As payroll departments prepare for year-end reporting, it may be useful to review two IRS memos released in 2017 concerning FICA (social security and Medicare) taxes imposed on nonqualified deferred compensation (“NQDC”). The first memo released in January addresses the IRS’ unwillingness to enter into closing agreements to protect employers who mishandled the FICA “special timing” rule. The second memo released in June addresses the application of the special timing rule for nonaccount balance NQDC plans. We summarize both guidance strategies in a two-part article below.
Part I: IRS Declines Entering into Closing Agreement to Protect FICA Special Timing Rule
In a memo released in January 2017 (AM2017-001), the IRS National Office was asked whether the IRS should enter into closing agreements with employers that had not timely included NQDC as wages in the year of vesting for FICA purposes, and are willing to pay the tax due (along with interest and penalties) even though the year is closed for assessment under the period of limitations. The memorandum concludes that IRS agents should not enter into closing agreements with these employers since the regulations already provided three years for them to correct the taxes that were due in the year of vesting.
Consequences of non-compliance with FICA special timing rule; motivation to enter into a closing agreement
Amounts deferred under a NQDC plan are subject to both a “special timing” rule and a “non-duplication” rule for FICA purposes. Under the special timing rule, deferred amounts are generally treated as wages for purposes of FICA taxes when the deferred compensation is no longer subject to a substantial risk of forfeiture (i.e., upon vesting). Under the non-duplication rule, once an amount is taken into account as wages for FICA purposes, neither that amount nor any subsequent earnings is treated as wages for purposes of FICA tax in any future year.
These rules generally result in less total FICA tax being paid than if the FICA taxes were paid under the “general timing” rule at the time the benefits were distributed. The social security portion of FICA tax is only imposed on wages up to the social security wage base. The employee often has other wages in the vesting year that equal or exceed the social security wage base, thereby making Medicare tax (and possibly the Additional Medicare tax) the only tax liability for such year. Also, less FICA tax is imposed because the future earnings on the amounts deferred avoid FICA tax pursuant to the nonduplication rule.
In contrast, paying FICA tax at the time of distribution under the “general timing” rule, rather than the year vested under the special timing rule, often results in more FICA tax being paid. To the extent the employees are retired at distribution, they are less likely to have other wages equal to or greater than the social security wage base for that year; thereby subjecting all or a portion of the distribution to social security tax as well as Medicare tax. This adverse tax consequence is amplified for employees who receive their deferred compensation in annual installments since the social security wage base must be satisfied multiple times, often resulting in the entire balance being subjected to social security taxes. Further, more FICA tax is imposed because all earnings on the amounts deferred are also subject to FICA tax.
In addition, the case of Davidson v. Henkel Corporation (2015) highlights potential employer liability under ERISA to NQDC plan participants if benefits are not taxed in the most favorable manner. In Davidson, the employer maintained a NQDC plan, but did not follow the special timing rule. As a result, plan participants experienced a reduction in net benefits due to the increased FICA taxes they incurred with respect to those benefits. The participants brought a successful class action suit under ERISA seeking to recover the benefits they lost as a result of the employer’s failure to withhold FICA tax pursuant to the special timing rule.
IRS memo advising agents to decline requests for closing agreements
The tax regulations describes the steps to be taken if an employer fails to use the special timing rule under a NQDC plan. The employer may adjust its employment tax returns for any year for which the period of limitations has not expired to report and pay the additional FICA taxes attributable to the amounts deferred and required to be included under the special timing rule. For closed years, however, the general timing rule will apply.
To reinforce the importance of adhering to the special timing rule and its correction methods, the IRS National Office advised that it is not appropriate for the IRS to enter into a closing agreement in situations where employers did not timely take NQDC into account for FICA purposes and the period of limitations has closed.
To avoid paying significantly higher FICA taxes and potential employer liability under ERISA for not taxing the participants’ benefits in the most favorable manner, employers should ensure that account balances under NQDC plans are subject to FICA taxes at vesting. Upon any failure to timely include the deferred compensation in income for FICA purposes, remedial action should be taken immediately before the 3-year period of limitations closes. While the point of FICA taxation (i.e., the vesting date) on most deferred compensation may be readily determinable (e.g., a specified date or event), the vesting date of some provisions may not be as apparent (e.g., a “Rule of 60” provision where vesting occurs on the date in which the participant’s age plus years of service equals 60). The plan administration and payroll systems should be customized to recognize the vest date and trigger the FICA tax liability.
Part II: Applying the FICA Special Timing Rule to Nonaccount Balance Plans
In a memo released in June 2017 (AM2017-0012), the taxpayer questioned why his employer paid FICA taxes on the present value of the annuity payments in the year he began receiving distributions under the NQDC plan. The IRS National Office confirmed the employer’s method of withholding and paying FICA taxes on amounts deferred under the NQDC arrangement was proper.
The NQDC arrangement addressed in the memo was a nonaccount balance plan, which does not credit deferred amounts to a particular participant’s individual account. Under a special rule for nonaccount balance plans, an employer is permitted to delay subjecting the deferred compensation to FICA taxes until the amount is considered “reasonably ascertainable.” Reasonably ascertainable is defined as the first date on which the amount, form, and commencement date of the benefit are known, so that its present value can be computed. When the present value of a benefit becomes reasonably ascertainable, such amount is subject to FICA tax. The IRS National Office confirmed the employer’s method of withholding and paying FICA taxes on the present value of the payments upon the first distribution amounts deferred under the NQDC arrangement was proper.
Employers should determine when nonaccount balance plans become reasonably ascertainable for purposes determining the present value of a participant’s benefits and withholding and paying FICA taxes on the amount at such time. Under some nonaccount balance plans, retirement benefits become reasonably ascertainable at the time of retirement. Notably, the present value calculation does not consider the probability that an employer will not make payments because of the unfunded status of the plan. Nor does it consider the risk associated with any deemed or actual investment of the amounts deferred under the plan, or similar risks or contingencies.
For more information on the matters discussed above, please contact MFA’s Tax Team.