             Appendix U
                             Effect of Section 312103(2) on Social
                             Security Revenues Cannot Be Measurd




                      I-__                            _--~_-




                             reports do not itemize the amount of employee earnings and their elec-
                             tive wage contributions or provide information to determine whether
                             payments from plans met retirement-related exclusions existing in the
                             code.

                             Another approach would be to examine the change in the social security
                             tax revenues associated with nonqualified deferred compensation.
                             Annually, employers must report (on form W-2) to SSA the wages paid to
                             their employees so that SSA can record each worker’s social security
                             earnings for eligibility and benefit purposes. However, these reports
                             show total aggregate wages only, not the amount of the wages attributa-
                             ble to a nonqualified deferral. Thus, examining changes in the tax reve-
                             nues would not show t,he effect of section 3121(v)(2).

                                --
                              In the absence of information needed to measure the revenue effects of
IRS and SSA                   section 3 12 l(v)( 2). we discussed the issue with IRS and SSA representa-
Representatives               tives. In general, both agencies believed that the section had a marginal
Believe the Effects           effect on the amount of social security tax revenues. However, they dif-
                              fered as to whether the relatively small net effect on such revenues was
Were Marginal                 positive or negative

                              For two reasons, IRSofficials believed that the section had a small
                              adverse effect on social security tax revenues:

                              1. Before enactment of section 3121(v)(Z), IRS officials said payments to
                              most participants in nonqualified deferred compensation plans would
                              have been subject to social security tax when received. IRSdid not
                              believe t,hat exclusions existing in the code at that time for retirement-
                              related payments had broad application. They said this was because the
                              retirement-related exclusions required payments to be made under plans
                              that provided benefits for employees in general or for a class of employ-
                              ees Essentially, from their experience, IRSofficials did not believe that
                              most nonqualified deferred compensation plans met this requirement.

                              2. Recognizing nonqualified deferred wages when they were earned
                              would not result in the collection of additional tax revenues, IRS officials
                              believe. In their opinion, nonqualified plans are offered primarily to
                              higher paid executives and managers of corporations rather than rank-
                              and-file or lower paid classes of employees. As a result, most of the
                              employees in these l)lans would have wage amounts above the social
                              security wage base Adding the deferred amount to their wages would



                               Page 15                               GAO/HRDW82   Taxing Nonqualified Deferred Compensation
Appendix II
Effect of Section 3121(v)(2) on Social
Security Revenues Cannot Rr Measured




not produce any further tax revenues. In effect, the new legislation
shielded these deferred amounts from later taxation.

ss~ representatives, on the other hand, believe that the section had a
small positive effect on tax revenues. Before section 3121(v)(Z), they
asserted, most of the payments to employees under nonqualified plans
were excluded from the social security wage base by the retirement-
related exclusions existing in the code at that time. Thus, SSArepresenta-
tives conclude, only limited social security tax revenues were collected
from payments made under nonqualified deferred compensation plans
before the enactment of section 3121(v)(Z).

Also, SSA representatives believe that nonqualified plans were offered to
employees in general, including rank-and-file workers. As a result, some
plan participants had wages below the wage base during their working
years. Thus, taxing the deferred amount in the year in which it was
earned would generate a small increase in tax revenues.

Some IRS revenue rulings on deferred compensation issues were rendered
before the enactment of section 3121(v)(Z); the rulings supported both
agencies’positions. But these rulings cannot be used to generalize about
whether payments from most plans were subject to the social security
tax. If anything, these rulings show that the taxing of compensation
under nonqualified plans should be judged on a case-by-case basis
because the plans and circumstances of each case can vary.




Page 16                         GAO/HRDSO-82 Taxing Nonqualified Deferred Compensation
Appendix III

Implementation Problems Arising From the
Enactment of Section 3121(V)(2)

                     One potentially significant tax administration problem in implementing
                     section 3 12 1(v)( 2) is that IRS has not yet issued regulations or other
                     guidance for it. IRS gave priority to implementation of major tax legisla-
                     tion enacted after the 1983 amendments. Also, IRSsaid two major con-
                     ceptual problems have caused delays in developing regulations:

                 l defining which pay arrangements section 3121(v)(2) covers and
                 . determining the amount deferred for the tax year.

