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Taking employee benefits to the next level with an NQDC plan

Does your organization offer a 401(k) plan to its employees? This is a common fringe benefit for the rank and file. However, some employers might want to take their benefits packages to the next level by offering special options to key employees. In such cases, a nonqualified deferred compensation (NQDC) plan could fit the bill.

Qualified vs. nonqualified

When it comes to understanding the concept of an NQDC plan, be sure to first know the difference between a qualified and nonqualified plan.

Under a qualified plan, so long as the employer follows various tax law requirements, its contributions are deductible when made and payments to participants are guaranteed. A 401(k) is a type of qualified deferred compensation plan.

With a nonqualified plan, participants rely on the employer’s promise to pay out the benefits at a specified date — but there are no guarantees. Participants run the risk that the organization might run out of money before any dollars are paid out.

This is because a key design component of most NQDC plans is that they’re “unfunded.” The employer can’t set aside money to fund the plan. A mitigating factor for participants, though, is that they’ll owe no tax on the deferred compensation until they receive it.

No more “haircuts”

Usually, employers intend to preserve tax deferral until payments are made to participants when they retire. That’s why NQDC plans are typically designed to be unfunded.

However, because of changes to tax law and accompanying regulations, certain restrictions now apply to the timing of NQDC plan distributions. If a plan doesn’t meet the requirements, the deferred compensation could become currently taxable. Specifically, funds can’t be distributed before:

  • Separation from service (plus an extra six months for key employees of publicly traded companies),
  • Death or disability,
  • A date specified by the participant at the time of deferral (or per a fixed schedule elected by the participant),
  • A change in control (subject to IRS guidance), or
  • The occurrence of an unforeseeable emergency.

Thus, subject to limited exceptions, NQDC plans can no longer include what are sometimes called “haircut” provisions that allow participants to receive accelerated distributions in exchange for paying a penalty.

Complex arrangements

As you can see, NQDC plans are complex. There are many potential tax pitfalls, so an employer considering one should first learn the rules and be prepared for compliance challenges. Our firm can help you decide whether an NQDC plan is right for your organization.

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The tax obligations if your business closes its doors

Sadly, many businesses have been forced to shut down recently due to the pandemic and the economy. If this is your situation, we can assist you, including taking care of the various tax responsibilities that must be met.

Of course, a business must file a final income tax return and some other related forms for the year it closes its doors. The type of return to be filed depends on the type of business you have. Here’s a rundown of the basic requirements.

Sole proprietorships.  You’ll need to file the usual Schedule C, “Profit or Loss from Business,” with your individual return for the year you close the business. You may also need to report self-employment tax.

Partnerships. A partnership must file Form 1065, “U.S. Return of Partnership Income,” for the year it closes. You also must report capital gains and losses on Schedule D. Indicate that this is the final return and do the same on Schedule K-1, “Partner’s Share of Income, Deductions, Credits, etc.”

All corporations. Form 966, “Corporate Dissolution or Liquidation,” must be filed if you adopt a resolution or plan to dissolve a corporation or liquidate any of its stock.

C corporations.  File Form 1120, “U.S. Corporation Income Tax Return,” for the year you close. Report capital gains and losses on Schedule D. Indicate this is the final return.

S corporations. File Form 1120-S, “U.S. Income Tax Return for an S Corporation,” for the year of closing. Report capital gains and losses on Schedule D. The “final return” box must be checked on Schedule K-1.

All businesses. Other forms may need to be filed to report sales of business property and asset acquisitions if you sell your business.

Employees and contract workers 

If you have employees, you must pay them final wages and compensation owed, make final federal tax deposits and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes can result in full personal liability for what’s known as the Trust Fund Recovery Penalty.

If you’ve paid any contractors at least $600 during the calendar year in which you close your business, you must report those payments on Form 1099-NEC, “Nonemployee Compensation.”

Other tax issues

If your business has a retirement plan for employees, you’ll want to terminate the plan and distribute benefits to participants. There are detailed notice, funding, timing and filing requirements that must be met by a terminating plan. There are also complex requirements related to flexible spending accounts, Health Savings Accounts, and other programs for your employees.

We can assist you with many other complicated tax issues related to closing your business, including debt cancellation, use of net operating losses, freeing up any remaining passive activity losses, depreciation recapture, and possible bankruptcy issues.

We can advise you on the length of time you need to keep business records. You also must cancel your Employer Identification Number (EIN) and close your IRS business account.

If your business is unable to pay all the taxes it owes, we can explain the available payment options to you. Contact us to discuss these issues and get answers to any questions.

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How disability income benefits are taxed

If you’ve recently begun receiving disability income, you may wonder how it’s taxed. The answer is: It depends.

The key issue is: Who paid for the benefit? If the income is paid directly to you by your employer, it’s taxable to you just as your ordinary salary would be. (Taxable benefits are also subject to federal income tax withholding. However, depending on the employer’s disability plan, in some cases they aren’t subject to Social Security tax.)

