Jun 19, 2017
This paper is intended to summarize for plan sponsors and their financial advisers the FICA taxation of deferred compensation, including the rules for when deferrals are considered "wages" subject to tax and the principles for determining how the tax is calculated.The summary reflects Newport Group's interpretation of the FICA tax rules and is not intended to be relied upon as tax or legal advice. Plan sponsors should seek independent advice for their specific situation.
Special Timing Rule
Deferred compensation is subject to FICA taxation in the year the compensation (i) is earned (ii) becomes “vested” and (iii) is reasonably ascertainable. Treas. Reg. §31.3121(v)(2)-1(a)(2) (ii); -1(e). (Unless noted otherwise, all citations are to Treasury Department regulations.)
Compensation is “earned” when the employee has performed the services and has a legally binding right to receive the compensation. More practically, an amount is “earned” and treated as deferred compensation when it is credited to an employee’s account or earned under a pension formula under the terms of a written deferred compensation plan.
Compensation “vests” for FICA purposes when it is no longer subject to a “substantial risk of forfeiture”. §31.6205-1(e)(3). Vesting occurs when the employee completes any “substantial” service requirements or satisfies one or more conditions to receive the compensation. §1.83-3(c)(1). The possibility that a forfeiture may occur, for example, by violating a noncompete restriction is disregarded when determining vesting. §31.6205-1(e)(3); §1.83-3(c)(2).
Deferred compensation is reasonably ascertainable when the amount of the benefit can be calculated. Deferred compensation in an account balance plan is always ascertainable—it is the employee’s individual account balance, determined by employee and employer contributions and the earnings on those contributions. §31.3121(v)(2)-1(c)(1)(ii)(A). If the plan is a not an account balance plan (for ease of reference, a “pension plan”), the benefit is typically ascertainable when all of the variables in the pension formula are known. §31.3121(v)(2)-1(c)(1)(ii)(B).
For example, a pension plan that pays a life annuity equal to 2% of average annual pay for each year of service with average pay determined over the three year period preceding termination of employment and payable upon separation from service on or after age 65 cannot be determined (and is not ascertainable) until the employee terminates employment on or after age 65. On the other hand, a pension plan that pays $100,000 per year for ten years beginning at age 65 is ascertainable and is included in FICA wages when the employee commences participation in the plan.
For purposes of this paper, “includible” deferred compensation means the amount of vested deferred compensation to which the employee became entitled under the terms of a written plan during the year.
In an account balance plan, the includible amount is the increase in the value of the vested balance during the year. For a pension plan, the includible amount is the present value (using reasonable actuarial assumptions) of the ascertainable future payments that were earned and vested during the year.
Calculating the FICA Tax
FICA tax includes Social Security (“OASDI”) and Medicare (“HI”) portions. The employee’s rate is currently 6.2% and 1.45%, respectively. The employer portion is the same. There is a potential .9% Medicare surtax on wages earned on and after January 1, 2013. Only the employee pays the surtax.
The OASDI portion applies only to wages up to the current “OASDI wage base” ($127,200 for 2017). The HI portion applies to all deferred compensation. §31.3121(v)(2)-1(d)(1)(i). The surtax applies to wages above $250,000 for married taxpayers filing jointly, $125,000 if filing separately and $200,000 for all other filers.
In applying the OASDI and Medicare surtax compensation limits, deferred compensation is combined with all other taxable wages paid to the employee during the year. §31.3121(v)(2)-1(d) (1)(i). The employer may select a date later in the year to calculate includible deferred compensation, thus ensuring that deferred compensation is results in withholding at the HI and surtax rates only. §31.3121(v)(2)-1(e)(5).
Once an includible amount of deferred compensation is taxed under the special timing rule, the deferrals and any related earnings cannot be taxed again. §31.3121(v)(2)-1(a)(2)(iii). The earnings on previously included amounts escape taxation altogether.
Benefits of the Special Timing Rule
Conceptually, the special timing rule limits FICA taxation on the includible amount to the HI and the surtax rates because the employee’s other taxable wages will push a highly compensated employee’s deferrals over the wage base. §31.3121(v)(2)-1(d)(1) (i). (Administratively, employers frequently calculate and pay FICA tax with each payroll to ensure the employee portion is paid. Deferred salary early in the year, for example, would be subjected to the OASDI rate for payroll purposes. This is mostly a withholding and timing issue and does not change the total FICA tax on combined wages for the year.)
If FICA tax on deferred compensation is not paid under the special timing rule, FICA tax must be withheld under the “general timing rule” that taxes wages when paid. §31.3121(v)(2)-1(a)(1); (d)(1) (ii). For the following reasons it is very likely (if not certain) that the employee and employer will pay more total FICA tax on deferred compensation under the general rule:
What If FICA Was Not Reported or Withheld Under the Special Timing Rule?
