TOP 10 TAX ISSUES THAT NON-TAX EMPLOYMENT LAWYERS SHOULD KNOW. June 27 30, Nancy L. Farnam Varnum Law Novi, Michigan

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1 TOP 10 TAX ISSUES THAT NON-TAX EMPLOYMENT LAWYERS SHOULD KNOW I. IRC 409A A. General June 27 30, 2012 Nancy L. Farnam Varnum Law Novi, Michigan 1. If an agreement is subject to IRC 409A, it must be in writing and must comply in form and operation with strict rules governing the timing of deferral elections and the timing of payments. IRC 409A; Treas. Reg A. 2. Failure to meet the requirements of IRC 409A results in immediate income inclusion, an additional 20% excise tax on the amount included in income and interest equal to the federal tax underpayment plus 1%. B. Arrangements Subject to IRC 409A 1. Generally, any arrangement that provides for the deferral of compensation is subject to IRC 409A. An arrangement provides for the deferral of compensation if it provides that an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. Treas. Reg A-1(a), (b)(1). 2. The employee does not have a legally binding right to compensation to the extent that it may be reduced unilaterally or eliminated by the employer after the services creating the right to the compensation have been performed. Treas. Reg A-1(a), (b)(1). C. Arrangements and Compensation That are Not Subject to IRC 409A 1. Qualified employer plans, including plans under IRC 401(a), 403(b) and 457(b). Treas. Reg A-1(a)(2). 2. Medical reimbursement arrangements that satisfy IRC 105 and 106. Treas. Reg A-1(a)(5). A self-insured medical plan must meet certain nondiscrimination requirements under IRC Payments made no later than 2 1/2 months following the end of the tax year in which the employee no longer has a "substantial risk of forfeiture" (called shortterm deferrals ). Treas. Reg A-1(a), (b)(4). 1

2 a. Compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services or the occurrence of a condition related to the employee's performance for the employer or the employer's business activities or goals and the possibility of forfeiture is substantial. Treas. Reg A-1(d)(1). b. If an employee's entitlement to the amount is conditioned on the employee's involuntary separation from service without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. Treas. Reg A-1(d)(1). c. A right to a payment that is never subject to a substantial risk of forfeiture is considered to be no longer subject to a substantial risk of forfeiture on the first date the employee has a legally binding right to the payment. Treas. Reg A-1(d)(1). d. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned upon the refraining from the performance of services. Treas. Reg A-1(d)(1). e. Examples: Example 1: On November 1, 2012, University X awards a bonus to Employee C. Employee C will forfeit the bonus unless Employee C continues performing services through December 31, The right to payment is subject to a substantial risk of forfeiture through December 31, If payment is scheduled to be made on or before March 15, 2014, the arrangement is not subject to 409A under the short-term deferral exception. If payment is scheduled to be paid on July 1, 2014, the arrangement is subject to 409A because the payment is not made within the short-term deferral period. Example 2: On November 1, 2012, University X awards a bonus to Employee F that is payable upon Employee F's separation from service regardless of cause. There is no substantial risk of forfeiture and the arrangement is subject to IRC 409A because the payment may occur outside of the short-term deferral period. 4. Separation pay plans meeting certain requirements (Treas. Reg A-1(b)(9)). See Section III below. 5. Legal settlements resolving bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or worker's compensation statutes. Treas. Reg A-1(b)(11). See Section V below. 2

3 6. Educational benefits for a former employee, but not the education of a spouse or dependent. Treas. Reg A-1(b)(12). D. Arrangements Subject to IRC 409A Must Satisfy the Following Requirements 1. A plan of deferred compensation must be in writing, must specify the amount (or the method or formula for determining the amount) of deferred compensation to be provided and must specify the time and form of payment. 2. The plan must comply with strict deferral election rules. Treas. Reg A-2. a. General rule. An employee who is deferring income must make the initial deferral election no later than December 31 of year before the year in which the services are performed. The election will include whether or not to defer, how much to defer, and the time and form of payment. Treas. Reg A-2(a)(1). b. If the employee does not have any election, the arrangement itself must specify the time and form of payment no later than the time the employee obtains a legally binding right to the compensation or, if later, the time the employee would have been required to make an election. Treas. Reg A-2(a)(2). c. When an employee is newly eligible to participate (either a new hire or a new plan), the election may be made within 30 days of becoming eligible to participate and may only apply to compensation paid for services following the date of election. If the plan is a non-elective plan, the employer must designate the time and form of payment within 30 days after initial eligibility, but the election may apply to all compensation earned during the period (not just compensation earned after the election). Treas. Reg A-2(a)(7). d. In the case of a separation pay plan, where such separation pay is the subject of bona fide, arm s length negotiations at the time of separation from service, the election must be made before the date the employee has a legally binding right to the payment. Treas. Reg A-2(a)(11). e. In the case of separation pay under a window program, the election must be made before the date the employee makes an irrevocable election to participate in the plan. Treas. Reg A-2(a)(11). 3. The time or form of payment may be changed after the initial election only under limited circumstances. Treas. Reg A-2(b). Generally, a plan may permit a delay in payment or a change in the form of payment only if the following conditions are met: a. The subsequent election may not take effect until at least 12 months after the date on which the election is made. Treas. Reg A-2(b)(1)(i). b. For any subsequent election as to a payment that is to be made at a specified time (or pursuant to a fixed schedule), upon a separation from service, or upon a change in control, (but not any payment that is to be made on account of disability, death or an unforeseeable emergency), the payment must be 3