                     Without regulations, there are no criteria, beyond the statute, for
                     employers to follow in making consistent and correct tax decisions rela-
                     tive to section 3 12 l( v)( 2). This has affected a limited but important
                     number of cases, IRS officials said. The lack of regulations undermines
                     IRS’S ability to question taxpayer decisions and protect the interests of
                     the social security trust funds. Some taxpayers have already asserted
                     that certain arrangements, which IRS officials believe represent current
                     rather than deferred compensation, are sheltered from social security
                     taxes by section 3121(v)(2).

                                         ..-
                     In administering the federal tax system, IRSissues various types of
Purpose of IRS       guidelines to aid taxpayers in interpreting the code. The two most
Guidelines           important of these guidelines are the regulations of the Internal Revenue
                     Code and IRS revenue rulings.

                     The Commissioner of Internal Revenue issues tax regulations with the
                     approval of the Secretary of the Treasury. The regulations amplify, sup-
                     plement, and interpret the statutory provisions. In addition, they give
                     examples of the application of code provisions to particular tax situa-
                     tions to help taxpayers meet their legal obligations.

                     IRS also issues many revenue rulings on tax matters. These rulings usu-
                     ally arise out of questions taxpayers ask IRSabout particular tax situa-
                     tions. While the rulings are not as authoritative as the regulations, they
                     are important guides to the position that IRS will take with respect to
                     similar factual situations.

                     Although section 3121(v)(2) was enacted in April 1983, regulations for
                     it have not yet been issued. IRS has not published any rulings on ques-
                     tions related to this section of the code. Lacking published guidance
                     reflecting IRS’S interpretation of this section, taxpayers have decided in
                     their own interest which types of compensation arrangements are
                     covered.


                     Page 17                    GAO/HlU390-82 Taxing Nonqualified Deferred Compensation
                                                  -
                          Appendix III
                          Implementation Problems Arising From the
                          Enactment of !kction 3121(V)(2)




                              officials have devoted extensive time and attention, they said, to
ReasonsDelaying IRS       IRS
                          developing regulations under section 3121(v)(2). Since May 1984, they
Regulations               told us, at least seven drafts of proposed regulations have been pre-
                          pared, circulated internally, and modified as a result of review com-
                          ments. The latest set of proposed regulations was circulated in June
                          1989. Three basic problems that have contributed to delays in issuing
                          these regulations were identified by the officials: (1) the enactment of
                          subsequent legislation, (2) the need to define coverage under section
                          3121(v)(2), and (3) the need to develop uniform procedures for the com-
                          plex calculations required to determine the amount of wages deferred.


Subsequent Tax            Three major tax laws, including the substantial changes in the tax sys-
Legislation Enacted       tern under the Tax Reform Act of 1986, affected priorities for issuing
                          regulations on section 3121(v)(2). Beyond affecting priorities, the new
                          tax laws also amended other statutory provisions related to the pro-
                          posed regulations for the section and necessitated changes to the draft.


Pay Arrangements          The regulations need to define the types of plans or pay arrangements
Covered Need Definition   covered under section 3121(v)(2), IRSofficials said. Failure to properly
                          define the extent of coverage could result in taxpayers shielding current
                          payments from social security taxes. The shielding of certain types of
                          compensation from such taxes could occur in a specific situation, the
                          officials pointed out. This is when (1) the wages received are alleged to
                          have been subject to the tax in an earlier year and (2) the employee had
                          earnings above the wage base in that year.

                          For example, when a bonus is paid in 1989 based on an employee’s 1988
                          performance, IRS officials said some taxpayers assert that additional
                          social security taxes were not due for the bonus. The bonus is a nonqual-
                          ified deferred compensation payment, the taxpayers contend. If it is
                          considered paid under a nonqualified deferred compensation plan, and
                          the employee had earnings above the wage base in 1988, social security
                          taxes are not due on the 1989 bonus under the provisions of section
                          3121(v)(2).

