New Rules on Nonqualified Deferred Compensation Plans Add Special Requirements for Employers and Taxpayers

New Rules on Nonqualified Deferred Compensation Plans Add Special Requirements for Employers and Taxpayers

General Information

Act 40 of 2005 changed the definition of constructive receipt for Pennsylvania Personal Income Tax purposes.  Specifically, the act’s new definition of constructive receipt adopts many of the provisions established by the Internal Revenue Code with respect to what to include and when to include certain deferrals of compensation as income for Pennsylvania Personal Income Tax purposes.  The Act also provided that distributions from nonqualified deferred compensation plans attributable to elective deferrals (and earnings thereon) are taxable at the time of the distributions irrespective of retirement.

Employer Requirements

For tax years before 2005:

Employers who have nonqualified deferred compensation plans that provide for elective deferrals need to provide plan participants with a letter establishing the amount of elective contributions previously included in Pennsylvania taxable income so that plan participants have an acceptable record of their elective deferrals.  The letter should set forth (for each taxable year of elective deferral between July 1, 1971 and December 31, 2004) amounts of elective deferrals of compensation to nonqualified deferred compensation plans that were not taxable for Federal income tax purposes (Box 1 of the W-2), but were included in Medicare Wages (Box 5 of the W-2) and in Pennsylvania taxable wages (Box 16 of the W-2) and were subject to withholding.

For tax year 2005:

Employers should also provide a letter to their plan participants that outlines amounts included in Box 11 of the W-2 that are attributable to: 1) nonqualified deferred compensation plan deferrals that were included in Medicare wages as a result of the amount no longer being subject to a substantial risk of forfeiture for prior year services; or 2) earnings from prior year deferrals not previously included in Medicare wages.  The letter should set forth the value of each of these amounts.

For tax years after 2005:

Employers that have nonqualified deferred compensation plans for employees and directors must use Box 14 of the W-2 form to indicate additional information regarding these plans in cases where: 1) the employee had a deferred amount of nonqualified deferred compensation that was included in Medicare wages as a result of the amount no longer being subject to a substantial risk of forfeiture (for prior year services); 2) the employee had a distribution from the nonqualified deferred compensation plan; 3) the employee had a distribution from the nonqualified deferred compensation plan when the employee had a deferral for prior year services and a distribution in the same year; or 4) the employee had earnings from prior year deferrals not previously included in Medicare wages.  Employees with only a deferral of nonqualified deferred compensation that is included in Medicare wages that are not subject to a substantial risk of forfeiture for current year services are required by the IRS to have this amount shown in Box 12 of the W-2 with a code Y and do not need to complete Box 14 of the W-2. 

Employees who have a deferral of compensation that is included in Medicare wages as a result of the amount no longer being subject to a substantial risk of forfeiture (for prior year services) should have that amount shown in Box 14 of the W-2 along with the code YN.  Employees who have a distribution of nonqualified deferred compensation should have that amount shown in Box 14 of the W-2 along with a code YT.  Employees who have had a deferral for prior year services and a distribution in the same year should have both the amounts shown in Box 14 of the W-2.  The deferral for prior year services will have a code YN next to that amount and the distribution will have a code YT next to that amount.  Employees who have earnings from prior year deferrals not previously included in Medicare wages should have these amounts shown in Box 14 of the W-2 with the code ZN.

Chart for New PA Codes in W-2 Box 14 for Nonqualified Deferred Compensation Plan

Code When to use:
 - Deferrals under Nonqualified Deferred Compensation (NQDC) plans (coded as a Y in Box 12 of the W-2).
YN Deferrals under a NQDC plan included in social security and Medicare wages as a result of the amount no longer being subject to a substantial risk of forfeiture and are for prior year services.
YT Distributions from a NQDC plan included in Box 1 of the W-2.
ZN

Earnings from prior year deferrals now included in social security and Medicare wages.

Withholding requirements

When distributions exceed the amount of elective deferrals previously taxed by the Commonwealth, inclusion of the amounts in Pennsylvania taxable compensation and withholding on the excess is required.  Employers are required to withhold PA Personal Income Tax from nonqualified deferred compensation plan distributions when payment is made to employees (except for distributions of deferrals for taxable years prior to January 1, 2005, if the deferrals were previously included in Pennsylvania taxable compensation).

