Tax obligations of deferred compensation under divorce agreements

Employers often provide separate nonqualified deferred compensation (NQDC) plans to their top employees. These plans, unlike 401(k) plans, or other similar qualified plans, are technically unfunded and are always treated as Form W-2 compensation (subject to payroll tax). If the deferred compensation is to be paid to an independent contractor rather than an employee, the tax reporting would be different.

Occasionally employees will go through a divorce and the employee’s future rights under a NQDC plan will be a factor in the negotiations. Employers need to know what to do if the divorcing parties agree to split the rights to the employee’s NQDC plan.

This article briefly addresses some of the payroll tax, distribution, required tax withholding, and reporting obligations when the employer will have to eventually pay a part of the employee’s NQDC amount to the employee’s former spouse.

General explanation of NQDC

NQDC refers to any arrangement by the employer to pay compensation in a future taxable year in connection with the performance of services in a current (or prior) taxable year. A NQDC arrangement can either be paid in cash or equity (stock-based). NQDC may be in the form of deferred bonuses; phantom stock plans; stock appreciation rights (SARs); restricted stock units (RSUs); or supplemental executive retirement plans (SERPs). For a more in-depth analysis of the forms of equity compensation, read Understanding equity compensation devices.

If a NQDC arrangement is designed to comply with section 409A the employee will have compensation income when the NQDC is paid, regardless of when it vests. Some NQDC arrangements are designed to pay on vesting, some pay on a specified event (such as separation from service or a change in control), and some are paid over time, such as after retirement.

Importantly, a typical NQDC plan is not an asset of the employee and is not a funded arrangement (though the employer might hold some money in the employer’s own rabbi trust (a grantor trust of the employer)) so there is nothing that the employee can transfer other than a right to a future payment.

This article is not about divorce rules, but generally, the parties cannot force an employer to pay promised compensation earlier than is provided for under the NQDC plan. Instead, the employer usually receives a court order or other agreement stating that when the employee would otherwise receive a payment, the employee’s former spouse will receive a specific portion of the payment (generally under the same terms). Nevertheless, some employers may be willing to pay NQDC amounts to the employee’s former spouse earlier if the plan so provides. Under section 409A, the employer generally cannot accelerate payments to the employee.

NQDC in divorce proceedings

Courts or spouses amid divorce proceedings may use a domestic relations order (DRO), or a similar agreement, to notify the employer that the parties have agreed to transfer certain vested nondeferred compensation payment rights from the employee to the employee’s former spouse.

The IRS has taken the position in Revenue Ruling 2002-22 that when an employee transfers his or her right to future payments under a specific NQDC arrangement to a former spouse, incident to a divorce, there is no immediate tax, withholding, or reporting consequences (this was a departure from the longstanding assignment of income principle but is supported under the special section 1041 provisions (transfers incident to a divorce). The assignment of income principle was applied to NQDC arrangements such that deferred income was taxed to the person who earned it (transferor), and that the incidence of income taxation could not be shifted to the transferee by anticipatory assignment, even if between spouses in divorce proceedings. Thus, the employee's former spouse has ordinary income when the NQDC is paid to the former spouse.

Because these arrangements remain compensatory plans (and thus subject to payroll tax withholding), the employer is obligated to withhold federal income tax and may be obligated to withhold the employee’s portion of federal employment taxes—Federal Insurance Contributions Act (FICA), which includes Social Security and Medicare tax, from the amounts paid to the employee’s former spouse. The employer is also obligated to timely deposit both the employee and the employer portions of FICA and federal income tax withholding to the IRS. The employer reports the taxable income, and the federal income tax withholding, on Form 1099-MISC boxes 3 and 4 to the employee’s former spouse. The employee’s former spouse will be credited with the federal income taxes withheld.

Under this treatment, the employee and the employee’s former spouse are separately taxed, at their own tax rates and under their own social security numbers. The IRS’s position, which is described in revenue rulings, contemplates that the employer will:

• Withhold federal income tax (state and local tax, if any, as applicable) from each payment. Most employers use the federal supplemental wage withholding rate (currently 22%) for both the employee’s and the employee’s former spouse’s payments. The 37% federal withholding rate applies to supplemental income that exceeds $1 million.
• Report the employee’s federal income tax withholding on the employee’s Form W-2, Box 2.
• Report the employee’s former spouse’s federal income tax withholding on the employee’s former spouse’s Form 1099-MISC.
• Withhold FICA from both the employee’s and the employee’s former spouse’s payments (generally – there are some complex exceptions based on whether the NQDC arrangement was subject to FICA in earlier years). The employee’s prior wage base is considered when determining the amount of FICA taxes due (i.e., Social Security taxable wage base limit and Additional Medicare Tax threshold) from the employee. For additional information on FICA rules for deferred compensation read Operating Nonqualified Deferred Compensation Plans FAQs for Employers
• Report all of the FICA that is withheld from both the employee’s and the employee’s former spouse’s payments on the employee’s own Form W-2 (as applicable, included in Boxes 4 and 6).

The IRS eventually provided similar rules for other types of executive compensation, such as stock options and restricted shares.

Conclusion

An employer faced with paying amounts from a NQDC plan based on agreements arising out of a divorce needs to work closely with human resources and payroll to make sure the payments are properly treated under the IRS guidance. The company may also need to work closely with the payroll company to make sure the right amounts are reported on the correct forms.