FICA Taxation of Nonqualified Deferred Compensation

The IRS has issued final regulations relating to when amounts deferred under (or paid from) nonqualified deferred compensation plans are considered FICA wages. The final regulations are effective for amounts deferred and vested, or benefits paid, after 1999. For periods prior to that date, transition rules apply.

Regs. Sec. 31.3121(v)(2)-1 and -2 address the following matters for FICA tax payments:

• What is nonqualified deferred compensation?
• When is nonqualified deferred compensation reported as FICA wages?
• What transition rules apply for periods before 2000?

Nonqualified Deferred Compensation

A nonqualified deferred compensation plan is any written plan or arrangement, other than one qualified under Sec. 401(a), under which an employee has a legally enforceable right to compensation payable in a later year. A deferral can be either a reduction of the employee's current compensation or an amount credited in addition to the employee's current pay.

The definition of "deferred compensation" is very broad. However, some amounts to be paid in later years (such as bonuses earned for services during the year, but paid after the end of the year; stock options; stock appreciation rights; restricted property; accrued vacation benefits and severance pay) are generally not considered deferred compensation. Benefits accrued within a year of termination will generally not be deferred compensation. However, nonqualified deferred compensation plans under Sec. 457 sponsored by state and local government and tax-exempt employers, are subject to Regs. Sec. 31.3121(v)(2)-1 and -2.

Nonqualified Deferred Compensation as FICA Wages

Under the general-timing rule, FICA wages are to be reported when paid or constructively received. However, a special-timing rule provides that such amounts will be taken into account for FICA purposes as of the later of when the services are performed or when the deferred amounts are no longer subject to a substantial risk of forfeiture (i.e., the amounts are vested).

Recognizing deferred compensation accruals when an employee has other compensation in excess of the FICA taxable wage base provides a significant tax planning opportunity. Amounts deferred will generally be subject only to the Medicare or health insurance portion of the FICA tax at a combined employer/employee rate of 2.9%. Under the nonduplication rule, once these deferrals are taken into consideration for FICA purposes, the deferrals and their "reasonable" attributable earnings are not subject to FICA when subsequently paid to an employee.

Because earnings subsequent to the date that deferrals are recognized are not subject to FICA, Regs. Sec. 31.3121(v)(2)-1(d)(2) contains an anti-abuse rule to prevent employers from crediting an artificially high interest factor to employee account balances in lieu of future principal credits that would be subject to FICA. Earnings tied to a predetermined actual investment are "protected," even though the investment may have extraordinary performance. An employer also may determine earnings based on a fixed rate of return. If a fixed rate of return is reasonable when established, that rate will be treated as reasonable for up to six years. Thereafter, the rate would have to be reset to a then-prevailing reasonable rate.

Regs. Sec. 31.3121(v)(2)-1(d)(2) distinguishes between account balance plans and nonaccount balance plans. For an account balance plan, deferrals and earnings are credited to an account in the employee's name. The employee's benefit is based solely on the account's balance. Deferrals in account balance plans subject to FICA are (1) the current-year vested deferral and (2) deferrals from prior years and accumulated earnings that become vested.

Any plan that is not an account balance plan is a nonaccount balance plan. These plans use a benefit formula that normally relates to an employee's compensation and years of service. Examples of nonaccount balance plans are excess benefit plans, supplemental executive retirement plans and early retirement subsidies.

In a nonaccount balance plan, the amount deferred in a given year is (1) the actuarial present value of the vested benefit earned during the year and (2) the actuarial present value of any benefit that becomes vested in a later year. The present value can be determined by using any reasonable actuarial assumption and method. The mid-term applicable Federal rate and the Sec. 417(e) mortality table may be used to make safe harbor interest and mortality assumptions.

In a nonaccount balance plan, an employee's final benefit may be uncertain. Therefore, Regs. Sec. 31.3121(v)(2)-1(e)(4) provides that an employer may defer taking the benefits into account as FICA wages until the "resolution date," when the benefits are "reasonably ascertainable." Benefits are reasonably ascertainable when the actuarial present value of an employee's benefit is dependent only on interest, mortality and/or cost-of-living assumptions. Simply put, benefits are reasonably ascertainable on the first date that the amount, form and commencement date are known. This is known as the "modified special-timing rule," which reduces the risk that an employee will pay FICA tax on disappearing benefits.

Example: In 2001, an employer, E, establishes a deferred compensation benefit of a $500,000 lump-sum payment for T (now age 45) at age 65. T will forfeit the benefit if he dies before age 65. Because the amount, form and commencement date of the benefit are known, and only interest and mortality assumptions are needed to determine the amount deferred, the amount is considered reasonably ascertainable when the plan is established in 2001. However, if the benefit were payable at the later of age 65 or termination of employment, the commencement date would not be set and the deferred amount would not be considered reasonably ascertainable. As a result, E could choose to delay the inclusion of the deferred amount in T's FICA wages until the resolution date, when the commencement date is finally known.

Although an employer may elect to use the modified special-timing rule and wait until the resolution date to report deferred amounts as FICA wages, it may also choose to include the deferred vested amounts as FICA wages at any time before the resolution date. This presents a planning opportunity for employers. For example, if, in 2001, an employee elected to retire early in 2002, the employer may choose to recognize the actuarial present value of the deferral as of the last day of 2001. If the employee's other compensation were greater than the taxable wage base in 2001, the FICA tax would be 2.9% of the entire actuarial present value, rather than 15.3% up to the taxable wage base and 2.9% thereafter in 2002.