Frequently, the payments aren’t made by an employer but by an insurance company under a policy providing disability coverage. In other cases, they’re made under an arrangement having the effect of accident or health insurance. In these cases, the tax treatment depends on who paid for the insurance coverage. If your employer paid for it, then the income is taxed to you just as if it was paid directly to you by the employer. On the other hand, if it’s a policy you paid for, the payments you receive under it aren’t taxable.

Even if your employer arranges for the coverage (in a policy made available to you at work), the benefits aren’t taxed to you if you (and not your employer) pay the premiums. For these purposes, if the premiums are paid by the employer but the amount paid is included as part of your taxable income from work, the premiums will be treated as paid by you. In these cases, the tax treatment of the benefits received depends on the tax treatment of the premiums paid.

Illustrative example

Let’s say Max’s salary is $1,000 a week ($52,000 a year). Additionally, under a disability insurance arrangement made available to him by his employer, $10 a week ($520 annually) is paid on his behalf by his employer to an insurance company. Max includes $52,520 in income as his wages for the year ($52,000 paid to him plus $520 in disability insurance premiums). Under these facts, the insurance is treated as paid for by Max. If he becomes disabled and receives benefits under the policy, the benefits aren’t taxable income to him.

Now assume that Max includes only $52,000 in income as his wages for the year because the amount paid for the insurance coverage qualifies as excludable under the rules for employer-provided health and accident plans. In this case, the insurance is treated as paid for by the employer. If Max becomes disabled and receives benefits under the policy, the benefits are taxable income to him.

There are special rules if there is a permanent loss (or loss of the use) of a member or function of the body or a permanent disfigurement. In these cases, employer disability payments aren’t taxed, as long as they aren’t computed based on amount of time lost from work.

Social Security disability benefits 

This discussion doesn’t cover the tax treatment of Social Security disability benefits. They may be taxed to you under the rules that govern Social Security benefits.

Needed coverage

In deciding how much disability coverage you need to protect yourself and your family, take the tax treatment into consideration. If you’re buying the policy yourself, you only have to replace your “after tax” (take-home) income because your benefits won’t be taxed. On the other hand, if your employer is paying for the benefit, keep in mind that you’ll lose a percentage of it to taxes. If your current coverage is insufficient, you may want to supplement the employer benefit with a policy you take out on your own. Contact us if you’d like to discuss this issue.

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How do taxes factor into an M&A transaction?

Although merger and acquisition activity has been down in 2022, according to various reports, there are still companies being bought and sold. If your business is considering merging with or acquiring another business, it’s important to understand how the transaction will be taxed under current law.

Stocks vs. assets

From a tax standpoint, a transaction can basically be structured in two ways:

1. Stock (or ownership interest). A buyer can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership, or a limited liability company (LLC) that’s treated as a partnership for tax purposes.

The current 21% corporate federal income tax rate makes buying the stock of a C corporation somewhat more attractive. Reasons: The corporation will pay less tax and generate more after-tax income than it would have years ago. Plus, any built-in gains from appreciated corporate assets will be taxed at a lower rate when they’re eventually sold.

Under current law, individual federal tax rates are reduced from years ago and may also make ownership interests in S corporations, partnerships and LLCs more attractive. Reason: The passed-through income from these entities also will be taxed at lower rates on a buyer’s personal tax return. However, individual rate cuts are scheduled to expire at the end of 2025, and, depending on future changes in Washington, they could be eliminated earlier or extended.

2. Assets. A buyer can also purchase the assets of a business. This may happen if a buyer only wants specific assets or product lines. And it’s the only option if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes.

Note: In some circumstances, a corporate stock purchase can be treated as an asset purchase by making a “Section 338 election.” Ask your tax advisor for details.

What buyers and sellers want 

For several reasons, buyers usually prefer to purchase assets rather than ownership interests. Generally, a buyer’s main objective is to generate enough cash flow from an acquired business to pay any acquisition debt and provide an acceptable return on the investment. Therefore, buyers are concerned about limiting exposure to undisclosed and unknown liabilities and minimizing taxes after the deal closes.

A buyer can step up (increase) the tax basis of purchased assets to reflect the purchase price. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are sold or converted into cash. It also increases depreciation and amortization deductions for qualifying assets.

Meanwhile, sellers generally prefer stock sales for tax and nontax reasons. One of their main objectives is to minimize the tax bill from a sale. That can usually be achieved by selling their ownership interests in a business (corporate stock or partnership or LLC interests) as opposed to selling business assets.

With a sale of stock or other ownership interest, liabilities generally transfer to the buyer and any gain on sale is generally treated as lower-taxed long-term capital gain (assuming the ownership interest has been held for more than one year).

Keep in mind that other issues, such as employee benefits, can also cause unexpected tax issues when merging with, or acquiring, a business.

Get professional advice

Buying or selling a business may be the most important transaction you make during your lifetime, so it’s important to seek professional tax advice as you negotiate. After a deal is done, it may be too late to get the best tax results. Contact us for the best way to proceed in your situation.