4 deferred for a period of not less than five years from the date the payment would otherwise have been paid. Treas. Reg A-2(b)(1)(ii). c. The election as to a payment that is to be made at a specified time (or pursuant to a fixed schedule) must be made not less than 12 months before the date on which the payment is scheduled to be paid. Treas. Reg A-2(b)(1)(iii). 4. Generally, the time or schedule of payments under the plan may not be accelerated. Treas. Reg A-3(j). 5. Benefits under the plan may only be paid upon one of the events specified in Treas. Reg A-3(a), as follows: a. The employee's separation from service" as defined in Treas. Reg A- 1(h). Treas. Reg A-3(a). An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer. A termination of employment has occurred if the facts and circumstances indicate that the employer and employee reasonably anticipated that after a certain date (i) the employee would perform no further services, or (ii) the level of bona fide services the employee would perform (as an employee or independent contractor) would permanently decrease to no more than 20% of the average level of bona fide services performed (as an employee or independent contractor) over the immediately preceding 36-month period (or the full period of services if the employee has been providing services to the employer less than 36 months). b. The date the employee becomes "disabled" as defined in Treas. Reg (i)(4). Treas. Reg A-3(a)(2). An employee is considered "disabled" if the employee (i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months; or (ii) by reason of any medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months, is receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the employer. c. The employee's death. Treas. Reg A-3(a)(3). d. At a specified time or fixed schedule specified under the plan at the date of deferral of the compensation. Treas. Reg A-3(a)(4). e. A change in ownership or control, as defined in Treas. Reg A-3(i)(5). Treas. Reg A-3(a)(5). f. Upon the occurrence of an unforeseeable emergency, as defined in Treas. Reg A-3(i)(3). Treas. Reg A-3(a)(6). The term unforeseeable emergency means a severe financial hardship to the employee resulting from (i) an illness or accident of the employee, the employee's spouse, beneficiary or dependent; (ii) loss of the employee's property due to casualty; or (iii) other 4

5 similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the employee. Examples include the imminent foreclosure of or eviction from the employee's primary residence, medical expenses and funeral expenses. The purchase of a home and the payment of college tuition are not unforeseeable emergencies. 6. General rules on permissible payments: a. Only a single time and form of payment may be designated for each payment event. b. An arrangement may state that payment will be made in a taxable year (for example, payments will be made in three installments, one in 2013, one in 2014 and one in 2015). c. An arrangement may state that payment will be made in a designated period if the period is within the same taxable year or if the period is not more than 90 days and the employee doesn t have a right to designate the taxable year (for example, payment will be made within 90 days of separation from service). E. If a Noncompliant Document Exists or if There are Certain Operation Errors, Correction Programs are Available 1. Document failures IRS Notice and IRS Notice Operational errors IRS Notice II. Employment Agreements IRC 409A Considerations A. General 1. Generally, employment agreements provide current compensation and benefits in exchange for services. However, certain provisions providing deferred compensation are frequently found in employment agreements (for example, bonuses, separation pay). 2. To avoid IRC 409A, subject any payments of deferred compensation to a substantial risk of forfeiture (for example, must be employed on date of payment or entitlement to payment is conditioned on the employee's involuntary separation from service without cause) and make payment on or before 2-1/2 months after the end of the year that compensation is earned (short-term deferral). 3. If can t avoid IRC 409A, make sure the agreement is in writing and provides specific payment terms (the time and form of payment). Don t permit any changes in the terms except as permitted by IRC 409A. B. Items Typical to Employment Agreements That May Be Subject to IRC 409A 5

