Social Security: Taxing Nonqualified Deferred Compensation

Published by the Government Accountability Office on 1990-04-05.

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

                   United St++       Geneml Accorurdn- 06~8    /LJ/    z) $9 I


For Release        SOCIAL SECURITY:
on Delivery        Taxing  Nonqualified        Deferred
Expected at        Compensation
1:3@ p.m. EDT
April   5, 1990

                   Statement  of Lawrence        H. Thompson
                   Assistant  Comptroller        General
                      for Human Resources        Programs

                   Before the
                   Subcommittee  on Social Security
                   House Committee on Ways and Means


Nonqualified    deferred   compensation       refers    to employer            eponsored
income deferral     plans that do not qualify           for favored            income tax
treatment.    Basically,     the plans are like 100s.              They        represent
employer promises      to provide    additional      future     income         to
employees for the services        they currently        render.
Self employed persons can also defer                    income through      contractual
arrangements         with their      clients.      Such contractual        deferrals
used to face similar             tax treatment       as nonqualified       plans until
enactment       of section       3121(v) (2) in the Social Security
Amendments of 1983.              Before the amendments were passed,               both
types of deferrals             were subject     to income and social          security     tax
when persons received              payments.      After    the amendments,
nonqualified         deferrals      are subject      to the social      security     tax
before     they are received.             Simply stated,      nonqualified       deferrals
are recognized          as income either        (1) in the year services            were
performed       to earn them or (2) in the year when conditions
associated        with their       payment are met and the employee no longer
risks    forfeiting        his right      to them.
Early recognition      of deferred     income can have tax advantages         for
persons with current      income at or over the social         security    wage
base and covered by section         3121(v)(2).      For these people,     it
means that no additional        social    security   taxes have to be paid
in the year the income is recognized             and the payments would not
be subject    to the tax when later        received.     Thus, se1 f -employed
persons meeting     these conditions       could avoid paying social
security   taxes on their     deferred     income if they had a comparable
Given this situation,  you asked us several   questions                      about
deferred  income and section  3121(v) (2).  Our answers                      follow.
Self-employed      taxpayers    use contractual    arrangements    to defer
income but probably        not extensively.     Risks associated     with
collecting    deferred     income and tax prerequisites       appear to be
discouraging     factors.

Section   3121(v)(2)      evolved    from concerns about how employee
voluntary   contributions        to qualified    deferred  compensation   plans
could escape social        security     taxes.   During deliberations   the
Congress also changed social            security  tax rules for employer
sponsored   nonqualified       plans.
Limited   reporting    on nonqualified          plans precludes      measurement          of
the effects     of section  3121(v)(2)          on social   security    revenues.                    . e..
Both   IRS and SSA believe          it   was,marginal.
IRS ofricials       believe     the section    has     complicated     tax
administration       and regulations        on the     use of the provision         are          i
needed.       It has been unable to issue             such regulations       because of
higher    priority     projects    and problems        in drafting     regulations.                    l
Hr.       Chairmbn           and     Members of the                     Subcommittee:

‘I am pleased                to be here            today       to discuss                the     social             security
taxation         of certain               types        of deferred               income.               Last         oummer, you
asked        us whether              self-employed                  taxpayers           defer          income          through
arrangements                 that      can be viewed                    as similar         to employer-sponsored
nonqualified              deferred             compensation                  plans.        Your         interest              in this
matter        stemmed from                1983 legislation                      that      changed             the      social
security         tax         treatment           of nonqualified                   deferred             income          for
employees,             but     did      not make a similar                       change          for         comparably
situated         self-employed                   taxpayers.                  You also          asked          us about           (1)
the       legislative               history       of     the    change,               (2) the          revenue          effect         of
the     change          on the         trust       funds,       and          (3) problems               in administering
the     provision.