If a deferral amount is taken into account before the resolution date, an employer may be required to "true up" to the resolution date actuarial present value by paying an additional FICA tax. However, any amount attributable to differences in the interest rate at the resolution date and at the inclusion date will not be subject to additional FICA tax.

If an employer does not recognize deferred amounts for FICA purposes before the commencement of the payment of benefits, the general-timing rule applies: Each payment will be subject to FICA taxation in the year paid. If an employee has no other income from the employer in the year of payment, the amount up to the taxable wage base will be subject to a combined 15.3% FICA tax. If the employee has wages from another employer in the same year, he may be able to receive a credit for the FICA taxes paid, if the total wage amount is above the FICA taxable wage base. However, the employer is not entitled to a refund.

Transition Rules for Periods Before January 2000

In general, an employer may rely on a reasonable good-faith interpretation of the rules for reporting nonqualified deferred compensation before Jan. 1, 2000. Regs. Sec. 31.3121(v)(2)-1(g) provides transition rules, depending on the date of the deferrals:

Amounts deferred before 1994: Any amount deferred or vested in a period before 1994 will automatically be treated as having been taken into account. Assuming a reasonable good-faith interpretation of the rules for deferrals after 1993, pre-1994 deferrals and attributable earnings will not be subject to FICA taxes at any time.

Amounts deferred that should have been taken into account in 1994 or 1995: If amounts were deferred or became vested in 1994 or 1995 and should have been reported for FICA purposes, an employer may treat them as paid for any period before April 1, 2000 by including them on the employer's regular Form 941, Employer's Quarterly Federal Tax Return, and paying the applicable FICA tax.

Amounts deferred that should have been taken into consideration in an open tax year: If amounts were deferred or vested in years ending before 2000 for which FICA taxes were not paid, the employer may make a correction by reporting and paying the applicable tax. The amount is reported on a current Form 941 with the adjustments noted on a Form 941C, Supporting Statement to Correct Information. In addition, the employer must file and furnish a Form W-2 or W-2C, so that the earnings will be correctly posted to the employee's earnings record.

Conclusion

Under Regs. Sec. 31.3121(v)(2)-1, the special-timing rule is not elective. If an employer does not take a deferred compensation amount into account for FICA tax purposes when required, interest and penalties may be imposed on the failure to file and pay FICA taxes timely. Moreover, to the extent that a deferred amount is not taken into account when required by the special-timing rule, any later payments attributable to that deferral (including any increased value) will be under the general rule and fully subject to FICA taxes when paid, because the nonduplication rule will not apply.

By comparison, effective and timely application of the special-timing rule may be used to provide employers and employees with an opportunity to avoid a significant amount of FICA tax on deferred compensation. However, the rules are complex and employers must be careful to observe the requirements to take full advantage of this rule.

From James Colville, Rochester, MN

Revised Form 5500 and Information Reporting

It should no longer be news that Form 5500, Annual Return/Report of Em-ployee Benefit Plan (with 100 or more participants), has been significantly revised for plan years beginning in 1999. There are many changes, including appearance, content and filing approach.

A change that may prove particularly thorny is the enhanced reporting by direct filing entities (DFEs) and by the plans that invest in them. "Direct filing entity" describes those investment arrangements that hold plan assets or provide benefits for several, possibly unrelated, plans. DFEs include bank common/collective trusts (CCTs), insurance company pooled separate accounts (PSAs), master trust investment accounts (MTIAs), group insurance arrangements (GIAs) and 103-12 Investment Entities (103-12 IEs).

Direct filing is optional for CCTs, PSAs, GIAs and 103-12 IEs. However, such direct filing can substantially reduce a plan's filing requirements or costs associated with such entities; see Employee Retirement Income Security Act of 1974 (ERISA) Regs. Sections 2520.103-35, -8 and -9, 2520.104-43 and 2520.103-12. Direct filing is mandatory for MTIAs.

Given the many changes, a DFE's sponsor needs to consider the benefits of filing Form 5500 for each DFE that it sponsors. For example, a bank may offer four different CCTs to its retirement plan customers; many local businesses may invest their retirement-plan assets in these CCTs. When the bank files four Forms 5500 (one for each CCT), any plans subject to a financial audit will have significantly fewer disclosures required on filing. The Form 5500 is due within nine-and-a-half months after the end of the trust year.

The new Form 5500 instructions provide specific guidance about DFE filing requirements. Pages 810 include a table illustrating which schedules must be attached to the form. In general, a Form 5500 filed for a DFE will include Schedules D and H. Schedule D lists the name, plan number, sponsor's name and employee identification number (EIN) for each retirement or welfare plan that invests in the DFE. Schedule H shows the DFE's assets and liabilities.

DFE sponsors should take action now to compile the information they will need to file their Forms 5500.

Plan sponsors whose plans invest in DFEs also have enhanced reporting requirements. They now are required to list the DFE's name, sponsor and EIN, and the plan's number and value on Form 5500. Sponsors will also need to determine whether any eligible entity complied with the voluntary direct filing; if not, the PSA, CCT or 103-12 IE would not be considered a DFE.

To improve tracking of plan assets, the IRS intends to cross-check the information it receives from a DFE with the information reported by participating plans. Therefore, plan sponsors should take steps now to obtain required information from the banks and insurance companies that hold their retirement and welfare plan assets.

From Becky Miller, Rochester, MN