6 1. Sign on bonus. If the period between the date the employee is hired and the date payment is made covers more than one taxable year, the bonus will be subject to IRC 409A unless an exception applies. For example, assume an employment agreement dated January 1, 2012 provides for a sign on bonus of $100,000, with 50% of the bonus payable on hire date and 50% of the bonus payable on the first anniversary. To avoid IRC 409A, the bonus could be structured as follows: a. The employee is entitled to the bonus if employed on the first anniversary or will forfeit 50%. Because employee must be employed when paid, the bonus will not be subject to IRC 409A. b. The second 50% will be paid on or before March 15, Because the bonus is paid in the short-term deferral period, it will not be subject to IRC 409A. 2. Annual bonus. If the bonus is earned in one year but not paid until another taxable year, it will be subject to IRC 409A unless an exception applies. To avoid IRC 409A, the bonus could be structured as follows: a. The employee is entitled to the bonus if employed on day bonus is paid. Because employee must be employed when paid, it will not be subject to IRC 409A b. Employee entitled to bonus if employed on last day of year. If paid on or before March 15 of the year following the year in which the bonus is awarded, the arrangement is not subject to IRC 409A. However, if the bonus is not payable until sometime after March 15, the arrangement is subject to IRC 409A. 3. Retention bonus. If the bonus is earned in one year but not paid until another taxable year, it will be subject to IRC 409A unless an exception applies. For example, assume an employment agreement provides that the employee will receive a retention bonus on January 1, 2015 (payable no later than March 15, 2015), provided that the employee remains employed through December 31, This arrangement is not subject to IRC 409A because the benefit is forfeited if not employed on December 31, 2014 and is paid within the short-term deferral period if employed on such date. 4. Pension benefits. Qualified plans providing pension benefits are exempt from IRC 409A. Non-qualified deferred compensation plans are subject to IRC 409A. 5. Continued pay and/or benefits upon a separation from service. See Section III below. III. Separation Pay Plans 409A Considerations A. Separation Pay Plans Meeting the Following Requirements are Not Subject to IRC 409A: 1. A collectively bargained separation pay plan that provides for separation pay only upon an involuntary separation from service or pursuant to a window program. 6

7 2. A separation pay plan that provides for separation pay only upon an involuntary separation from service (follow the IRC 409A definition of "separation from service") under a separation pay plan or as a result of voluntary or involuntary participation in a window program if the separation pay: a. Does not exceed the lesser of two times the employee s annual pay or the IRC 401(a)(17) limit ($500,000 for 2012), and b. Is paid no later than end of second year after separation from service. 3. An involuntary separation from service requires independent authority of the employer to terminate the employee s services where the employee was willing and able to continue performing services. This includes the failure to renew a contract. Treas. Reg A-1(n)(1). 4. An involuntary separation from service may include an employee's voluntary separation from service for "good reason." The plan must define what actions constitute good reason and must require actions by the employer resulting in a material negative change to the employee's employment, such as the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. The IRC 409A regulations provide a good reason safe harbor definition. Treas. Reg A-1(n)(2). 5. A separation pay plan (including a plan providing payments upon a voluntary separation from service) may include the following: (i) reimbursements of business expenses that would otherwise be deductible by the employee and (ii) reasonable outplacement expenses and moving expenses (including loss on sale of home). Expenses must be incurred by the last day of the second taxable year following the year of separation from service, and reimbursements must be paid by the end of the third taxable year. In addition, a separation plan may provide for the reimbursement of medical expenses, but only for the maximum COBRA period (generally, 18 months in the event of separation from service). Other payments are also permitted to the extent they do not exceed the dollar limit under IRC 402(g)(1)(B) ($17,000 for 2012). Treas. Reg A-1(b)(9). B. Drafting Tips to Avoid IRC 409A 1. Subject any payments of deferred compensation to a substantial risk of forfeiture (for example, employee must be employed on date of payment or entitlement to payment is conditioned on the employee's involuntary separation from service without cause) and make payment on or before 2-1/2 months after end of year that compensation is earned (short-term deferral). 2. Pay under a "separation pay plan meeting" the IRC 409A requirements (two times pay, payable in two years). 3. If the aggregate amounts payable under an exempt separation pay plan do not exceed $17,000 (in 2012), the agreement is not subject to IRC 409A. 7

8 4. Example: University B is negotiating a severance provision in an employment agreement that provides for a payment of $100,000 upon the employee's involuntary separation from service without cause. To avoid IRC 409A, the agreement could provide that payments will be made in installments over two years with all payments being made by the end of the second year following separation or that the entire amount will be paid by March 15 of the year after separation from service. If the amount in the above example was $500,000, the University could pay $500,000 in installments over two years, and pay the remaining $100,000 by March 15 of the year following the year of separation (designating these as separate payments), or pay the entire amount by March 15 of the year following separation from service. C. Separation Pay Plans Subject to IRC 409A. If can t avoid IRC 409A, make sure agreement is in writing, provides specific payment terms, follows timing rules for any expense reimbursements and do not permit changes in the terms except as permitted by IRC 409A. D. Payments Contingent on a Release. If agreement is subject to IRC 409A, the payment date must be specified and the employee may not be able to designate the year of payment. An issue arises if the agreement provides that payment won't be made until the employee signs and does not revoke a release of claims because the consideration and revocation period may extend over two taxable years. IRS Notice Example: An employee terminated in late November 2012 could choose to delay the timing of his benefits by waiting to sign the release until January The IRS views this as a problem under IRC 409A because the payment trigger is the execution of the release (not the separation from service), which is not a permissible payment event under IRC 409A, and the employee is able to control the tax year in which the payment is made. 2. Suggestions in drafting: a. Avoid IRC 409A by making sure that the consideration and revocation period fall within the short-term deferral period. b. If separation agreement is subject to IRC 409A, the release language may not provide the employee with an election as to the timing of benefit payments. Following are design alternatives: i. Later year approach. Payment will be made during a specified period not longer than 90 days following separation from service and, if payment may cross tax years, payment will be made in the later tax year, regardless of when the employee signs the release. ii. Fixed date. Payment will be made upon a fixed date either 60 or 90 days following separation from service (for example, payment will 8