Taxpayer Requirements

Amended returns for tax years between 2003 and 2005:

Taxpayers do not have to file amended returns for tax years between 2003 and 2005.  Taxpayers who paid tax on elective deferrals of nonqualified deferred compensation for such years will not be subject to tax on such deferrals when such amounts are distributed from the nonqualified deferred compensation plan.  However, if a taxpayer elects to do so, amended returns can be filed to remove the elective deferrals of nonqualified deferred compensation plans previously included in Pennsylvania taxable compensation from such taxable compensation.  As a result, special processing procedures and supporting documentation are needed to establish and validate the reduction to compensation.  Therefore, the Department of Revenue will require that taxpayers, who amend their returns and remove the deferrals from Line 1a, Gross Compensation, of the PA-40 return, write the words “Deferred Compensation” across the top of the amended return.  They must also provide a copy of the letter to them from their employer establishing the amount of deferrals previously included in Pennsylvania taxable compensation for each tax year along with a copy of the original W-2 from their employer.  Taxpayers with distributions and deferrals within the same tax year should also include a worksheet with their amended return reconciling the Federal wages (Box 1) shown on their W-2 to the Medicare wages (Box 5) on their W-2 as well as to their PA wages (Box 16) on their W-2 by clearly indicating on that schedule each category of compensation included in each of the three aforementioned areas.  The PA-W-2 Reconciliation Worksheet is a new form developed by the Department to provide a standard format for the information required. Click here for a link to the PA-40 W-2 Reconciliation Worksheet .  

For tax year 2005:

The PA-40 W-2 Reconciliation Worksheet should be included with taxpayers’ returns if they have not yet filed their 2005 returns.  This worksheet should indicate whether the amount is due to a distribution or as a result of the amount no longer being subject to a substantial risk of forfeiture for prior year services and/or from earnings from prior year deferrals.  The worksheet will also indicate whether any distributions were previously taxed as Pennsylvania compensation.  Taxpayers should also obtain a letter from their employer indicating each of these amounts as previously discussed in the employer section of this article.  For taxpayers who have already filed their returns for 2005, the Department will request PA-40 W-2 Reconciliations on an as needed basis.

For tax years after 2005:

Taxpayers whose employers do not include codes in Box 14 of their W-2s may be requested to provide additional information and reconciliations of PA Gross Compensation if there is an amount reported in Box 11 of the W-2 or if the Department is not able to reconcile the PA wages with Medicare and/or Federal wages from their W-2 forms.  If an employer does not provide the new codes in Box 14 of the W-2, the PA-40 W-2 Reconciliation Worksheet should be provided with the return.

Any taxpayer who receives distributions from their nonqualified deferred compensation plans must include the distributions from nonqualified deferred compensation plans in their Pennsylvania Gross Compensation to the extent that they have not already paid tax on their deferrals.  Taxpayers who have already paid tax on any deferrals should complete the PA-40 W-2 Reconciliation Worksheet and include it with their return along with a copy of the letter from their employer indicating the amounts previously taxed.

Proof deferrals were previously taxed:

In addition to the letter from their employers showing the amounts previously included in Pennsylvania compensation, taxpayers may also be requested to provide proof that the deferrals were previously taxed.  Proof of tax paid may include, but may not necessarily be limited to: copies of W-2s for the tax years showing the deferrals were included in Pennsylvania compensation; copies of the tax returns for the tax years showing the amount included in the reported gross compensation for those tax years; copies of any Departmental assessments showing that the compensation amount reported for the taxpayer was adjusted by the Department to included the deferred amount; and copies of any amended returns including or excluding the compensation from taxation.

Important:   Taxpayers and practitioners should keep the above listed tax records and all other related tax records for deferrals of compensation (or other contributions to retirement plans) indefinitely with their permanent tax records for purposes of documenting their recoverable costs and previously taxed contributions and deferrals.

For additional information regarding the taxation of Deferred Compensation, please see PA Personal Income Tax Bulletins 2005-03 and 2005-04 available on our Website at www.revenue.state.pa.us.