As discussed                 in our       report         to youl,             some self-employed                        taxpayers
do defer          income            through       contractual                 arrangements                with        their
clients,         and these              are      similar            to nonqualified                   plans          in that       they
receive         comparable              income         tax     treatment.                 However,             not many self-
employed         persons             seem to use these                       arrangements.                   Before
discussing             the      results         of our         work,          I would          like       to explain
briefly         nonqualified                  deferred         compensation                plans,             the     taxing       of
these       plans        for        income      tax      and social              security              tax     purposes,           and
income        deferrals              by self-employed                       taxpayers.
lSocia1  Security:     Taxing Nonqualified                                        Deferred              Compensation
 (FAO/HRD-90-82,   Mar. 15, 1990).                                                                                                          i



Oeferred           com pensation                   plans          can be classified                      as either              qualified
or nonqualified.                           Nonqualified                 plans          refer      to employer-sponsored
plans      under              which        the     deferred             amounts           do not         qualify          for         certain
favored        incom e               tax    treatm ent                under      the      Internal          Revenue             Code.
Essentially,                   nonqualified                    plans       are    IOUs by which                   the     employer
prom ises          to pay employees                            participating                  in such plans               additional
incom e       in the             future           for      services            currently           rendered.                  Such plans
are     used to provide                      work             incentives          or to supplem ent                     retirem ent
incom e       and lim it               employees’                 current         incom e         tax     liabilities.

Self-em ployed                   taxpayers               can also             defer       their         incom e     through
contractual                   arrangem ents               with         their      clients.               These arrangem ents
are     sim ilar              to nonqualified                     deferred            com pensation               plans         for
employees                in    that        they         (1)     represent             a prom ise           (by their             client)
to pay in the                    future           for     goods         or services               currently             rendered            and
(2)     do not            receive           the         favored         incom e         tax     treatm ent.

A m ounts deferred                     under            nonqualified              plans         and contractual
arrangem ents                  are     subject            to      incom e tax            in the          year      received.
However,           these          arrangem ents                   receive         different              social         security            tax
treatm ent.                   E m ployees          have         the     social          security          tax      imposed             on
their      nonqualified                     deferred             com pensation                 in the      year         the      deferred             l +,-
amount* is earned.                          Self-em ployid                    taxpayers           have the          social
                                                                          2                                                                             .
security           tax         imposed         on their            contractually                  deferred               income        in
the year           the deferred                  amount           is received.

This      difference                  in social           security                tax     treatment           resulted            from

enactment              of      section         3121(v)(2)               of        the    code by the              Social
Security           Amendments              of      1983.           This        section           changed          the      social
security           tax         treatment           for      nonqualified                    deferred          compensation.
Before          this        section        was enacted,                     the     tax       was imposed                when the
amounts          were received.                     Subsequently,                       the    tax     is     imposed
essentially                 in the        year      the          income was earned.                          The 1983
amendments               did      not     affect          the      taxing           of deferred               income        for        the
self -employed.

Earlier          recognition               of deferred                  income           can have tax              advantages
for      persons            who have other                  current            income          at’least           equal      to the
social          security           wage base               ($51,300            in       1990).         For       these      people           no
additional               social         security            taxes           have to be paid                  on the         deferred
amount          either          (1)      in the          year      it       is considered                 taxable          because            it
is     above       the        wage base or                 (2) when received                      because           it     would        not
be subject               to     the     tax.        Thus,         8ome self-employed                         persons         in a
similar          situation              could       limit         their            social        security          taxes          if    the
law was changed                    to treat              their      deferred                income        like     nonqualified
deferred           compensation.

On the       other            hand,      earlier            recognition                  of deferred              income may not                       l e.,*
have      tbx     advantages               for      person:             with        current          income below              the

                                                                        3                                                                                .
wage ba8e”in              the     year        the deferred              amount       is earned.               In these
cases,       persons         will        pay social              security         taxes         on deferred             amounts
up to the          wage base             in the year              the     amounts         were earned.                  Since
crarly      recognition               does not          result         in a tax       savings,             such persons
would       probably         want        to pay the              tax    later      (when they              receive           the
income)        rather        than       sooner           (when they          have earned             but      not
received         it).


You asked          if     self-employed                 taxpayers           use deferred             income
arrangements              similar            to those        used by employees                    that       are    subject
to taxation              under        section          3121(v)(2)           of the        tax     code.         We found
that      some types             of    self-employed                  taxpayers       use contractual
arrangements              to defer            income       owed them by their                     clients,          however,
they      do not         seem to make extensive                         use of these              arrangements.                    We
could       identify         only       four       types      of professionals                    paying        self-
employment              taxes --medical                doctors,         ministers,          insurance              agents,
and directors              of corporations--                     in which         some people             had
contractual              arrangements              to defer            income.

