Hedge Fund Deferred Bonus: When It's Taxed and FICA at Vesting

Is a deferred bonus taxed when it vests or when it's paid?

Both, for different taxes. Income tax usually comes in the year the bonus is paid to you. Social Security and Medicare (together called FICA on pay stubs) come earlier, in the year each part (tranche) vests, meaning you no longer have to keep working at the firm to keep it.

Pay you defer under such a plan (nonqualified deferred compensation) is not included in your income for the year you defer it (Publication 525). Section 409A adds a condition. Deferred pay that has vested is taxed at once, with extra tax, unless the plan follows rules on when you elect and when it pays (Publication 15-A).

Many fund deferrals pay each tranche soon after it vests. If a tranche vesting in one year is paid by March 15 of the next (for a firm with a calendar tax year), it is a "short-term deferral" and sits outside section 409A, as long as the plan does not set a later payment date. A firm with a different tax year can use the 15th day of the third month after its own year ends, if that is later (Reg. 1.409A-1(b)(4)). Income tax still falls in the year you are paid. What changes is whether the section 409A rules on elections, payout dates and penalties apply.

Your case needs a closer look if the W-2 shows code Z, a tranche vested in one year and paid in another, you moved states, the plan sits with an offshore entity, or the firm is in financial trouble. Gather the plan document and award letters, every deferral election, vesting and account statements, and the W-2s for each vesting and payment year. Reading a plan against these rules and matching it to your W-2s is part of tax work for fund employees.

Why did Social Security and Medicare (FICA) come out at vesting?

The law counts deferred pay for Social Security and Medicare at the later of two dates: when you do the work, or when it vests. Payment does not matter (26 USC 3121(v)(2)). The amount counted is the tranche's value on that date, including any gain or loss before it (Reg. 31.3121(v)(2)-1(c)(1)).

• Taxed once. After the amount is counted, neither it nor its later earnings are wages for Social Security and Medicare again. Earnings qualify if they follow an investment named in advance, such as the fund, or a reasonable interest rate (Reg. 31.3121(v)(2)-1(a)(2)(iii) and (d)(2)).
• Often only Medicare. Social Security stops once your wages for the year reach $184,500. Salary and cash bonus have often passed that before a tranche vests (Publication 15).
• On the W-2 before the cash. The employer reports the vested amount in box 5, and in box 3 up to the Social Security wage base, for that year, though box 1 leaves it out (W-2 instructions).
• On a later paycheck. The employer may take the tax on any later date in the same calendar year, or, with interest added, up to three months later, which can move it into the next year (Reg. 31.3121(v)(2)-1(e)(5) and (f)(3)).
• Paid soon after the year ends. If a tranche vests in one year and is paid within about two and a half months after that calendar year ends, the employer may choose to treat it as ordinary wages when paid, if it does so for everyone in the plan and similar plans. Then Social Security and Medicare come in the payment year, when your Social Security limit has started over (Reg. 31.3121(v)(2)-1(b)(3)(iii)).
• A small early payment. A plan may pay out part of the deferral to cover the Social Security and Medicare due and the income tax withheld on that part (Reg. 1.409A-3(j)(4)(vi)). That part shows in box 1.

Two traps. If the employer did not take the tax at vesting and does not pay it, with interest and penalties, before the period for assessing that year closes, the special rule is lost: the whole payment, growth included, is taxed for Social Security and Medicare when paid (Reg. 31.3121(v)(2)-1(d)(1)(i) and (ii)(A)). The employer owes your share it failed to withhold, and until it is collected you owe it too (Reg. 31.3102-1(d)). And a tranche is at risk only while you must keep working to get it, judged under the section 83 rules. If the plan pays you even after you leave, for example once you reach a retirement age set in the plan, the tax can come before the vesting date on your statement (Reg. 31.3121(v)(2)-1(e)(3)).

My deferred bonus tracks the fund: is the growth wages or capital gain?

All of it is wages when paid: ordinary income in box 1 of your W-2, with no K-1 and no capital gain. Under a deferral plan you do not own the fund interest. The fund's return only measures what the firm owes you.

The rules treat a plan's return as following an investment whether or not any money is actually invested in it (Reg. 31.3121(v)(2)-1(d)(2)(i)(B)). Payments of deferred pay are supplemental wages for income tax withholding (Reg. 31.3402(g)-1(a)(1)). A fund loss lowers what you are owed, and so the income you report. It does not undo the Social Security and Medicare already taken at vesting.

How the plan credits the return matters for Social Security and Medicare. A return equal to the greater of the fund's return and a floor, such as never below zero, is not a predetermined investment. Neither is a fund the firm picks after the period starts. Then any growth above a reasonable interest rate can count as new wages (Reg. 31.3121(v)(2)-1(d)(2)(i)(B) and (d)(2)(iii)(A)).

Can I put my bonus straight into the fund without paying tax first?

Only through the firm's deferral plan, which delays income tax but not Social Security and Medicare. If you take the bonus in cash and then invest, you invest money that was already taxed as wages.