                          Early retirement incentive programs also have resulted in questions
                          about when this form of compensation is subject to social security taxes.
                          Employers reducing the size of their work force may offer early retire-
                          ment incentive payments to employees. Under these arrangements,
                          employees can retire early and receive payments for several years to



                          Page 18                        GAO/HED-90-82 Taxing NonqualifIed Deferred Compensation
                        Appendix Lll
                        Implementation Problems Arising From the
                        Enactment of Section 3121(V)(2)




                        supplement their retirement benefits. Such employees will receive com-
                        pensation when they are no longer working. If the payments are consid-
                        ered paid under a nonqualified deferred compensation plan, no social
                        security taxes would be due on deferred amounts assigned to tax years
                        when the retired worker had earnings above the social security wage
                        base. IRS officials believe that payments under these types of programs
                        usually represent current rather than deferred compensation. This is
                        because the compensation is not related to services performed in a pre-
                        vious tax year. Therefore, it would be taxable up to the social security
                        wage base in the year received.

                        This problem in defining the scope of coverage exists because of the
                        broad definition of a nonqualified deferred compensation plan. Section
                        3121(v)(2)(C) defines it as “any plan or other arrangement for deferral
                        of compensation other than a plan described in subsection 3121(a)(5).”
                        Subsection (a)(5) specifically exempts from social security taxes wage
                        payments made under various types of qualified deferrals or other tax-
                        favored plans.

                        Although the code definition describes the boundaries of what consti-
                        tutes a nonqualified plan, it does not describe the types of pay arrange-
                        ments that constitute deferred compensation. Given that compensation
                        is typically paid after services are rendered, it is unclear whether cer-
                        tain types of compensation are subject to section 3121(v)(Z). W ithout an
                        IRS interpretation of what constitutes a nonqualified deferred compensa-
                        tion plan, taxpayers have been left to decide when the social security
                        tax should be imposed on certain payments.


Determining Amount of   To determine how much in deferred wages is included in the social
Wages Deferred Can Be   security wage base for the year the deferral is earned, the amount of
                        such wages must be determined. Calculating the amount deferred, IRS
Complex                 officials said, can require complex present-value calculations. Also the
                        regulations need to provide uniform procedures for determining present
                        value. Developing uniform procedures has proved difficult given the
                        unlimited range of payment deferral options an employer can establish.
                        For example, employers could base the deferral on a percentage of the
                        employees’highest salary when they retire, making it difficult to deter-
                        mine how much compensation currently is being deferred.


                        In addition to other priorities impeding issuance of regulations on sec-
                        tion 3121(v)(2), IRS officials called the latter two conceptual problems a


                        Page 19                        GAO/HRDW-32 Taxing Nonqualified Deferred Compensation
Appendix III
Implementation Problems Arising From the
Enactment of Section 31210(Z)




significant cause of delays. Issuing regulations is a priority item, they
advised us.

Because of the limited reporting on nonqualified deferred compensation,
we could not determine how the absence of regulations has affected
social security tax revenues. However, in the absence of specific guid-
ance, it appears reasonable to assume that taxpayers will interpret the
law to their advantage where possible.




Page 20                        GAO/HRlMO-82 Taxing Nonqualified Deferred Compensation
Appendix IV

The Use of Deferred Income by Taxpayers
Subject to Self-Employment Tax

                       How taxpayers subject to the self-employment tax (self-employed tax-
                       payers) use deferred income arrangements is discussed in this appendix.
                       The information is intended to aid the Committee in its deliberations
                       about whether to provide tax treatment similar to section 3121(v)(2) for
                       this group of taxpayers.

                       Self-employed taxpayers do use contractual arrangements to defer
                       income owed from customers, but probably not extensively. Business-
                       related risks and certain tax prerequisites appear to discourage and
                       complicate use of these arrangements. We identified four professions
                       subject to the self-employment tax in which at least some members had
                       contractual arrangements to defer, until subsequent tax years, income
                       owed to them. The four were medical doctors, ministers, insurance
                       agents, and directors of corporations. Our survey of the self-employed
                       community and review of IRS and federal court rulings was limited.
                       Thus, it, is possible that other self-employed taxpayers also may have
                       deferred income arrangements.

