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Insight IRS Memorandum NQDC and FICA

On December 9, 2016, the IRS issued a Chief Counsel Memorandum that eliminates a correction option for employers who do not pay or deduct FICA tax from employees’ nonqualified deferred compensation at the time of vesting. Employers will want to review their tax processes for their nonqualified deferred compensation plans to ensure compliance going forward and to determine how to best address any prior issues.

Nonqualified Deferred Compensation FICA Taxation Rules

FICA tax consists of a 6.2% Social Security tax and an additional 1.45% Medicare tax payable by each of the employer and the employee (plus an additional employee-paid 0.9% Medicare tax on income over a certain limit). The employee’s Social Security portion of the tax only applies to wages up to a specified limit, which in 2017 is $127,200. Generally FICA taxes are deducted and paid when the subject wages are paid.

Nonqualified deferred compensation, however, is subject to special FICA tax rules set forth in Section 3121(v)(2) of the Tax Code and the regulations thereunder. The rule that is the focus of this article, the “special timing rule,” subjects nonqualified deferred compensation to FICA taxation upon vesting instead of upon payment. If FICA tax is applied upon vesting, the compensation and all subsequent earnings on that compensation are not subject to FICA taxation upon payment. This rule is important in traditional nonqualified deferred compensation plans because employees are typically vested in the compensation several years prior to payment. Applying FICA at the time of vesting protects the earnings on the contributed compensation from later FICA taxation at the time of payment. Depending on the plan, the length of time till payment occurs, and the earnings, this can result in a substantial portion of payments from nonqualified deferred compensation plans being subject to limited FICA taxation.

Correction Options

Prior to the issuance of the Memorandum, employers who did not take advantage of the special timing rule generally had three options: (1) apply the regular FICA timing rules and deduct/pay FICA tax from nonqualified deferred compensation payments when the payments were made, (2) file Form 941-X to retroactively apply the special timing rule and pay any FICA taxes due, or (3) enter into negotiation with the IRS for a Closing Agreement to allow retroactive payment of FICA taxes under the special timing rule and thus avoid withholding or paying FICA taxes at the time of payment.

The issue with the first option is not a tax question, since FICA taxes may be paid on nonqualified deferred compensation at the time of payment if not paid at the time of vesting. In fact, the regulations under Section 3121(v) specifically address this. The issue is that employees may be very unhappy about the timing of the taxation, unhappy enough to even file suit against the employer. The employer’s failure to use the special timing rule in effect causes employees to pay taxes on their nonqualified deferred compensation that they would not otherwise have had to pay (especially on earnings), so there is a detrimental financial impact on the employees. Whether the lawsuit is successful depends on the terms of the nonqualified deferred compensation plan and the court’s view of what is being promised to employees under the plan.

The issue with the second option is that filing an amended FICA tax return on Form 941-X is available only for open tax years. The statute of limitations is three years from the date the return is due, so this option works only for the most recent few tax years. FICA tax issues are often discovered only many years down the road, when an employee’s nonqualified account begins to pay out. Unless the failure to use the special timing rule is discovered relatively quickly, the amended FICA return does little to address the taxation issue and causes administrative issues in calculating the portion of each benefit payment that is subject to FICA taxation at payment.

The third option was the most attractive for employers who discovered FICA issues well down the road to payment, and was used in conjunction with the second option. While they could file Form 941-X for the most recent tax years, they could also address closed tax years with the Closing Agreement with the IRS, and thus completely resolve the issue. The December 2016 Memorandum, however, provides that a Closing Agreement is not appropriate because the regulations already contain provisions for applying FICA tax when the special timing rule is not correctly applied. According to the Memorandum, a Closing Agreement in this circumstance circumvents the regulatory mechanism for correction and should not be entered into by the IRS.

This change in position makes it even more critical that employers ensure up front that they are correctly handling all taxes on nonqualified deferred compensation, especially the special timing rule for FICA taxation, as later correction opportunities are limited.

For a copy of the IRS Chief Counsel Memorandum, see https://www.irs.gov/pub/lanoa/am-2017-001.pdf

For assistance with review of your nonqualified deferred compensation plan, including potential FICA tax issues, contact a member of our Tax, Estate Planning and Employee Benefits Group 208.344.6000.

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