Deferred Comp & Making Work Pay Credit

[origun]

Retired client receives about $7000 in deferred comp from former employer. It is shown on a W-2 with nothing for SS or Medicare wages and Box 11 indicates that it is Deferred Comp. On his tax return it was shown as Box 7 Wages and not eligible for MWP. However, he has
been contacted by IRS who will re-adjust his refund to allow for MWP.

Who is correct--IRS or me (and my software)?

And if he is not eligible for the credit, how are you advising such clients--send it back or keep it?

[Koss]

Nonqualified Deferred Compensation

I'm gonna stick my neck out pretty far on this one, and say that the software might be wrong. Or it might be right. This one may actually fall into the twilight zone, since the Making Work Pay Credit is relatively new law.

I tested your assumptions in my software, and I got the same result that you did. My software is not allowing the Making Work Pay Credit. (And I'm fairly certain we are not using the same software.)

You better hang on, 'cause this is gonna get really complicated really fast.

Box 11 is used to report two different things. The employer's instructions for Form W-2 direct the employer to use box 11 to:

Show distributions to an employee from a nonqualified plan or a nongovernmental section 457(b) plan. Also report these distributions in box 1. Make only one entry in this box. Distributions from governmental section 457(b) plans must be reported on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc., not in box 1 of Form W-2. (emphasis added)

Your client did not receive a Form 1099-R, and the amount reported in box 11 was also reported in box 1. Therefore, it seems reasonable to assume that your client received a distribution from a nonqualified plan--not a distribution from a nongovernmental section 457(b) plan.

In the case of a distribution from a nongovernmental section 457(b) plan, the distribution is reported on Form W-2 in box 11 only, not in box 11 and box 1. Then, it is also reported on Form 1099-R.

So in very general terms, it appears that distributions from a nongovernmental section 457(b) plan are treated as retirement income. But distributions from a nonqualified plan are treated as... well, something else.

It is not entirely clear what that something else is. It seems to be something different from a pension plan distribution, because the IRS decided that it should not be reported on Form 1099-R. But what is it?

The taxpayer's eligibility for the Making Work Pay Credit hinges on whether this particular distribution is considered earned income. If it is earned income, then it qualifies the taxpayer for the MWPC. If it isn't, then it doesn't.

The legislation that authorizes the MWPC is found in IRC 36A. The credit is the lesser of $400 ($800 for MFJ) or 6.2% of the taxpayer's earned income. It is noteworthy that although 6.2% is the amount of the social security portion of FICA, and this is certainly not a coincidence, the text of the law does not say that the earned income in question must be subject to social security tax in order to qualify for the MWPC. Whether it is subject to social security tax appears to be irrelevant.

The text of the law that establishes the MWPC does provide a definition of earned income. It says:

The term “earned income” has the meaning given such term by section 32 (c)(2), except that such term shall not include net earnings from self-employment which are not taken into account in computing taxable income. For purposes of the preceding sentence, any amount excluded from gross income by reason of section 112 shall be treated as earned income which is taken into account in computing taxable income for the taxable year.

Section 112 deals with nontaxable combat pay, which is not relevant to this discussion.

Section 32 is the Earned Income Credit.

Sooooo...

The definition of earned income for purposes of the MWPC is the same as the definition of earned income for purposes of EIC.

In support of Origun's position, and the software's conclusion, that nonqualified deferred compensation is not earned income under this definition, see the IRS instructions for EIC, contained within the instructions for Form 1040. In Step 5, the taxpayer is directed to enter the amount from line 7 and then subtract

Amount received as a pension or annuity from a nonqualified deferred compensation plan or a nongovernmental section 457 plan (enter "DFC" and the amount subtracted on the dotted line next to Form 1040, line 7). This amount may be shown in box 11 of Form W-2. If you received such an amount but box 11 is blank, contact your employer for the amount received as a pension or annuity.

These instructions effectively confirm that an amount shown in box 11 is not considered earned income for purposes of EIC. Since the definition of earned income for EIC is the same as the definition of earned income for the MWPC, this would appear to confirm that Origun and his software are correct, and the IRS is wrong for adjusting the return to include the MWPC.

I am not entirely convinced.

The amount in box 11 is sometimes reported on Form 1099-R, and it is sometimes reported in box 1 of Form W-2. When it is reported on Form 1099-R, the income appears on Form 1040 on line 16b as a pension or annuity distribution. But when it is reported in box 1 of Form W-2, it is reported on line 7 of Form 1040 as wages.

This doesn't prove that it is earned income. But it proves that on some level, the IRS recognizes that amounts reported in box 11 can be treated in two different ways...

In my humble opinion, the text of the law is ambiguous. I am referring to IRC 32(c)(2), which provides the definition of earned income for both the EIC and the MWPC.