9 be made on the 90th day after separation from service, provided the release has become final; otherwise, forfeit). iii. Payment in specified year (year after termination). 3. Under voluntary correction programs, employers have until December 31, 2012 to correct non compliant agreements. IRS Notice IV. IRC 457(f) Plans 409A Considerations A. IRC 457 Plans. Two types of tax deferred retirement plans permitted under IRC 457: 1. Eligible plans under IRC 457(a) are exempt from IRC 409A. 2. Ineligible plans under IRC 457(f) are subject to IRC 409A. B. I neligible plans under I R C 457(f) ar e subject to both I R C 457(f) and I R C 409A 1. IRC 457(f). Amounts are included in taxable income when no longer subject to a substantial risk of forfeiture. Under IRC 457(f), amounts are subject to a substantial risk of forfeiture if the rights in the compensation are conditioned upon the future performance (or refraining from performance) of substantial services by any person. Under IRC 457(f), the following may be recognized as a substantial risk of forfeiture: a. A non-compete agreement. b. A consulting agreement. c. An extension of the period during which the risk of forfeiture (called a "rolling risk of forfeiture"). d. The IRS has proposed changing this definition to the same definition that applies under IRC 409A. 2. IRC 409A. An agreement is not subject to IRC 409A if amounts are paid within the short-term deferral period (2-1/2 months following the year in which the amount is no longer subject to a substantial risk of forfeiture). Under IRC 409A, a right to an amount of compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned upon the refraining from the performance of service. a. A non-compete agreement will not be effective to postpone the date on which a substantial risk of forfeiture lapses; plans using this technique will not qualify for the short-term deferral exception. 9

10 b. The addition of any risk of forfeiture after the right to the compensation arises, or any extension of a period during which compensation is subject to a risk of forfeiture (a rolling risk of forfeiture ), is disregarded for purposes of determining whether the compensation is subject to a substantial risk of forfeiture under IRC 409A. Therefore, a plan using a rolling risk of forfeiture will not be able to rely on the short-term deferral rule and any extension of the risk coupled with a delay in payment must satisfy the IRC 409A deferral extension rules. c. Example: College U hires Employee R under a five-year employment contract expiring on December 31; payment of deferred compensation is payable on December 31, if employed on December 31, In September of 2015, R negotiates an additional five-year renewal of his employment contract and a related five-year extension of the substantial risk of forfeiture that will end on December 20, The substantial risk of forfeiture for purposes of IRC 409A is on December 31, 2015 (the requirement that R keep working until December 31, 2020 will be ignored). Therefore, the agreement will not fall within the short-term deferral exception and will be subject to IRC 409A. Because the extension will likely violate IRC 409A, benefits become immediately taxable (including the 20% penalty and interest) pursuant to IRC 409A. V. Settlements 409A Considerations. Legal settlements resolving bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or worker's compensation statutes. Treas. Reg A-1(b)(11). The regulations do not define bona fide legal claim, and it isn t clear what types of claims constitute a bona fide legal claim, particularly where a claim has not actually been filed in court. VI. Annualized Pay 409A Considerations A. Avoiding IRC 409A. Some universities and colleges require professors to work during the academic year (typically 9 or 10 months) but pay them over a full 12 month period. To avoid IRC 409A issues, such an arrangement must meet the following requirements: 1. The arrangement must not defer payment of any of the part year compensation beyond the 13th month following the beginning of the service year. 2. The arrangement must not defer from one taxable year to another taxable year an amount in excess of $17,000 (in 2012). B. Annualized Pay Subject to IRC 409A. If IRC 409A cannot be avoided (because, for example, the professor's salary is too high to satisfy the $17,000 limit), the arrangement must meet the following requirements: 1. The arrangement must specify the timing of payments (for example, in accordance with the 12 month normal payroll schedule). 10

11 2. Benefits may not be accelerated. 3. If an employee has an election to spread compensation over 12 months, the election must be in writing, made before the beginning of the work period (for example, before the first day of the school year for which the teacher is paid) and irrevocable. 4. The employee's election may remain in effect until changed. IRS Notice VII. Education Benefits How to Provide Tax Free A. Qualified Tuition Reduction (IRC 117(d)) 1. Universities and colleges may offer tuition reduction or remission to employees and their family members. a. Applies to education organizations that normally maintain a regular faculty and curriculum and normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. b. Courses may be taken at the organization offering the reduction or at another institution offering reciprocal privilege. c. There is no dollar limit on the amount that may be excluded from income. 2. Reduction must be for undergraduate education. However, if the individual is a graduate student of the organization and is engaged in teaching or research activities for the organization, reduction can apply to graduate courses. IRC 117(d)(4). 3. Reduction may be provided for employees, spouses and/or dependents of employees and certain former employees. IRC 117(d)(2), 132(h). Reduction may be provided for former employees who separated from service due to retirement or disability. a. Reduction may be provided to a widow or widower of an employee who died while employed or after separation from service due to retirement or disability. b. To exclude coverage for a spouse, the spouse must be of the opposite sex and legally married to the employee. c. Benefits for same sex domestic partners will be included in income unless the domestic partner is considered a dependent under the Internal Revenue Code. d. To exclude coverage for a dependent, the dependent must be a dependent under the Internal Revenue Code. 11