Some firms pay part of a bonus as an actual interest in a fund. That is property received for services. Its value, less anything you pay, is income in the first year it is vested or transferable (26 USC 83(a)), and it is wages for withholding (Reg. 31.3402(g)-1(a)(1)). For property that is not yet vested, a section 83(b) election within 30 days of the grant changes that timing; see Carry points for fund employees.

If your share of fund profits comes as an allocation on a K-1, not as pay on a W-2, see Carried interest and the three-year rule.

What do W-2 box 11 and box 12 codes Y and Z mean, and is code Z a problem?

Box 11 and code Y are information only. Code Z means your employer is reporting that the plan failed section 409A, which brings extra tax. Check with the employer that it is correct before you file.

Sources: W-2 instructions; Publication 525.

When a plan fails, every vested amount you deferred under it, for this year and earlier years, becomes income now. The firm's plans of the same kind, such as all its account-based deferrals, count as one plan for this (Reg. 1.409A-1(c)(2)(i)). Your tax then rises by 20% of that amount. It also rises by interest at the IRS underpayment rate plus 1 percentage point, counted from the year the pay was first deferred or, if later, vested (26 USC 409A(a)(1)). You report these on Schedule 2 of Form 1040 (Form 1040 instructions). The employer withholds income tax on the amount but not these extra taxes (Publication 15-A).

First ask the employer whether code Z is correct. IRS correction programs cover some payroll and payout mistakes fixed in the year they happen, or by the end of the next year if you are not a director, officer or owner of more than 10% of the firm; a few others, by the end of the second year after. Fixes after the year of the mistake are not available if your return for that year is under examination. Under some of them, you attach a statement to your return for the year the mistake was found (Notice 2008-113).

Should I elect to defer more, and when is the election due?

Generally, you must elect by December 31 of the year before the year you do the work. For next year's pay, that means by December 31 of this year (Reg. 1.409A-2(a)(3)). The year that counts is the year of the work, not the year the bonus is paid. The bonus for this year's work, paid next spring, can no longer be deferred under the general rule; only the windows in the table below might still be open. The plan can set an earlier date. A few later windows exist:

Performance-based pay must depend on written criteria set no later than 90 days into the period, with an uncertain outcome (Reg. 1.409A-1(e)(1)). A bonus left to the firm's discretion may not qualify.

How much to defer is a personal decision. The tax effects to weigh:

• Rates. Deferring moves income tax to the payout year. It lowers the tax only if your federal and state rate then is lower than now, for example after you stop working, and raises it if several payouts stack into one high year. It does not move Social Security and Medicare, which come when the deferred pay vests.
• A planned move. Your old state may still tax pay earned while you worked there; see State tax on deferred pay after a move.
• Risk. Deferred pay is usually a promise from the firm (see below).
• No way back. Once the election is final, you generally cannot take the money early (narrow exceptions below), and later changes follow strict rules.
• The payout year. Several tranches can arrive in one year; see the payout section below.

Can I change when it pays out, or take it early, without a section 409A problem?

Not early. A section 409A plan may not speed up any payment, and payments can only follow events the law lists: leaving the firm, disability, death, a fixed date or schedule, a change in control, or an unforeseeable emergency (26 USC 409A(a)(2) and (3); Reg. 1.409A-3(a) and (j)(1)). Narrow exceptions exist, such as the payment to cover Social Security and Medicare described above. If the firm's stock is publicly traded and you are one of its key employees, a payment on leaving must wait at least 6 months (26 USC 409A(a)(2)(B)(i)).

You can push a payment later only if all of these hold (Reg. 1.409A-2(b)(1)):

1. The plan allows it.
2. The change takes effect no sooner than 12 months after you make it.
3. Each payment moves at least 5 years later, except payments on death, disability or an unforeseeable emergency.
4. For a payment set for a fixed date, you make the change at least 12 months before that date.

Breaking these rules is a plan failure, with the code Z result above. If you are leaving the firm, see Leaving a fund with unvested pay and carry.

Our deferral sits with the offshore fund: does section 457A tax it before I'm paid?

Only if the entity that owes you the pay is a "nonqualified entity". Then the pay is income as soon as it is no longer at risk of forfeiture, even if it has not been paid (26 USC 457A(a)). Income tax then comes in the vesting year, though no cash has reached you, so plan to pay it from other funds; see Estimated tax in a big bonus year.

• Nonqualified entity. A foreign corporation, unless substantially all its income is US business income or is subject to a comprehensive foreign income tax. Or a partnership, unless substantially all its income goes to people other than tax-exempt organizations and foreign persons not subject to such a tax (26 USC 457A(b); Publication 525).
• Whose plan it is. The plan belongs to the entity that could deduct the pay if it paid you in cash (Notice 2009-8, Q&A-14). An employee of a US management company owned by US partners usually has that company's plan, so section 409A applies, not 457A, even if the account tracks the offshore fund. Confirm with the plan document.
• At risk. Only a condition to keep performing substantial services counts. Performance targets and non-compete terms do not (26 USC 457A(d)(1)(A); Notice 2009-8, Q&A-3).
• Short-term exception. Pay received within 12 months after the end of the entity's tax year in which it vests is not deferred for section 457A (26 USC 457A(d)(3)(B); Notice 2009-8, Q&A-4).
• Earnings. Reasonable earnings credited at least once a year are income as they vest (Notice 2009-8, Q&A-15).