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Paying tribute to auditor independence

In the spirit of Independence Day, it’s a good time to review the rules for auditor independence. If you discover potential issues now, there’s still plenty of time to take corrective action before next year’s audit begins.

Definition of independence

Independence is one of the most important requirements for audit firms. It’s why investors and lenders trust CPAs to provide unbiased opinions about the presentation of a company’s financial results. The AICPA and the Securities and Exchange Commission (SEC) have rules regarding auditor independence. Even the U.S. Department of Labor has issued independence guidance for auditors of employee benefit plans.

The AICPA specifically goes to great lengths to explain how audit firms can maintain their independence from the companies they audit. In short, auditors can’t provide any services for an audit client that would normally fall to the company’s management to complete. Auditors also can’t engage in any relationships with their clients that would 1) compromise their objectivity, 2) require them to audit their own work, or 3) result in self-dealing, a conflict of interest or advocacy.

Independence is a matter of professional judgment, but it’s something that accountants take seriously. A firm that violates the independence rules calls into question the accuracy and integrity of its clients’ financial statements.

Prohibited services

Under Rule 2-01 of Regulation S-X, the SEC specifically prohibits auditors from providing the following nonaudit services to a publicly traded audit client or its affiliates:

  • Bookkeeping,
  • Financial information systems design and implementation,
  • Appraisal or valuation services, fairness opinions or contribution-in-kind reports,
  • Actuarial services,
  • Internal audit outsourcing services,
  • Management functions or human resources,
  • Broker-dealer, investment advisor or investment banking services, and
  • Legal services and expert services unrelated to the audit.

This list isn’t exhaustive. Audit committees should consider whether any service provided by the audit firm may impair the firm’s independence in fact or appearance. SEC independence rules also prohibit audit firms and auditors from engaging in financial relationships with their public audit clients, such as contingent fees, banking, insurance, debtor-creditor arrangements, broker-dealer relationships and futures commission merchant accounts.

In the spotlight

In a recent statement, the SEC’s Acting Chief Accountant Paul Munter noted that current market conditions have caused many companies to engage in complex business arrangements, including restructurings and special purpose acquisition companies. “Such arrangements have the potential to undermine auditor independence. The [general standard of independence, Rule 2-01(b)] is the heart of the Commission’s auditor independence rule, it always applies, and the Commission investigates and enforces against violations of the general standard,” said Munter.

Independence is a critical issue for public and private companies alike. Contact your auditor to discuss any questions you may have regarding auditor independence.

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Motivate those you serve and employ with gamification

Gamification concept. Infographics. Chart with keywords and icons. Vector illustration.

Employers spend a lot of time on motivation. You create marketing plans to, in part, motivate those you serve to support your mission — be they customers, members or some other constituency. And you likely deploy many resources to motivate employees to stay with your organization and do their best work.

It’s not easy, is it? One approach that’s taken off in recent years, especially with the widespread popularity of apps and social media, is gamification. The term generally refers to integrating characteristics of game-playing into business-related interactions or tasks.

External campaigns

Sometimes gamification is used externally. For example, a business might award customers points for purchases that they can collect and use toward discounts. Or a company might offer product- or service-related games or contests on its website to generate traffic and visitor engagement. A nonprofit could use gamification to spur members to invite others to join or to improve fundraising.

There are substantial upfront costs to consider, both in developing a gamification campaign and carrying it out. However, despite the expense, many organizations have seen some success in their efforts.

Internal benefits

For years now, various employers — including some major ones — have been using gamification internally. They’re using games to:

  • Enhance their onboarding and training processes,
  • Promote friendly competition and camaraderie among sales staff or other employees, and
  • Measure and recognize progress toward shared strategic goals.

Creating positive experiences in these areas can improve morale and productivity. As a training tool, games tend to help employees learn more quickly and easily. Moreover, with the rise of social media, many workers are comfortable sharing with others in a competitive setting. And, from the employer’s perspective, gamification opens all kinds of data-gathering possibilities to track training initiatives and measure employee performance.

Training and leadership development

In most organizations, employee training is indeed the biggest area of focus when it comes to gamification. As many industries look to attract Generation Z — the next big demographic entering the workforce — game-based learning makes perfect sense for individuals who grew up both competing in various ways on their mobile devices and interacting on social media.

For example, safety and sensitivity training are areas that demand constant reinforcement. But it’s also common for workers to tune out these topics. Framing reminders, updates and exercises within game scenarios, in which participants might win or lose ground by following proper or improper work practices, is one way to liven up the process.

Game-style simulations can also help prepare employees for leadership roles. Online training simulations, set up as games, can test participants’ decision-making and problem-solving skills — and allow them to see the potential consequences of various actions before doing them in real-world situations.

Naturally, gamification has its risks. You don’t want to “force fun” or frustrate employees with unreasonably difficult games. Doing so could lower morale, waste time and money, and undercut training effectiveness.

Ready to launch?

If you’re unsure of how to create and launch a gamification initiative, whether internal or external, consider engaging a professional consultant. We can help you identify and assess the potential costs involved.

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