12 4. Reduction is excluded from the income of highly compensated employees only if the plan does not discrimination in favor of such employees. IRC 117(d)(3). a. For 2012, an employee is highly compensated if he/she earned more than $115,000 during 2011 and, if the employer elects, was in the top 20% of employees when ranked on the basis of compensation during The dollar amount is adjusted for cost of living changes. b. A plan will be considered to not discriminate in favor of highly compensated employees if the reduction is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer that does not discriminate in favor of highly compensated employees. B. Education Assistance Program (IRC 127) 1. Employees may exclude from income amounts paid for qualified educational assistance that meet the requirements of IRC 127. Payments may be for undergraduate or graduate level courses and do not have to be for work-related courses. Income exclusion is limited to $5,250 per year. 2. To qualify, the program must meet the following requirements: a. There must be a written plan. IRC 127(b)(1), Treas. Reg (b). b. Benefits must be provided to employees (former employees may participate). IRC 127(c)(2), Treas. Reg (d). c. Benefits must be for qualifying educational expenses only, including tuition, fees and similar expenses, books, supplies and equipment. The following expenses may not be reimbursed: tools or supplies that may be retained by the employee after completion of a course, meals, lodging or transportation and courses involving sports, games or hobbies. IRC 127(c)(1), Treas. Reg (c). d. The plan may not discriminate in favor of highly compensated employees or their dependents (IRC 127(b)(2)) or provide more than 5% of total benefits in any year to more-than-5% owners of the employer (IRC 127(b)(3)). Union employees may be excluded from this determination.; e. Employees must be notified of the program. IRC 127(b)(6); Treas. Reg (g). C. Work Related Educational Expenses (IRC 162). Must meet one of following tests: 1. Education is required by employer or by law to keep the employee's present salary, status or job and must serve a bona fide business purpose of employer. 2. Education maintains or improves skills needed in present work. (e.g., refresher courses, courses on current developments, academic courses). 12

13 3. Education may not be part of a program that will qualify the employee for a new trade or business. Education needed to meet the minimum educational requirements for present job does not qualify. VII. Miscellaneous Fringe Benefits A. General rule. "Gross income means all income from whatever source derived including (but not limited to) compensation for services, including fees, commissions, fringe benefits and similar items " IRC 61. B. Non-taxable Fringe Benefits. IRC 132 provides for certain tax-free fringe benefits. Currently, IRC 132 excludes the following: 1. No-additional-cost services. Services provided to employees that are offered for sale to customers in ordinary course of business and employer incurs no substantial additional cost in providing the service to the employee. Nondiscrimination rules apply. 2. Qualified employee discounts. Employee discounts of property or services to the extent the discount does not exceed (a) in the case of property, the gross profit percentage of the price at which the property is offered to customers, and (b) in the case of services, 20% of the price at which the services are offered to customers. Nondiscrimination rules apply. 3. Working condition fringes. Any property or service provided to an employee to the extent that, if the employee paid for such property or service, the payment would be allowed as a deduction under IRC 162 or 167. Common examples: a. Cellular Telephones. To the extent an employer-provided or employer-paid phone is used for business purposes, the value of the benefit may be excludable as a working condition fringe. Personal use may be excluded from income as a de minimis fringe benefit, so long as the phone is provided primarily for non-compensatory business purposes and certain related requirements are met. Examples of non-compensatory purposes include the need to be accessible to the employer at any time for work-related emergencies, or to be accessible to clients outside of normal business hours or when away from the office. A cell phone is not provided primarily for non-compensatory business purposes if it is provided to promote good will of an employee. to attract new employees, or to provide additional compensation to an employee. b. Employer provided home computers. If deductibility rules of 162 are met, don't include in income. Employer must determine value of any personal use and include such value in the employee's income. Must substantiate business use. 4. De minimis fringes. Any property or service the value of which is (after taking into account the frequency provided) so small as to make accounting for it 13

14 unreasonable or administratively impractical. Examples: occasional sporting event tickets and gifts of low fair market value. Cash and cash equivalents (i.e., gift cards) are not de minimis fringe benefits. 5. Qualified transportation fringes. Includes: (a) transportation in a commuter highway vehicle ($125 month in 2012), (b) transit pass ($125 month in 2012), (c) qualified parking ($240 month in 2012) and (d) qualified bicycle commuting reimbursement ($20 month in 2012). 6. Qualified moving expense reimbursements. Any amount received by an individual from an employer as a payment for (or a reimbursement of) expenses that would be deductible as moving expenses under IRC 127 if directly paid or incurred by the individual. 7. Qualified retirement planning services. Any retirement planning advice or information provided to an employee and spouse by an employer maintaining a qualified employer plan. Nondiscrimination rules apply. 8. Some on-premise athletic facilities. The facilities that qualify for exclusion under must: (a) they must be athletic facilities; gyms, and the applicable regulations state that the exclusion applies to other athletic facilities such as a pool, tennis court, or golf course, (b) be located on the premises of the employer, (c) be operated by the employer; and (d) substantially all of their use must be by employees, spouses, and their dependent children. 14