Self-employed              taxpayers’              limited            use of contractual                  arrangements
to defer        income may be related                         to two factors.                     One, they          may be
unwilling         to      incur        the      risk     of collecting               amounts         owed from                          .. 2.
                                                                                                                                        . .
clients       at substantially                     later     'points         in time,           especially              if    they
                                                                  4                                                                         c
have       not     had     a continuous                 business            relationship             with      the     clients.
Two, compliance                   with        tax      code prerequisites                    for     deferring           income
can be a complicated                          task      and could            discourage             use of      these

arrangements.                    In a number of tax                    decisions             involving          the

deferral           of     income         by self-employed                    taxpayers,             the     Internal
Revenue          Service          or the         federal        courts           have      held      that     taxes          had to
be paid          on alleged              deferred           income       before           payments          were actually
received           from     clients.

SECTION 3121 (v) (2)

You asked           how section                3121(v)(2)             came about.                  The section          evolved
from concern               that         the    increasing             use     of qualified                income deferral
arrangements               (401(k)            plans)        could      reduce         social         security          tax

Before       the        enactment             of section            3121(v)        (2),     employees
participating               in     401(k)           plans     could          avoid        paying      the     social
security          tax     on their             voluntary            wage contributions.                       Under          then-
existing          law,      voluntary               employee          wage contributions                     were excluded
from      taxation,          which            had the        effect         of    lowering           aggregate          wages
subject          to taxation.                  To preserve             the       social       security          tax     base,
the    Congress           proposed             taxing        employee            wage      contributions               for
401(k)       plans        and other             types        of employee             benefits             by imposing            the
social       security             tax     on employeq’wage                    contributions                 in the      year           :‘*a

the    w;ges        were earned.                                                                                                       d
During         consideration                   of      the       act;           the Congress             also       decided         to
change         the         tax      treatment           of nonqualified                         deferred         compensation
plans.             After          some discussion                   of this               matter,        the     Congress
enacted            section           3121(v)        (2).          During             the       Senate      debate,         it      was
noted     that             the     section          provided                similar            treatment         as was being
proposed             for         voluntary          wage contributions                             to qualified            plans.


You also            asked          what       effect         this           section            had on social              security
revenues.                  Unfortunately,                  the      revenue               effect       cannot          currently          be
measured            because           of      limited          reporting                  by employers              on
nonqualified                 plans.            The effect                   on tax         revenues         hinges         on two
   we whether                payments           made under                      nonqualified            plans          before       the
         1983 amendments                       were        included                 in workers’            social         security
         wage base                 when received                  or if             the    payments         were excluded
         under             then-existing                code provisions                         for    retirement-related
         payments,                 and
   --    the        extent           to which           plan        participants*                     current          income       levels
         exceed             the      social         security                wage base.
Sufficient                 information              does not                exist         to   measure          plan     uses       in
either        of      these         situations.                                                                                                                ; -1
                                                                        .                                                                          . *‘I

          0                                                         /

Notwithstanding                   these       measurement                problems,        both      the      Internal
Revenue           Service         and Social               Security         Administration
representatives                  believe            that      the       revenue       effects       of section
3121(v)(2)             have been marginal.                           They differ,              however,         on whether
the      effect        of     this        section          marginally          increased           or decreased
social        security           tax       revenues.


Finally,           you asked              whether          section         3121(v)(2)           was difficult                 to
administer.                 We found         only          one significant               tax     administration
problem           relating           to    the    need for              additional        guidance           on the       types
of arrangements                  covered          by the          provision.             IRS representatives
stated        that      regulations               for       the     section          are needed,          but        IRS has
not      been able            to develop               them despite            extensive          efforts.             IRS
attributed            the      delay        in    issuing            regulations          to several               factors.

First,        higher          priority           tax       legislation,              including       the      Tax Reform
Act      of   1986,         created         pressures             that      precluded           issuance        of
regulations             for      section          3121(v)         (2).       Second,       problems           were
encountered             in drafting               regulations.                 These      included           the
difficulty            in delineating                   which        plans      and arrangements                 the
section           covers       and deciding                 how the         amount deferred               should        be
quantified.                 Without         regulations,                 IRS is concerned              that         taxpayers              _
                                                                                                                                   * *9
may be avoiding                  social          security’taxes                on deferred           payments           by         ’
considering             the      payments           to be made under                   nonqualified             plans.             d

                                                                    7                                                                  .

This     concludes   my statement     Mr.             Chairman.       I will    be happy   to

answer     any questions    that    you may have              about     our    rapart.

                                                  ,                                                 . c.


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