                                             -~
                       The self-employment tax is imposed on earnings that self-employed indi-
Deterrents to Income   viduals derive from operation of their own trades or businesses. Most
Deferral Found         individuals subject to this tax are considered self-employed. However,
                       certain individuals engaged in employer/employee relationships, such as
                       ministers, are by statute explicitly subject to the self-employment tax.
                       Risks of noncollection and certain tax prerequisites appear to discourage
                       these taxpayers from using income deferral arrangements.


Income Deferral        Some self-employed individuals may encounter risks in collecting pay-
Can Carry Risks        ments from customers substantially later. Included are those whose
                       income is derived from many different sources (i.e., by selling goods or
                       rendering services to a variety of customers rather than just one or a
                       select few). The risk derives from the nature of this type of payment
                       arrangement. Since the taxpayer would accept no payment or only par-
                       tial payment immediately and collect the remaining income due substan-
                       tially later, collection problems could occur in the future. For example,
                       the customer may have died, may no longer be willing or able to pay, or
                       may not be easily located.

                       These risks could be mitigated if the deferral arrangement involves a
                       customer with whom the taxpayer has a longstanding business relation-
                       ship or who is judged to be very reliable. Under such conditions, the



                       Page 21                    GAO/HRB90432 Taxing Nonqualified Defend   Compensation
                                 Appendix IV
                                 Tbe Use of Deferred Income by Taxpayers
                                 Subject to Self-Employment Tax




                                 risks of collecting deferred payments could be reduced, and the use of
                                 nonqualified income deferral arrangements made more attractive.


Certain Tax Doctrines            Certain tax doctrines associated with deferred income arrangements can
                                 be obstacles in deferring tax liabilities. These are the constructive
Seen as Obstacles                receipt and economic benefit doctrines, which are discussed below.
                                 Under them, income need not be actually received before it is subject to
                                 current taxation.

                                 These doctrines are applied to determine whether the taxpayer has
                                 effectively deferred the tax liabilities on the income involved. Their
                                 application is complex and involves considering such questions as the
                                 following:

                                 Does the taxpayer risk forfeiture of the deferred income?
                                 Is the deferred income inaccessible to creditors of the indebted party?
                                 Was the deferral arrangement established before the income was
                                 earned?
                                 Can a current value for the deferred income be established with some
                                 exactness?

                                 These doctrines could discourage self-employed taxpayers from estab-
                                 lishing deferred income arrangements.

Constructive Receipt Precludes   Under the constructive receipt doctrine, taxpayers cannot deliberately
Taxpayers’ Option                “turn their back” on income to select the tax year for which they will
                                 report the income. For example, in Llewellyn v. Commissioner of Inter-
                                 nal Revenue, 295 F.2d 649 (7th Cir. 1961), the court ruled on an issue
                                 involving constructive receipt. The case concerned an income deferral
                                 arrangement established by a doctor who was the director of each of
                                 two hospitals’ clinical and pathological laboratories. The hospitals origi-
                                 nally paid the doctor a stated percentage of the monthly gross receipts
                                 of their laboratories.

                                 At the doctor’s request, the hospitals amended their initial employment
                                 contracts to reduce the monthly amount of payments due to the doctor.
                                 The reduced amount was used by the hospitals to purchase a retirement
                                 income annuity policy for the doctor.

                                  IRSdid not believe the arrangement represented a deferral of income,
                                  and the case eventually was litigated. The doctor argued that by virtue
                                  of the amended employment agreement, his income had been decreased,


                                  Page 22                        GAO/HRD9@82 Taxing Nonqualified Deferred Compensation
                          Appendix IV
                          Tbe Use of Deferred Income by Taxpayers
                          Subject to Self-Employment Tax




                          and that the annuity contracts were paid for by the hospitals. Thus, the
                          annual cost of the annuity policy was not current income. IRS argued
                          that the doctor’s income in question was not reduced but, at the doctor’s
                          option, was diverted to be used for a specific purpose. The court ruled
                          that the deductions in the doctor’s income were not employers’ contribu-
                          tions. Rather, the deductions used to purchase the annuity were income
                          that was constructively received, the court said. As such, they consti-
                          tuted taxable income to the doctor in the year they were earned.

Economic Benefit Can Be   Under the economic benefit doctrine, in certain circumstances, promises
Currently Taxed           to pay deferred compensation constitute an economic benefit. This eco-
                          nomic benefit can be taxed currently, if it can be valued with some
                          exactness.