15 TOP 10 TAX ISSUES THAT NON-TAX EMPLOYMENT LAWYERS SHOULD KNOW June 27 30, 2012 Joseph R. Irvine 1 The Ohio State University I. Taxability and Reporting of Settlements and Judgments A. Gross Income 1. Defined in IRC 61 to include all income from whatever source derived. 2. Exclusions from gross income must be strictly construed. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955); Badaracco v. Commissioner, 464 U.S. 386, (1984). 3. Burden is on taxpayer to prove an exclusion from gross income. See Greer v. U.S., 207 F.3d 322 (6th Cir. 2000). B. Settlement v Judgment Irrelevant whether litigation (or the threat of litigation) is settled through adjudication or by agreement among the parties. See Longino Estate v. Commissioner, 32 T.C. 904 (1959); Sager Glove Corp. v. Commissioner, 36 T.C. 1173, aff d, 311 F.2d 210 (7 th Cir. 1962). C. Taxability of Settlements and Judgments 1. Amounts recovered by either settlement or judgment are taxed based on the nature of the claims resolved. See U.S. v. Gilmore, 372 U.S. 39 (1963). 2. If a litigant is paid compensatory damages that would have otherwise been fully taxable but for the harm caused by the defendant, the recovery is still fully taxable. a) If taxpayer sues employer to recover additional compensation, the recovery is fully taxable just as if it were paid to taxpayer as wages. See McKim v. Commissioner, T.C. Memo b) If a recovery is intended to compensate a taxpayer for damage to a capital asset, then gain is recognized only to the extent the taxpayer s basis in the asset (generally the asset s cost) is exceeded. 3. Gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. IRC 104(a)(2). a) If a taxpayer recovers $1M in damages for physical injuries, the entire amount (assuming there are no punitive damages) would be excludable from gross income. 1

16 b) No need to file a formal claim in order for a recovery to be excludable under IRC 104(a)(2). See Taggi v. U.S., 35 F.3d 93 (2d Cir. 1994). 4. Punitive Damages Punitive damages, even those paid on account of personal physical injury or physical sickness, are fully taxable. See IRC 104(a)(2); O Gilvie v. U.S., 519 U.S. 79 (1996). 5. Emotional Distress Recoveries a) Emotional distress recoveries are excludable from gross income only if there is a related personal physical injury or physical sickness. b) Absent a related personal physical injury or physical sickness, emotional distress recoveries are fully taxable. 6. Taxation of Interest Pre-judgment and post-judgment interest are fully taxable, even where the remainder of the recovery is excludable under IRC 104(a)(2). See Kovacs v. Commissioner, 100 T.C. 124 (1993), aff d, 25 F.3d 1048 (6 th Cir. 1994); TAM ; IRC 61(a)(4). 7. ERISA Settlement a) Payments received in an ERISA settlement have been found to be taxable wages. See Mayberry v. U.S., 151 F.3d 855 (8 th Cir. 1998). (1) Wages included any payments made in the entire employer-employee relationship not otherwise specifically excluded. (2) Amounts received to replace what would have been nontaxable fringe benefits may be nontaxable. (3) Examples: (a) Health insurance (b) Working condition fringe benefits (c) Qualified transportation fringes (d) Dependent care assistance 8. Common Examples of Taxable Recoveries a) Defamation; b) Discrimination based on race, age, or sex; c) Wrongful termination; d) ADA recoveries; e) ERISA recoveries; f) Lost profits; g) Fraud; 2

17 h) Breach of Fiduciary Duty; i) Negligence; and j) False Claims Act recoveries. 9. Allocation of Recoveries a) If a claim includes personal injury and other damages, allocation will be recognized if entered by the parties in an adversarial context, at arms length, and in good faith. b) However, allocations by the parties will not always be respected: (1) In LeFleur v. Commissioner, T.C. Memo , the Tax Court upheld a reallocation of settlement proceeds done by the IRS. (2) The settlement had allocated a large amount to emotional distress (nontaxable at the time of the settlement); however, that amount was reallocated and became taxable. (3) The Court stated: " We conclude that petitioner suffered no injury to his health that could be attributed to the actions of the defendants, and we are not persuaded that such injury was the basis of any payment to him " 10. IRS Guidance a) Market Segment Specialization Program Lawsuits Awards and Settlements (11/00). b) Office of Chief Counsel Memorandum October 22, c) Publication 957. d) Lawsuits, Awards, and Settlements Audit Technique Guide (2011). 11. Reporting Obligations a) Nontaxable payments no reporting. b) Taxable payments that are not wages Form c) Taxable wages Form W-2. D. Payments to Attorneys 1. If check is jointly payable to plaintiff and attorney report to both plaintiff and attorney 2. Report gross wages on Form W-2 3. Report net payment amount on Form Example: a) Plaintiff receives $500,000 settlement, but $150,000 is withheld for taxes. b) $500,000 is reported on Form W-2. 3