The text of the law reads as follows:

(2) Earned income
(A) The term “earned income” means—
(i) wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year, plus
(ii) the amount of the taxpayer’s net earnings from self-employment for the taxable year (within the meaning of section 1402 (a)), but such net earnings shall be determined with regard to the deduction allowed to the taxpayer by section 164 (f).

Reading the plain language of the law, an amount in box 11 is "employee compensation." That's why it's called deferred compensation, right? It is compensation that it is earned in one year, and then paid to the employee in a later year.

Which brings us to the second point in the text of the law. An amount in box 11 is certainly "includible in gross income for the taxable year." Here again, the whole concept is that the money was earned in an earlier year, but was not included in gross income in that year. It is included in gross income for this year.

On this plain English reading, nonqualified deferred compensation that is not a distribution from a nongovernmental section 457(b) plan could be construed as earned income, for both EIC and MWPC.

I have to concede that the IRS handling of the return that Origun prepared is inconsistent with the instructions for calculating earned income for purposes of EIC. In other words, if the IRS believes that nonqualified deferred comp is not earned income for purposes of EIC, then it should be treating nonqualified deferred comp the same way for MWPC, because the definition is the same for both credits. Put another way, if the IRS is correct about allowing the MWPC for someone with deferred comp, then they should also be allowing EIC.

But as I read IRC 32(c)(2) over and over again, I can't get past the fact that deferred compensation is still employee compensation, and it is includible in gross income for the taxable year, and that even the IRS appears to recognize that these distributions are not pension or annuity distributions, because they are reported on Form W-2 and not on Form 1099-R.

This wouldn't be the first time that the IRS produced instructions that are not an accurate reflection of the law.

BMK

[Koss]

IRS Instructions

It's probably starting to look like I have too much time on my hands, but...

I discovered that the IRS instructions for Schedule M appear to be ambiguous as well. The instructions say that

The amount of your wages is generally the amount reported on line 7 of Form 1040A or 1040. Wages do not include income from self-employment.

Granted, the use of the word generally implies that there are some exceptions, in which the amount of your wages may be something different from the amount reported on line 7.

But the instructions never tell you to enter your wages. For line 1a of Schedule M, you have to first check yes or no. The question is whether you have wages of more than $6451. This is the magic number, because 6.2% of 6451 is $400, so if you have wages of $6451 or more, then you max out on the credit and you're done. If you answer yes, then you don't even have to "enter your earned income" on line 1a.

But if you answer no, then you have to complete a mind-numbing worksheet to calculate your earned income. And the worksheet has instructions that are the same as the instructions for EIC that I described in my previous post. The taxpayer is directed to subtract any amount from a pension or annuity from a nonqualified deferred comp plan or a nongovernmental section 457(c) plan. The verbiage is identical, right down to the part about entering "DFC" on line 7 of Form 1040.

As I look into this further, I am quickly reaching the conclusion that this is indeed a case where the IRS instructions cannot be relied upon. Reading the form itself on the surface, you won't even get to the worksheet unless you have wages that are less than $6451.

This actually creates a much more serious problem, that has nothing to do with deferred comp, but has everything to do with the definition of earned income.

What if someone has regular wages of $6900 and a net loss on Schedule C of $6800?

If you read the instructions on the face of Schedule M, you can simply check yes, skip lines 1 through 3, and enter $400 on line 4. The form leads to the conclusion that wages of $6451 or more automatically qualify you for the maximum $400 MWPC, even if you have a net loss on Schedule C that is greater than your wages.

But if you have wages that are less than $6451, you are taken into the worksheet, where you have to enter your net profit or loss from Schedule C, and calculate your Making Work Pay Credit, based on your net earned income.

This doesn't make sense, and it does not reflect the plain English meaning of the text of the Internal Revenue Code. Section 32(c)(2), cited in my previous post, explicitly refers to both wages and net earnings from self-employment.

My software performs the net calculations, regardless of whether the wages are $6451 or more.

But a literal reading of Schedule M leads to a very different result.

Returning to the original question raised by Origun...

I already reported that my software, like Origun's, does not allow the MWPC when there is an amount in box 11 of Form W-2 that is equal to the amount in box 1, and no other income on the return.

Curiously, my software does not insert the legend "DFC" on line 7 of Form 1040.

I use TaxAct.

But here's a real eye-opener...

TurboTax online gives Origun's taxpayer both the Making Work Pay Credit and the Earned Income Credit.

For Origun's real client, maybe EIC isn't possible, because he may be over age 65.

But my point is that TurboTax is treating the nonqualified deferred comp in box 11 as earned income for both MWPC and EIC.