Deferred pay is an unsecured promise: what happens to the tax if the firm can't pay?

Under a plan that meets section 409A, pay you never receive is never subject to income tax. If it was already taxed before payment, under section 457A or after a section 409A failure, how the loss is treated depends on the facts. Social Security and Medicare taken at vesting usually stay paid.

The regulation lets an employer claim a refund when it overestimated the amount at the time it was counted (Reg. 31.3121(v)(2)-1(f)(2)(iii)). It provides no refund for pay later lost. In one case, an employer's bankruptcy ended a retiree's pension-type benefits after Medicare tax was taken on their value at retirement. The Federal Circuit refused a refund and upheld the rule that values such benefits with no discount for the risk that the employer will not pay (Federal Circuit, appeal No. 2014-5127). No rule refunds the tax on a fund-tracking account the firm later fails to pay.

A plan cannot remove that risk by moving assets to a trust outside the US (for work done in the US), or locking them up for the plan if the firm's finances weaken: those assets are taxed to you once vested, plus 20% and interest (26 USC 409A(b)).

What should I plan for in a payout year?

A payout is supplemental wages. The employer may withhold a flat 22%, and must withhold 37% on supplemental wages above $1,000,000 it pays you in the year (Publication 15). The flat rate can be well below your actual rate, so a year when several tranches pay out may need estimated payments; see Estimated tax in a big bonus year. If you have moved since the work was done, see State tax on deferred pay after a move.

When does the management company deduct it?

In the year you include the pay in income, not when it is promised or when it vests (26 USC 404(a)(5)). Pay received within about two and a half months after the end of the firm's tax year in which the work was done is not deferred for this rule, so the firm deducts it under its usual accounting method (Reg. 1.404(b)-1T, Q&A-2).

Example

Illustrative only, in US dollars. You are single. Each year, your salary from the firm passes $200,000 before any tranche vests, so Social Security has stopped and Additional Medicare withholding has started.

A tranche vests in December and pays in January

A deferred bonus of $500,000 vests in three tranches of about $166,667. Each tracks the fund. The first tranche vests on December 31 of Year 1, worth $180,000 after fund gains.

• Year 1: the employer withholds Medicare of $2,610 (1.45%) and Additional Medicare of $1,620 (0.9%) on $180,000. No Social Security and no income tax. Box 5 includes the $180,000. Box 3 does not, because it already holds the full $184,500 wage base; box 1 does not either.
• Year 2: the fund falls, and the firm pays $175,000 in January. That is wages in box 1, with $38,500 (22%) of income tax withheld. No Social Security or Medicare again. The tax on the $5,000 drop is not refunded.

If the firm uses the option to treat a tranche paid soon after the year ends as wages when paid, Year 1 shows nothing, and Year 2 carries Social Security and Medicare on $175,000 instead.

You elect to defer and are paid years later

In Year 1, by December 31, you elect to defer part of the bonus for your work in Year 2 to a fixed date in Year 5. In Year 2, the firm credits $200,000 to your account, fully vested and tracking the fund.

• Year 2: Medicare of $2,900 and Additional Medicare of $1,800 on $200,000. Box 12 may show $200,000 with code Y.
• Years 3 and 4: the account grows. Nothing is taxed. If the firm reports code Y, the growth may show there.
• Year 5: the firm pays $260,000. It is wages in box 1, with $57,200 (22%) withheld, and no Social Security or Medicare. Box 11 may show $260,000.

The plan fails section 409A

Same facts, but in Year 3 the firm pays you the $220,000 balance early, outside the plan's rules, and the failure is not corrected. Your Year 3 W-2 shows $220,000 in box 1 and in box 12 with code Z. You owe regular income tax on it, plus $44,000 (20%), plus interest counted from Year 2.

Different for you?

• You are leaving the firm, or were let go: forfeiture, continued vesting and payout are covered in Leaving a fund with unvested pay and carry.
• You moved states before it paid: see State tax on deferred pay after a move.
• A big payout year, or other moves before December 31: see Estimated tax in a big bonus year.
• Your firm pays phantom carry in cash: see Carry points for fund employees.
• Your bonus may really be an incentive allocation: see Carried interest and the three-year rule.
• You are a partner, not an employee: see Becoming a partner at a fund manager.
• You must pay back a bonus you were taxed on: see Repaying a bonus you were taxed on.
• You left the US, or are giving up a green card, before it paid: pay for work done in the US is generally still US income when paid later (Publication 519); see Leaving the US and Exit tax.
• You are moving to Canada with deferred pay: see Stock awards and pay after a move.
• Your W-2 shows code Z, the plan sits with an offshore entity, or you want your plan, elections and W-2s checked: get tax help for fund employees.