18 c) $350,000 is reported on Form Payments to Multiple Attorneys a) Report with Form 1099 to attorney who actually received the check. b) If plaintiff received the check, report with Form 1099 to attorney who is named first. 6. Attorney Fees in Settlement of an Action Under a Fee Shifting Statute a) IRS believes whether such fees are wages is an open question. b) Example would be a lawsuit for back pay under Title VII. E. Physical Injury and Emotional Distress 1. If there is a physical injury, payments for emotional distress related to the injury are also excludable. 2. In Rev. Rul , an individual s lump-sum payment for physical injury and lost wages was all held to be excludable from gross income. The payment was not from the taxpayer s employer. 3. In Rev. Rul. 61-1, the entire amount received by an employee in a settlement of claims against his employer was excludable from gross income even though it included amounts for lost wages. F. Calculation of Employment Taxes. Employment taxes are calculated based on the year of the payment rather than the year wages would have been payable. See Cleveland Indians Baseball Co. v. U.S., 532 U.S. 200 (2001). G. Summary Table 4

19 H. Payments Deferred Until Later Years Generally, unless there is a substantial risk of forfeiture all amounts are taxable in the year of the settlement. The present value of all future payments would be taxable. I. Deduction for Attorneys Fees 1. Attorneys fees relating to purely personal matters (such as divorce) are generally not deductible. See U.S. v. Gilmore; IRC IRC 162 generally allows for the deduction of payments made in the ordinary course of business (including payments made to settle litigation claims or for attorneys fees). See United States Freight Co. v. U.S., 422 F.2d 887 (Ct. Cl. 1970). 3. The American Jobs Creation Act of 2004 amended IRC 62(a)(20) to provide for a deduction for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination. a) The deduction for attorneys fees cannot exceed the amount included in income. b) This can create problems if attorneys fees are paid in a year other than the year in which the income is received. c) Unlawful discrimination is defined in the code and includes a number of acts beyond traditional discrimination. II. Independent Contractor versus Employee A. Definition of an employee Restatement (First) of Agency 2. A servant (employee) is a person employed by a master to perform service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right to control by the master. B. Definition of an independent contractor. Restatement (First) of Agency 2. An independent contractor is a person who contracts with another to do something for him but who is not controlled by the other nor subject to the other's right to control with respect to his physical conduct in the performance of the undertaking. C. Internal Revenue Code and IRS Regulations 1. The IRC definition of employee in I.R.C. 3401(c) offers little guidance in distinguishing between employees and independent contractors. 2. Employee.--For purposes of this chapter, the term employee includes an officer, employee, or elected official of the United States, a State, or any political subdivision 5

20 thereof, or the District of Columbia, or any agency or instrumentality of any one or more of the foregoing. The term employee also includes an officer of a corporation. 3. However, the IRS regulatory definitions in 26 C.F.R (c)-1(b) provide more clarity. Generally the relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so. The right to discharge is also an important factor indicating that the person possessing that right is an employer. Other factors characteristic of an employer, but not necessarily present in every case, are the furnishing of tools and the furnishing of a place to work to the individual who performs the services. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, he is not an employee. D. Right to Control Test 1. In determining whether an individual is an employee or independent contractor, courts have generally relied on a list of factors to determine if the employer has control or a right to control. Clackamas Gastroenterology Associates, P. C. v. Wells, 538 U.S. 440 (2003); Rumpke v. Rumpke Container Serv., Inc., 240 F. Supp. 2d 768 (S.D. Ohio 2002); Sublett v. Edgewood Universal Cabling Sys., Inc., 194 F. Supp. 2d 692 (S.D. Ohio 2002) 2. Factors per Restatement (Second) of Agency 220 (1958): a) the extent of control which, by the agreement, the master may exercise over the details of the work; b) whether or not the one employed is engaged in a distinct occupation or business; c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision; d) the skill required in the particular occupation; e) whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person doing the work; f) the length of time for which the person is employed; g) the method of payment, whether by the time or by the job; h) whether or not the work is a part of the regular business of the employer; i) whether or not the parties believe they are creating the relation of master and servant; and j) whether the principal is or is not in business. 6

