Companies required to use “box 11” of Form W-2 in 2023 to report either payments of nonqualified deferred compensation (deferred compensation) or FICA taxation of unpaid deferred compensation may soon be challenged by employees angry about potential double taxation of deferred compensation. This double tax is created because the Form 1040 filing instructions for 2023 require deferred compensation payments reported in box 11 of Form W-2 to be reported on an employee’s Form 1040 as “wage” income subject to income tax and again as “additional income,” also subject to income tax.
This results in double taxation of deferred compensation payments, which the employee escapes only by ignoring the new Form 1040 filing instructions.
Potential IRS audits are also likely. In processing Forms 1040 for 2023, IRS computers may wrongly assume that Form W-2 box 11 entries should have been reported on Form 1040 as “additional income.” As explained below, deferred compensation reported in W-2 box 11 should virtually never be reported as “additional income” on the taxpayer’s Form 1040. But if the employee correctly declines to report W-2 box 11 income as “additional income” on the employee’s Form 1040, it is possible that the IRS computers may reflect the confusion shown in the Form 1040 filing instructions and assess tax and penalties on purportedly unreported income.
The problem is created by instructions to Form 1040 (new in 2023) that require all individual taxpayers receiving payments of deferred compensation to report such payments as “additional income” by completing a new “line 8t” to Schedule 1 of the Form 1040.
The Form 1040 instructions for new line 8t of Schedule 1 say simply:
Line 8t Pension or annuity from a nonqualified deferred compensation plan or a nongovernmental section 457 plan. Enter the amount that you received as a pension or annuity from a nonqualified deferred compensation plan or a nongovernmental 457 plan. This may be shown in box 11 of Form W-2. If you received such an amount but box 11 is blank, contact your employer or the payer for the amount received. (Emphasis supplied.)
That is, the instructions for new line 8t of Schedule 1 require the taxpayer to include W-2 box 11 amounts as part of the Schedule 1 amounts reported as “additional income” on line 8 of the Form 1040. But W-2 box 11 amounts should virtually never be reported on the Form 1040 as Schedule 1 additional income. Here’s why: confusingly, the employer is required to report deferred compensation in W-2 box 11 in two different situations. The first is actual payment of deferred compensation, and the second is unpaid deferred compensation that becomes subject to FICA taxation when vested. Under the first situation (actual payment), the box 11 amount is also required to be reported by the employer as “wage” income in box 1 of Form W-2. In this first situation, if the taxpayer reports the W-2 box 11 amount in line 8t of Schedule 1, the taxpayer is taxed twice on this amount, once as “wage” income (Form 1040, line 1a) and once as Schedule 1 additional income (Form 1040, line 8). Under the second situation (vested unpaid amounts), the box 11 amount is not Schedule 1 additional income because it is not yet paid, and therefore not yet subject to income taxation.
Box 11 income is not “additional income” in either situation. But there is no statement indicating that line 8t should be left blank if either (1) the employee received a payment also reported in box 1 of Form W-2 or (2) the amount reported in box 11 was never paid and is therefore not taxable. In almost all cases, therefore, the line 8t instructions confusingly lead to double taxation (in the case of paid deferred compensation) or incorrect taxation (in the case of unpaid FICA-taxable amounts).
PROBLEMS FOR EMPLOYEES (AND DERIVATIVE PROBLEMS FOR EMPLOYERS) IF AMOUNTS ARE REPORTED IN BOX 11
This cross-reference to box 11 in the instructions for line 8t of Schedule 1 no doubt created confusion and potential problems for employees for the 2023 tax year, which certainly will continue for 2024 and beyond unless the IRS addresses the problem.
In addition to incorrect double-income taxation of deferred compensation distributions, these problems include the following:
Potential Audits of Employees Who Do Not Complete Line 8t
It is very possible that the IRS will program its computers to conduct computerized audits of employees who have amounts reported in box 11 and have not completed line 8t. As explained above, these audits would be incorrect for two reasons considering box 11 amounts should virtually never be included in line 8 of Schedule 1.
First, if there was a distribution reported in box 11, it would also have been reported in box 1 and then subjected to income tax, so the IRS is not entitled to impose income taxes twice. Second, if there was vested undistributed deferred compensation subject to FICA taxes reported in box 11, the IRS is not entitled to impose income taxes on amounts that were not yet distributed. In neither case should the employee owe additional 2023 income taxes—but the baselessness of these audits does not mean that they will not occur.
Potential Complaints By Employees to Employers About Completion of Box 11 (and Possible Whistleblower Reports to the IRS)
We know that some employees have already been lodging complaints to their employers about the completion of box 11 on Forms W-2 for 2023. In cases where the box was completed due to FICA taxation of undistributed deferred compensation, even though this reporting does not trigger any need to complete line 8t (which applies only to employees’ receipt of deferred compensation), employees are still concerned that simply having an entry in box 11 could trigger an IRS audit, as discussed above.
Because the reporting instructions literally state that box 11 should not be completed if the FICA-taxable income was separately reported (in boxes 3 and 5), some employees have asked for amended 2023 Forms W-2, while some others have threatened to report the employer’s reporting violation to the IRS if the Forms W-2 are not corrected.
CONCLUSION
The new 2023 filing year instructions for box 11 of Form W-2 and for line 8t of Form 1040 Schedule 1 have been confusing many individual taxpayers, who are calling their employers to complain that Box 11 has been completed, which triggers the following problems:
- Doubled current-year income taxes on amounts that were distributed (and reported in Box 1)
- Potential income taxes on amounts that have never been distributed (since the IRS’s reporting instructions imply that the IRS considers deferred compensation “other income”)
- Potential audits of employees with Box 11 amounts who do not complete line 8t to Schedule 1 and attach it to Form 1040
It appears that the only way to resolve these problems is for the IRS to issue guidance both eliminating the use of line 8t (to avoid the obvious double-tax problem) and also either correcting its ambiguous instructions for completing box 11 or deleting the box altogether from Form W-2.
HOW WE CAN HELP
We encourage businesses to consider writing comments to the IRS to lodge their complaints about these problems or participate in the comments that Morgan Lewis is submitting to the IRS on behalf of its clients.
If you have any questions or would like more information on the issues discussed in this blog post, please contact any of the authors.