Nonqualified deferred compensation plans often include anti-assignment language prohibiting a plan participant from assigning benefits to anyone.  Because top-hat plans are exempt from most aspects of ERISA including the requirement that a plan honor a domestic relations order (DRO) regarding the division of marital assets, a nonqualified deferred compensation plan has to specifically permit that a participant’s account may be assignable. Without such language, the plan has no discretion to honor a DRO. If the plan terms do grant a plan administrator discretion to honor a DRO, Internal Revenue Code Section 409A permits accelerated payments to a non-employee former spouse, as there is a specific exemption to the general anti-acceleration rule for payments made pursuant to DROs.

If deferred compensation benefits are accelerated on account of a DRO, the distribution is taxable to the non-employee former spouse and excluded from the taxable income of the employee spouse. Accordingly, the non-employee former spouse must recognize income upon the distribution from the deferred compensation plan.

It is the reporting and withholding on this distribution that gets a bit tricky.  Plan sponsors should withhold federal income tax at the supplemental withholding rate (currently 22%) on the payments to the non-employee former spouse (if under $1M, otherwise, the payments are subject to the regular withholding rate) and report the income and income tax withholding to the non-employee former spouse on Form 1099-MISC in Boxes 3 and 4, respectively.  The amount reported in Boxes 3 and 4 is the gross amount of income and income tax withholding, irrespective of the amount that is actually distributed to the former spouse.

To the extent employment taxes (FICA and FUTA) have not applied to the deferred compensation payments (under the special timing rule), employment taxes must be withheld from the payment to the non-employee former spouse.  As a result, the gross payment to the non-employee former spouse is reduced by the amount reported in Box 4, as well as the FICA and FUTA taxes that are owed at the time of the distribution.  Any Social Security and Medicare wages and withholding that are owed at the time of the distribution should be reported to the employee on the employee’s Form W-2 in Boxes 3 through 6 (the total amount subject to FICA and FUTA taxes reported in Boxes 3 and 5, and the tax owed in Boxes 4 and 6).

Since Social Security and Medicare wages are included in the non-employee former spouse’s income reported on the Form 1099-MISC, however, no amounts should be reported to the employee in Boxes 1 and 2 of the Form W-2 as a result of the deferred compensation payments to the non-employee former spouse.  This also means that the employee’s Social Security wage base would limit the application of the Social Security withholding on the payment to the non-employee former spouse.