Tax Court: Deferred Compensation Triggers Self-Employment Tax

Generally, as long as certain requirements are met, taxes aren’t due until payments are made.

Mar 11th 2020
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A company may reward its executives and others by setting up a deferred compensation plan that pays out amounts in the future. But as evidenced in a new case involving an independent contractor, Dunlap, TC Memo 2020-10, 2/18/20, recipients may still owe self-employment tax on the deferred compensation payments.

Typically, a nonqualified deferred compensation plan is used to supplement a qualified retirement plan for employees like a 401(k). Comparable to a 401(k), the compensation that is deferred grows without any current tax erosion until payments are made a specified date—say, at retirement.

But the money can’t be made available to the employee or set aside for him or her. The employee is merely counting on the company’s “promise” to pay the amount that is due.

In other words, your client would run the risk that creditors could make a dent in the payout. Even worse, the company could go under.

Under the regulations relating to deferred compensation arrangements, the amount that is deferred must be treated as wages for payroll tax purposes at the later of the date when services are performed or there’s no longer a substantial risk of forfeiture.

In the new case, a taxpayer residing in Washington was employed as a national sales director for Mary Kay, the well-known manufacturer and distributor of cosmetic products. The taxpayer’s duties included recruitment of other sales directors and beauty consultants. Mary Kay has consistently treated its national sales directors as independent contractors.

National sales directors were eligible to participate in Mary Kay’s “Family Security Program” (FSP). Under this plan, the taxpayer’s tenure was scheduled to end at the retirement age of 65, at which point she was entitled to receive FSP payments for 15 years based on her highest average sales activities.

In 2006, the taxpayer began receiving FSP payments reflecting her work activities prior to reaching 65. These payments did not represent income that had previously been reported as gross income or income that was subject to self-employment tax.

Mary Kay had long maintained FSP payments were subject to self-employment tax when they were paid to retired national sales directors. It had previously indicated that the FSP was intended to be a nonqualified deferred compensation arrangement under the regulations and should be interpreted in this manner. In addition, due to legislative changes relating to nonqualified deferred compensation arrangements that were initiated in 2008, the FSP was amended to comply with those changes.

Now the Tax Court has ruled that the FSP payments were payments from a nonqualified deferred compensation plan subject to self-employment tax under the prevailing regulations. Notably, the Tax Court said that the FSP “is intended to be a non-qualified deferred compensation arrangement… and shall be construed and interpreted in accordance with such intent.”

The taxpayer argued that another regulation supported her position that the FSP was not a deferred compensation plan. But the Court noted that this regulation only applies to employees and thus is moot. There was no disagreement that the national sales directors were independent contractors.

Finally, the Court determined the annual FSP payments were related to the taxpayer's previous earnings and didn’t include any prior amounts subject to self-employment tax, even though the amounts were earned in prior years. Accordingly, the FSP payments are subject to self-employment tax.

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