                          IRSRevenue Ruling 69-50 demonstrates the application of this doctrine.
                          The ruling concerns a nonprofit corporation that insures the medical
                          expenses of its subscribers. The medical services are provided to the
                          corporation’s subscribers at agreed-upon fees by self-employed physi-
                          cians under contract with the corporation.

                          As part of the payment arrangement, the corporation offered a deferral
                          plan to the physicians. Under the plan, the physicians could elect to
                          defer a stated percentage of the payments due from the corporation for
                          services provided to its subscribers. The corporation invested these
                          deferred amounts and established an accounts payable on its books for
                          the physicians.

                          The ruling concerns one physician who elected to defer 30 percent of
                          such compensation-$3,000 for the tax year in question. IRSruled that
                          the physician’s right to the amounts credited to his account by the cor-
                          poration emanated from the medical services rendered to the corpora-
                          tion’s subscribers. Under the agreement, IRSreasoned, the subscribers
                          had compensated the physician for his services by investing him with
                          the right to be paid by the corporation. As such, the subscribers had
                          given the physician an economic or financial benefit. Thus, IRS ruled that
                          the physician had to include the $3,000 in gross income for the year the
                          services were rendered rather than defer it to a later year(s).




                           Page 23                        GAO/HRIMO-32 Taxing NonqualifIed Deferred Compensation
                          Appendix IV
                          Tbe Use of Deferred Income by Taxpayers
                          Subject to Self-Employment Tax




                          Despite the aforementioned disincentives to using deferred income
Use of Deferred           arrangements, some medical doctors, ministers, insurance agents, and
Income Arrangements       directors of corporations use deferral arrangements. Although their
by the Self-Employed      deferral arrangements are structured differently, they are similar in one
                          respect. In each case, the risk associated with the deferral may have
                          been reduced because the taxpayer had a continuous relationship with
                          the party involved in the deferral arrangement.


Medical Doctors           Various court cases and IRS revenue rulings’ evidence the use of income
                          deferral arrangements by medical doctors. In some of these cases, IRS or
                          the courts found the taxpayer had deferred tax liability on the income in
                          question. In others, it was found the tax liabilities had not been deferred
                          because the income in question was constructively received or provided
                          a current economic benefit to the taxpayer.


M inisters                Although ministers are generally employees of religious organizations,
                          they are subject to the self-employment tax for social security purposes.
                          [Jnder code provisions, churches with whom’they are affiliated may
                          establish qualified tax-sheltered annuities that may be payable upon
                          ministers’ retirement. The disbursements received from these plans rep-
                          resent qualified rather than nonqualified deferred compensation.

                          In addition, churches may offer other pay arrangements to defer income
                          to ministers until after they retire because many retired ministers have
                          incomes inadequate to meet living expenses. It is a common practice, an
                          attorney told us, for churches to provide ministers with financial assis-
                          tance during retirement. Whether these payments would be considered
                          deferred or current income for social security purposes would depend on
                          several questions. For example, was there an understanding between the
                          church and the minister that additional income would be provided at
                          retirement? Did the church set aside assets for the exclusive purpose of
                          making the additional payments to the minister‘?


Self-Employed Insurance   Some insurance agents are recognized as self-employed even though
Agents                    they sell the policies of only one insurance company. These agents earn
                          income as commissions from the sale of new policies and the renewal of

                          ‘Rulings on medical docton’ mcome deferral practices that we identified were: -Goldsmith v. -United
                          States, 586 F.2d 810 (1978); lkuted States v. Basye, 410 U.S 441; Minor v. United States, 772 F.2d
                          1472 (9th Cir. 1985); Llewellyn v. Cammssioner of Internal Revenue, 295 F.2d 649 (7th Cir. 1961);
                          Revenue Ruling 69-50; Rev~~nur Ruling 6%474; and Revenue Ruling 77.420.




                           Page 24                            GAO/HRIMMZ        Taxing Nonqualified Deferred Compensation
                            Appendix N
                            The Use of Deferred Incume by Taxpayers
                            Subject to Self-Employment Tax




                            existing policies, When these agents retire or otherwise terminate their
                            business, they are likely to have policies that are still in effect and on
                            which they are entitled to renewal commissions. It is a common practice
                            for insurance companies, after agents terminate their business, to com-
                            pensate them over a period of years based on the renewal value of their
                            policies.