- The full amount of each payment of deferred compensation will be subject to FICA tax. Deferred earnings that would have escaped tax under the non-duplication rule are taxable under the general rule. The additional tax can be significant. For example, assuming an invested amount doubles in value every 7 years and an employee with $100,000 of deferred compensation in Year 1 starts payment in Year 21 with an $800,000 account balance, the entire $800,000 is taxable. Under the special timing rule only $100,000 is taxable.
- If there is no other wage income in the year of payment, the total FICA taxes will be substantially more than under the special timing rule. For example, a retiree receiving $127,200 of deferred compensation payments in 2017 with no other wage income will pay 6.2% ($7,886.40) in OASDI tax. The tax likely would not have been payable had his or her deferrals been taxed under the special timing rule while he or she was employed. If the retiree is receiving $127,200 annually for ten years, he or she will pay a total of $78,864 in OASDI tax at current rates. The employer must also pay its $78,864 share of the tax for a combined additional tax of $157,728.
- Payments made on or after January 1, 2013 may be subject to the additional .9% Medicare surtax. The surtax would not have applied under the special timing rule to deferred compensation that was earned, vested and ascertainable before 2013.
If includible FICA wages have not been reported and withheld under the special timing rule the employer may correct the mistake under the same rules for correcting underreported FICA wages generally.
If the correction is made by the end of the limitations period for the affected year, the deferred compensation will be treated as having been included in wages in the year the includible amount should have been taxed under the special timing rule. Treas. Reg. §3121(v)(2)-1(d)(1)(i).
Treas. Reg. §31.6205-1(b)(2)(i) describes the procedures for making an interest-free correction of underpaid/reported FICA tax. Although a full description of the correction rules is beyond the scope of this paper, a missed FICA payment can be corrected in most cases by filing IRS Form 941-X in the quarter the error was discovered indicating the correct amount of FICA wages and tax. The missed payment, including the employee portion, must be sent to IRS not later than the due date for filing the 941-X.
The employee portion of FICA wages must be deducted from current year remuneration (meaning any amount due from the employer, even if not FICA wages). §31.6205-1(d). If the deduction does not occur by the filing date for Form 941-X, the employer still must pay the employee portion and may collect from the employee at a later date. If there is no other remuneration, the collection from the employee is a matter of settlement. If the employer is unable to collect from the employee, the employee’s portion paid by the employer is taxable as additional wages to the employee.
Once Form 941-X is filed and the tax paid, the employer must prepare, file and deliver to the employee IRS Form W-2c for the year in which the error occurred, including the missed payment as FICA wages in boxes 3 (OASDI) and 5 (HI), as applicable, and the corrected amounts withheld in boxes 4 and 6. §31.6205-1(a)(8); IRC §6041, 6051; Instructions, IRS Form W-2. (For most employees, only boxes 5 and 6 will be completed for the HI tax under the special timing rule.)
The FICA regulations applicable to deferred compensation are lengthy, much of it dedicated to the specifics of calculating the includible amount with extensive examples. Because the amount of tax depends on the technical calculation methodologies of items such as present values and notional earnings most of these rules are intended to eliminate methodologies that would result in artificially low includible amounts. The regulations also explain what bona fide earnings are and treat amounts that are not tied to an actual investment or that were determined retroactively as additional, taxable deferrals to the extent such amounts exceed the AFR. Considerable portions of the regulations are devoted to defining a deferred compensation plan in order to distinguish ordinary payroll practices and other forms of deferred income that are not eligible for the special timing rule from bona fide deferred compensation. Other rules give employers additional flexibility such as the ability to include deferred compensation early with a subsequent true-up, to delay reporting and withholding by up to three months, to allow estimations of tax or an alternative “lag” method for amounts that become vested at the end of a calendar year. While all of these rules are important, they are mentioned here only briefly to reinforce that this paper highlights the conceptual rules that are of recurring interest to employers, employees and their financial advisors.
Positions taken by Newport Group or its affiliates in this paper may not be relied upon as independent tax, accounting or legal advice. The recipient is encouraged to seek independent advice from its accounting and legal advisers. Views expressed on tax matters may not be relied upon to avoid tax penalties imposed under U.S. tax laws.
The information contained in this summary is provided for information purposes only and does not constitute legal or tax advice; readers are encouraged to consult their own legal and tax counsel. This paper is a high-level summary of a complex subject that is intended for Newport Group’s clients and intermediary partners and should not be understood as providing a comprehensive discussion of all issues or requirements under the regulations or as a guide to compliance. This document may not be reproduced or transmitted in any form or by any means without Newport Group’s written permission. For financial professional and plan sponsor use only. Not intended for distribution to the public.