Compensation and Benefits

Taxation of Deferred Compensation

The Government Finance Officers Association (GFOA) opposes the taxation of deferred benefits at the time accrued rather than when the benefit is taken. The Department of the Treasury's interpretation of Section 457 of the Internal Revenue Code set out in Internal Revenue Notice 87-13 would require employers to tax at the time of accrual vacation, sick, severance, compensatory leave, death and disability benefits and other similar benefits. Previously these benefits were taxed when their economic value was received. Moving taxation to the time of accrual will result in several undesirable effects on state and local government workers and employers.

  • It will require workers to pay taxes on a current basis on benefits they have not and may never receive.
  • It will encourage workers to use leave time inefficiently as they will be taxed on benefits whether or not they are used. This is the opposite result that employers have been trying to achieve through wellness programs.
  • It will saddle state and local governments with costly and complex record keeping to track, compute and report the value of these benefits and to avoid double taxation of benefits.

IRS Notice 87-l3 overreaches and interferes with state and local governments' authority to set benefit levels for employees. The U.S. Department of Treasury is concerned that deferred compensation benefits will be offered by state and local governments in lieu of salaries thereby avoiding current taxation of earnings and reducing federal tax revenues. This is an inappropriate conclusion because state and local governments set maximum accrual limitations for employees under the scrutiny of the public and therefore are constrained from offering excessive benefits.

The GFOA supports legislation to clarify that bona fide deferred compensation be taxed on a cash rather than an accrual basis and not be subject to Section 457 provided that the benefits are established pursuant to state or local law, rule, regulation, procedure, or benefits provided under a collective bargaining agreement.

  • Publication date: May 1988