                            Whether these payments represent deferred compensation or current
                            income depends on how the pay arrangements are structured. For exam-
                            ple, if the agent chose to receive the commissions derived from actual
                            renewals each year, the payments would likely be considered by IRSto
                            be current income.

                            However, insurance companies can offer the agents the option of defer-
                            ring the renewal commissions over a period of time, such as 15 years.
                            Under such arrangements, the insurance companies estimate the
                            expected value of renewals from the agent’s customer base and provide
                            a level payment to the agent over the deferral period. IRS attorneys said
                            such payments can represent deferred income.


Directors of Corporations   Persons who serve as directors on corporate boards pay the self-
                            employment tax on this income and may defer the income through con-
                            tractual arrangements. Revenue Ruling 71-419 describes a situation in
                            which the director’s fees were deferred pursuant to a corporation’s
                            unfunded deferred compensation plan. As the director elected to defer
                            his fee before it was earned and the plan was unfunded, IRS ruled the
                            deferred fees did not have to be included in the director’s current
                            income. A mere promise to pay, not represented by notes or secured in
                            any way, is not receipt of income to a cash-basis taxpayer, the ruling
                            states.


                             Although we identified only four types of taxpayers subject to the self-
Potential for Others to      employment tax who have attempted to establish deferred income
Have Deferral                arrangements, others may also have such arrangements in place. It was
Arrangements                 difficult to identify such arrangements because we could not identify a
                             single voice that speaks for the 10.5 million self-employed persons on
                             such matters. Further, people tend to consider their compensation to be
                             a private matter.




                             Page 25                        GAO/HRD-90442 Taxing Nonqualified Deferred Compensation
Appendix V

Scopeand Methodology


                 The Subcommittee on Social Security of the House Committee on Ways
                 and Means requested that we provide information on the following four
                 specific matters:

             l   The origin and development of section 312 l(v)( 2) of the Internal Reve-
                 nue Code.
             l   The section’s effect on social security revenues.
             l   Problems that arose from the section’s enactment.
             l   Taxpayers subject to the self-employment tax who currently participate
                 in income deferral arrangements.

                 Our work was conducted between July and December 1989 at IRSand SSA
                 headquarters in Washington, D.C., and Baltimore, respectively. We
                 reviewed legislative materials related to the enactment of the Social
                 Security Amendments of 1983, IRS and court rulings on the tax treat-
                 ment of deferred income, and various tax-related documents on deferred
                 income. In addition, we examined SSApolicies and procedures related to
                 the enactment of section 3121(v)(2) and correspondence that SSApre-
                 pared in response to questions raised by various taxpayers about this
                 section.

                 We also interviewed current and former government officials who had
                 knowledge about either the origins of the section or its current opera-
                 tion. These officials included employees of IRS, SSA,and the Department
                 of Labor and congressional staff members.

                 To identify self-employed taxpayers who may have business income
                 deferral arrangements, we pursued several leads based on discussions
                 with IRS and SSArepresentatives. The representatives told us that pr@
                 fessions in which members customarily have longstanding relationships
                 with their customers lend themselves to these arrangements. Accord-
                 ingly, we contacted such groups as firms that offer assistance in setting
                 up benefit programs; accounting firms; certain companies that franchise
                 business opportunities to self-employed taxpayers; and trade associa-
                 tions that represent the interests of the legal profession, small busi-
                 nesses, the insurance industry, and automotive dealers.




                 Page 26                   GAO/HBD9O-S2 Taxing NonqudIfied D&d   Compensation
Major Contributors to This Report


                        Roland H. Miller III, Assistant Director, (301) 965-8925
Human Resources         William J. Staab, Assignment Manager
Division,               Jacquelyn Stewart, Evaluator-in-Charge
Washington, D.C.
                                            ---
                        Craig Winslow, Attorney-Advisor
Office of the General
Counsel




(105239)                Page 27                   GAO/HRD.S0442 Taxing Nonqudified   Deferred Compensation
I




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