At least the logic is consistent, which is more than can be said for the IRS.

What a mess...

Anyone with a professional Intuit product wanna try this, to see if it reaches the same conclusion as TurboTax?

What software are you using, Origun?

Hmmm??

BMK

[origun]

More info re my client

First, thank you, Koss, for taking so much time to research this and share with us. My client filed his taxes pretty early this year (Mid February) so he could head south for warmer weather. Perhaps more of you will be encountering this situation soon...for clients who filed later in the tax season.

My software did print "DFC" and the am't on the dotted line for line 7 of the 1040.

And my client did not qualify for EIC because his income is too high so that didn't enter into the situation. (He is in his 60's but under 65, as I recall.)

I work for HRBlock so, of course, used their software.

He has had this deferred comp for several years, shown on a W-2 in Box 1 and Box 11. I would have used the same software last year but he didn't receive a similar notice last year. Did any of your clients receive such notices last year?

I did some online research and someone on a Tax Almanac forum said the following concerning a similar situation last month:

"I thought the IRS made a mistake and we didn't want to get any refund by error (the IRS will charge you interest on it for their own mistake), so we corresponded with the IRS and explained to them how the refund is in error. Regrettably, the IRS agreed the TP is not entitled to the credit AND charged my client for a $3 penalty for cashing it in (TP cashed in the refund without my knowledge). It was ridiculous of the IRS but it wasn't worth to fight for the $3. However, imagine how much the IRS can make by charging penalty and interest when they realize they have been making mistakes and want all the money back."

I need to call my client on Monday...guess I will share the confusion with him and let him decide what to do. Actually when I talked to him yesterday, he hadn't received the check, only a notice that he would be receiving it in 4-6 weeks.

[Koss]

Possible Answer

I'm interested in this issue because there is enough conflicting evidence that it almost doesn't matter what the real answer is, or what the outcome of an individual case is.

This is a spectacular example of an area of the tax law that should be relatively straightforward, but is apparently causing significant confusion within the IRS and also within the highest reaches of the tax professional community, i.e., the software developers.

We're not dealing with some arcane, esoteric concept like passive activity losses or interest tracing rules. The Making Work Pay Credit shouldn't be that hard to figure out.

But here's what I found...

In my previous posts, I speculated that maybe the problem lies in the difference in treatment between nonqualified deferred compensation and distributions from a nongovernment 457(b) plan. Clearly there is a difference, because NQDC gets reported in box 1 of Form W-2, but the 457(b) distribution goes on Form 1099-R. And yet they both get reported in box 11 of Form W-2.

It seems like I was almost on the right track.

TaxAct, which is my professional software, would not allow the MWPC. TurboTax online free version does allow it. And Origun reports that HRB's professional software, used by their tax pros, did not allow the credit.

I have now tested the fact pattern in a fourth tax program.

The program has a special worksheet associated with Form W-2. It's called Additional Information for Box 11 (Nonqualified/457(B) Plan Distributions).

I've attached an image of the worksheet, as well as the associated help screens.

Apparently, the amount in Box 11 can be one of two things:

(i) a distribution from a nonqualified plan or nongovernmental Section 457 (b) plan, or

(ii) a prior-year deferral (plus earnings) under a nonqualified or Section 457(b) plan that became taxable for Social Security and Medicare taxes this year because there was no longer a substantial risk of forfeiture of your right to the deferred amount

So the critical distinction here is not between NQDC and 457(b), but rather between a plan distribution that was subject to FICA in an earlier year versus a prior year deferral that has now become subject to FICA because its character has changed, even though it has not actually been distributed to the employee.

This insanity is all related to the massive changes to employee stock option plans that went into effect in the wake of the Enron affair.

In this tax prep software, you can check yes or no to indicate whether the amount in box 11 is a distribution from an NQDC or 457(b) plan. If you check yes to indicate that it is, then the program does not allow the Making Work Pay Credit.

The help screen tells you to check no if the amount is a prior year deferral. If you check no, then the program allows the Making Work Pay Credit.

In other posts from a couple years ago, I have written extensively about the danger in drawing any conclusion about the accuracy of a return from the output of the software. I call it "the tail wagging the dog." It is a serious mistake to say, well, the software is allowing the credit, so this taxpayer must be eligible for the credit. If you can't explain how the credit works without the software, then you don't really understand it. There could be a genuine bug in the program. Or it could be working properly, but without the correct input, you won't get the correct output.

As another member of this community has said in the signature to his posts, "If you don't know how to do something, then you don't know how to do it with a computer."

So I'll be the first to concede that the output of this program doesn't provide a final resolution to the original question. That question is: Is the amount in box 11 considered earned income for purposes of the Making Work Pay Credit?

