The last of the Taxes from A to Z series is Z for Code Z.
Code Z is a relatively recent addition to the tax world. It made its debut on the 2005 federal form W-2 (and the related federal form 1099-MISC) as part of the American Jobs Creation Act of 2004. The purpose of the code was to report income that didn’t meet certain criteria for nonqualified deferred compensation plans under the section 409A of the Tax Code.
A little historical context is always helpful and is especially true in this case. For years, there had been a fairly weak interpretation of the idea of constructive receipt with respect to retirement plans and elective deferrals of income. In law school, we learned (more or less) that income becomes taxable when you could take it, whether or not you actually did. The courts didn’t always agree with this premise and abuse with respect to deferred compensation plans was pretty rampant. Enter Enron, whose executives further abused the system, by ramping up their own retirement distributions before the company went bankrupt; in terms of timing, Enron officials appeared before Congress beginning in December 2001 and the new rules went into effect January 1, 2005.
The rule doesn’t affect a lot of taxpayers but when it does, man, it’s pretty gruesome. If a plan doesn’t comply with the rules under section 409A, the penalties are severe: all of the deferred amounts become immediately taxable and subject to a 20% penalty. Some exceptions apply.
Under section 409A, distributions from these kind of plans can only be made to an employee upon the occurrence of one of these events:
- separation from the company;
- disability;
- death;
- a fixed time or schedule specified under the plan;
- change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation; or
- the occurrence of an “unforeseeable emergency” which is defined as, among other things, a severe financial hardship because of an illness or accident to the taxpayer, spouse or dependent, a casualty loss, or “other similar extraordinary and unforeseeable circumstances arising as a result of events” beyond the taxpayer’s control.
The rules that govern deferred comp plans can be tricky but there are generally reasons for the complexity. Congress often finds itself on side of trying to curb abuse – as in this case – from folks trying to game the system. Section 409A (and the resulting Code Z) is an excellent example of trying to set things right.
I have a W2 that has 12a with code “C” and 12b with code “Z” amounts. For example :
Box 12a on W2 shows Code “C” with an amount of $100
Box 12b on W2 shows Code “Z” with an amount of $800 – Rsu’s vested Jan’10
I was getting a REFUND of $500 Federal and $200 California refund. My tax preparer is adding is adding the amount of Box 12 ( $800 + $100 = $900) to my both federal and state tax and asking me to pay $400 (federal) and $800 (CA state) tax. I am not sure if the Box 12 should be added to income or tax.
I am not sure if his interpretation is correct.
I am reading the IRS publications these days Madam and I find your blog somewhat useful to know what is what. Kind of a starter into things.
Great write ups!
And Yes, I did find all the articles in your blog.