21 E. Internal Revenue Service 20 Factors Test 1. The IRS has identified 20 factors to guide businesses in classifying workers as employees or independent contractors. In Revenue Ruling 87-41, the IRS compiled 20 factors from common law and its own prior rulings. Under the following circumstances identified by the IRS, a worker would typically be an employee if: a) instructions are given to the worker b) training is provided to the worker c) the worker s services are integrated in the business d) the worker s services are rendered personally e) the worker is hired, supervised and paid by the company f) a continuing company-worker relationship exists g) the worker has set hours of work h) the worker s full-time services are required i) work is done on the company s premises j) there is an order or sequence set by the company for the worker k) the worker is required to submit reports l) the worker is paid by the hour, week or month rather than the task m) the worker is reimbursed for business and/or traveling expenses n) the employer furnishes the tools/materials o) no major investment is required by the worker p) the worker can t realize profit or loss q) the worker can t work for more than one firm at a time r) the worker is limited in making services available to the general public s) the company can discharge the worker t) the worker can terminate the employment 2. These factors are only meant as a guide by the IRS, and the ruling warns employers against excessive reliance on the factors. While all of the factors may help determine if an individual is an employee under common law, the importance of each factor will vary based on the job and other facts. F. Section 530 Safe Harbor 1. Employer penalties can be severe for misclassifying as an independent contractor, intentionally or not. The employer may be obligated to pay back taxes and contributions, including the employer's and employee's share of Medicare and Social Security, federal (and state) income taxes that should have been withheld, federal (and state) unemployment taxes, unemployment compensation taxes and workers' compensation benefits if the employee is injured on the job and was not covered 7

22 under workers' compensation. I.R.C. 3402(d) (failure to withhold), 26 I.R.C , 6682 (penalties) 2. To mitigate the burden of penalties, Congress enacted 530 of the Revenue Act of This act relieves some employers of FICA, FUTA and federal income tax withholding liabilities by providing them with a safe harbor, based on three criteria. III. Retirement Plans a) First, employers must have a reasonable basis for their classification of a worker as an independent contractor by: (1) relying on judicial precedent, published rulings, technical advice, or a letter ruling to that taxpayer; (2) relying on a past IRS audit in which no employment tax was assessed for individuals in positions substantially similar to the one in question; or (3) showing a long-standing recognized practice of classifying such a worker as an independent contractor in a significant segment of the industry in which such individual was engaged. b) Second, the company must also show that there has been substantial consistency in its treatment of workers (i.e., that they have consistently retained workers in similar positions as independent contractors). c) Third, employers must demonstrate reporting consistency (e.g., that 1099 IRS forms were filed for these individuals when required). A. Retirement plans are authorized by several sections of the Internal Revenue Code, including: 1. IRC 401(a) qualified pension, profit-sharing and stock bonus plans 2. IRC 403(b) annuity plans for certain employees of 501(c)(3) organizations or public schools 3. IRC 457 deferred compensation plans of state and local governments and taxexempt organizations 4. IRC 401(k) - retirement savings plan B. Contributions by an employer to the plan in a given year are deductible by the employer in that year. See IRC 404(a). C. Any contributions or earnings from contributions are not subject to tax until actually distributed to the employee. See IRC 402(a). The contribution and earnings are part of the plan trust, which is tax-exempt. See IRC 501(a). D. Qualified plans under 401(a). 8

23 5. Entire principal of the plan trust must be for exclusive benefit of participating employees or their beneficiaries. IRC 401(a)(2). Creditors of employer cannot reach the assets of the plan trust. 6. Plan cannot discriminate in favor of highly compensated employees. IRC 401(a)(4). Highly compensated employee for 2012 has an income greater than or equal to $115,000. See IRC 414(q). State universities are exempt from the discrimination rules. 7. Plan trust must satisfy minimum vesting standards. IRC 401(a)(7). Among other requirements, employee s interest in trust benefits must be nonforfeitable upon attainment of normal retirement age. See IRC 411(a). 8. Plan must provide for benefits to be paid in the form of a qualified joint and survivor annuity. IRC 401(a)(11)(A). Applies to all defined benefit plans and many defined contribution plans. See IRC 401(a)(11)(B). 9. Amount of each employee s compensation that may be taken into account under the plan may not exceed $250,000 for See IRC 401(a)(17). 10. Annual contributions are limited. $50,000 for Plans may be either defined contribution plans or defined benefit plans. E. Plans under 403(b). 1. Annuity contract must be purchased by an employer that is either tax-exempt under IRC 501(c)(3), a qualified educational organization, or a state, a political subdivision of a state, or any agency or instrumentality of a state. See IRC 403(b)(1)(A). 2. Employee contributions must be fully vested at all times; however, employer contributions may be subject to a vesting schedule. 3. Nondiscrimination requirements similar to those of qualified plans under IRC 401(a) must be met. See IRC 403(b)(12). State colleges and universities are exempt from the nondiscrimination rules. 4. Employer and employee contributions in a given year are not included in the employee s gross income for that year as long as such contributions do not exceed $50,000 for See IRC 403(b)(1). 5. Maximum amount that may be deferred by employee each year must not exceed the lesser of 100% of the employee s includible compensation or $17,000 for Any amount actually distributed to an employee in a certain year is subject to tax under IRC 72 (dealing with annuities). 7. Distribution rules similar to 457(b) below. 8. Individuals age 50 and older may elect to contribute an additional $5,500. 9