Technically, I feel like we still don't have a complete answer.

But the algorithm in this tax program provides a rational explanation as to why the answer might be yes in some cases and no in other cases. And that would explain why other programs are giving different answers, and why the IRS can't seem to get the story straight.

The relevant section of the program's worksheet appears at the top of the second page of the PDF. The help notes are on the third page.

BMK

[Koss]

NQDC Plans

In my last post, I wrote:

This insanity is all related to the massive changes to employee stock option plans that went into effect in the wake of the Enron affair.

I'm not sure what I was thinking. It's getting late. It wasn't the Enron affair. It was the whole controversy that erupted about six years ago over the inaccurate expensing of stock options by employers. There were major changes in GAAP that took effect in 2006. These changes had an impact on how and when certain types of deferred comp are subject to taxation...

And that's part of what this is all about.

When is earned income not earned income?

BMK

[origun]

Wow! More confused than ever!

Thanks again, Koss, for your extensive research and worksheets.

I believe my client's DFC would fit into the category of "welfare benefit plan ... and plans providing dismissal pay or early retirement pay" as mentioned on page 3 of your worksheet and therefore "not treated as nonqualified plans."

But SS and Medicare were never paid on this income; there was nothing in boxes 2-6 of the W-2.

It would seem that MWP should be a simple credit to figure...but it isn't!

[Burke]

I have the exact same situation. Client retired from major corporation in 1981 and has received W-2 ever since (in addition to 1099R for pension income). Probably only gets one check, he is not sure, but he is also in his 80's. This W2 income is shown in Box 1 AND Box 11 as "non-qualified plans," and it went on Line 7 as wages with DFC on the line. (He had another W-2 for actual earned wage income and Sche M was calculated in my software (ATX) NOT using this DFC amount). He just got a letter from the IRS recalculating the MWP to include the DFC income. Even though on the Schedule M question (d) says to check the "No" box on line 1a. Which I did. (I think I did it -- it might have checked itself automatically from the W-2 input.) He has already received a check from them for additional refund amount.

[Burke]

But SS and Medicare were never paid on this income; there was nothing in boxes 2-6 of the W-2. !

In the case of deferred comp, the SS/MC taxes are paid when it is credited, while they are still employed. In other words, it is included in Boxes 3 & 5, but not in Box 1. Sort of like 401k's are done now. Then, when it is paid out after retirement, nothing is shown in Box 2-6.

[origun]

Thanks Burke

Thanks for the info re paying SS and MC while still employed. I didn't know that had occurred and my client didn't have a clue.

So...do you now believe your client is entitled to the MWP or not--and are you encouraging him to return check to IRS or not?! In my last communication with my client, all I could tell him was that it was a gray area and it is possible he would be asked to repay at a later date. It was his call as to what to do with the money.

As I recall, my software asked me no further questions after I put in the info re DFC for box 1 and 11; I had no option to check any "no" box on line 1a of Sch M.

[BOB W]

One of my clients rec'd an extra $800 in his direct deposit because of the issues brought up in this thread. He paniced and called me. I came to the same conclusion> confused. I asked what he wanted to do as it would be possible the IRS would realized the error (if it was an error) and ask for the money back with interest. He opted to mail the money back with a note that I wrote claiming there was no earned "Earned Income" to qualify for the MWP credit.

This was about 3 weeks ago, before the 18th. I have not heard back from the client and if the IRS sent him the check back or whether the check was cashed or not. Maybe I should contact him to see the current status of the check and post the results on this thread.

[Burke]

At the time, I had not read this thread. So I told the client that I believed it was incorrect on the part of the IRS, but would attempt to research it. You never know what you don't know. Now Koss has me thinking as well. But frankly, I still think it is incorrect. Also, the client paper-filed this return so I thought it might be just an input error on the other end. Now, I believe their computers are auto-generating these addl refunds. PS: he brought me 2009 return, which was done by another preparer last year who did not figure MWP at all (he also had another W-2 that year). The IRS subsequently figured it on their end and sent him addl funds. If you think about it hard enough, though, DFC income WAS earned when it was earned, so why wouldn't it be treated as earned now -- except for the fact this is normally credited to high-income execs in past years, and the purpose of the MWP credit (I thought) was to help out the average working joe in the present. And it is specifically excluded on the Sche M. At least we don't have to worry with it from now on.

[BOB W]

Ok, here is my follow up on my client that sent back his own $800 check. IRS re-direct deposited $800 back into his account. No explanation other than saying they are looking into it.

[BOB W]

LATEST UPDATE:

Client just got a notice from IRS requesting the return of the $800 that they keep depositing into his account. This time with interest( $1.64). Client is sending the $800 (no interst) back to the IRS. ????????????????????????????