Some employers allow employees to defer current earnings until their retirement years. There are numerous rules regarding the taxation of deferred compensation which may include how long the compensation was delayed (the two and a half month rule) and whether the deferred compensation was paid from a qualified or a non-qualified plan.
While the employee likes the sound of deferring income until their retirement years when their tax rate will be less than what it is today (which is not necessarily true), often the taxation of the deferred compensation is not understood.
Let’s look at the 2016 U.S. Court of Appeals case of Christine Peterson who was a successful Mary Kay cosmetics salesperson. Mary Kay salespeople are independent contractors, and all agreements they enter into emphasize that status. Ms. Peterson had reached the level of national sales director (NSD) before she retired in 2009. NSDs are eligible to participate in a Mary Kay program called the Family Program, under which participating NSDs receive payments after they retire based on a reduced percentage of the sales commissions they received while they were working for the company, if they agree to retire at age 65. Peterson also received payments from another program (the Futures Program) that pays a percentage of foreign sales commissions.
In 2009, the year at issue in the case, Peterson did not pay self-employment tax on payments that she received under either plan. The IRS found that these “retirement” payments were nonqualified deferred income from a Sec. 409A plan and assessed Peterson $33,594 of self-employment tax. Peterson appealed to the Tax Court, which upheld the IRS’s determination.
Peterson, not agreeing with the Tax Court’s decision, made the argument at the Court of Appeals that the retirement payments she received were either payments for the sale of her Mary Kay business back to the company or payments for the covenant not to compete she had signed, neither of which would be subject to tax as earnings on self-employment. However, the court found that there was no evidence of a sale because there was no agreement to sell the business. And it rejected the argument that the payments were for the covenant not to compete, because Peterson had violated the covenant by seeking other employment within two years of her retirement and Mary Kay had not stopped the payments in response. The Appeals Court found that Peterson had signed documents with Mary Kay that amended its retirement plan and such amendments clearly had characterized the programs as Sec. 409A plans for tax purposes. Having adopted this characterization, the Eleventh Circuit found Peterson was bound to it and was required to treat the compensation from the plans as nonqualified deferred compensation that was subject to self-employment tax.
The lesson learned here is that just because an employer and employee have an arrangement to defer compensation to the future, it does not mean that such future payments will be considered qualified retirement benefits not subject to self-employment taxes, and if the retiree is a PA resident, the retiree may find such payments subject to the PA personal income tax as PA may find such payments not satisfying its definition of what constitutes a retirement plan.
If you want to discuss your business or personal tax planning and tax preparation concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
