IRS ISSUES FINAL REGULATIONS ON THE FICA TAXATION OF NONQUALIFIED DEFERRED COMPENSATION
Almost exactly three years after the long-awaited issuance of proposed regulations under Internal Revenue Code (Code) section 3121(v), the Internal Revenue Service (IRS) has published final regulations addressing the social security or "FICA" tax treatment of amounts deferred under a nonqualified deferred compensation plan. 64 Fed. Reg. 4542 (Jan. 29, 1999); Treas. Reg. §§ 31.3121(v)(2)-1 and -2. The proposed regulations were generally well-received and were considered to set forth a reasonable and practical approach to the issue. Not surprisingly, the final regulations retain the general structure and substance of the proposed rules. Most of the differences from the proposed regulations, in fact, reflect clarifications or liberalizations of the rules -- although the consistency rules described below with respect to the effective date and transition rules may restrict the flexibility that some assumed would be available for periods before the regulations became effective. The following provides a bref description of the rules under Code section 3121(v) and the modifications made by the final regulations.
Background
As a general rule, under Code section 3121(a), amounts received by an employee as remuneration for services rendered are treated as wages subject to FICA taxes when they are paid. Code section 3121(v) provides an exception to the general rule, under which amounts deferred under a nonqualified deferred compensation plan are treated as wages as of the later of when the services giving rise to the amounts are performed or the first day that the employee's right to these amounts is not subject to a substantial risk of forfeiture. After these amounts have been taken into account for FICA tax purposes, they, and earnings on them, will not be subject to FICA tax again when paid.
Although section 3121(v) was added to the Code by the Social Security Act Amendments of 1983, many questions about its application were left unanswered until the issuance of the proposed regulations in 1996. In particular, it was unclear what plans were subject to the special rules of Code section 3121(v), what constituted a "substantial risk of forfeiture" for the purpose of these rules and, most importantly, how to determine the amount that was required to be subject to FICA tax under these rules. The proposed regulations answered these questions but left other questions unanswered and, in a few cases, provided answers that troubled some commentators. The final regulations supply some of the missing answers and modify certain rules in a manner that responds to taxpayers' comments.
The Regulations: Generally
The proposed regulations indicated that amounts subject to section 3121(v) that were not taken into account for FICA tax purposes in accordance with the special timing rule of section 3121(v) would be subject to FICA tax when they were paid, in accordance with the general timing rule of section 3121(a). This rule created some confusion, causing taxpayers to wonder whether compliance with the rules of section 3121(v) was elective. While there have been no changes to the text of the regulations addressing this issue, the preamble to the final regulations states explicitly that "the special timing rule is not elective...." Moreover, if an employer does not properly take an amount into account under the rules of section 3121(v), interest and penalties may apply (presumably if the failure to comply with section 3121(v) is discovered by the IRS prior to the expiration of the applicable statute of limitations).
Plans Subject to Section 3121(v)
The final regulations retain the rule that, generally, any plan that defers the receipt of compensation from one year to another -- even for a short periodis a deferred compensation plan subject to section 3121(v). The final regulations also retain the exceptions from this general rule. Specifically: (1) amounts paid, consistent with the employer's ordinary payroll practice, after the end of the year for payroll periods overlapping the year-end are not subject to section 3121(v); (2) an employer may elect, in a manner applied consistently to all employees and all plans, to treat amounts paid within 21/2 months after the end of the year in which the services were performed as not subject to section 3121(v); and (3) stock options, stock appreciation rights, awards of restricted property, welfare benefits, benefits provided in connection with certain impending terminations (i.e., window benefits), excess parachute payments, and payments under plans established after termination of employment generally do ot constitute deferred compensation subject to section 3121(v).
With respect to arrangements that are not considered deferred compensation plans subject to section 3121(v), the final regulations make four changes from the proposed regulations:
Neither the grant nor the exercise of a stock option, stock appreciation right or other stock value right produces wages subject to section 3121(v); instead, the exercise of the option or right produces wages subject to FICA under section 3121(a) (as long as amounts payable upon exercise are actually or constructively received in the year of exercise).
Rules are provided for determining the portion of a participant's benefit constituting death or disability benefits where a plan provides both these benefits and deferred compensation.
An amendment made to a plan after an employee's termination of employment to provide a cost-of-living adjustment (COLA), rather than creating a benefit established after termination of employment that is not subject to section 3121(v), results in the present value of the COLA at the time of the plan amendment being considered wages subject to FICA at that time.
Under a transition rule, window benefits that are available for a period beginning before 2000 can be considered deferred compensation subject to section 3121(v) if they would otherwise be treated in that manner but for their being provided in connection with an impending termination of employment.
Substantial Risk of Forfeiture
The final regulations make no changes to the proposed regulations with respect to the definition of "substantial risk of forfeiture." Thus, nonqualified deferred compensation is generally subject to FICA tax when an employee is no longer required to perform services to be entitled to payment of the deferred amounts (i.e., when the employee becomes substantially "vested" in his benefit under the plan).
Determining the Amount Subject to FICA Tax
The final regulations retain the distinction established in the proposed regulations between "account balance plans" and "nonaccount balance plans." Generally, account balance plans are defined contribution arrangements (i.e., those in which deferred amounts and additional amounts representing income thereon are credited to a participant's account and the benefit payable from the plan is based solely on the participant's account balance). Under the final regulations, however, a defined contribution plan that provides for subsidized optional forms of payment (i.e., optional forms of payment that are not actuarially equivalent) is considered a nonaccount balance plan. Thus, as discussed below, if a defined contribution arrangement provides subsidized forms of distribution, treatment of deferred amounts as FICA wages may be delayed until the employee elects the form and time of benefit payment, although delaying payment until that date may be undesirable because a greater amount will be subject to FICA tx, as is also discussed below.
The rules governing the timing and amount of FICA taxation for account balance plans are rather straightforward. When an employee becomes vested in his benefit under such a plan, the total amount credited to his account at that time (including "contributions" and "earnings") is considered wages for FICA tax purposes. The FICA wages the employee has in any subsequent year as a result of his participation in the deferred compensation plan is generally the additional amount deferred in that year. As noted above, income on amounts previously taken into account for FICA tax purposes is not subject to FICA tax.
As under the proposed regulations, the final regulations limit the extent to which additional amounts credited to an employee's account will be treated as income for this purpose. Thus, an amount will be treated as income and thereby be exempt from FICA tax -- only to the extent that it does not exceed the actual rate of return for the year earned on a predetermined actual investment specified in accordance with the terms of the plan (regardless of whether assets are actually invested in that manner) or, if no predetermined investment is specified, a reasonable interest rate, as determined by the IRS. The final regulations continue the rule that does not treat a plan as specifying a predetermined investment if the plan (1) provides for income to be credited at the greater of the rates of return earned by more than one investment, or (2) puts a floor on the rate of return that will be considered earned under the plan. Also, while the final regulations give no affirmative guidance on what constitutes a reasonable" interest rate, they do indicate that the determination of the reasonableness is generally made annually, but, if an interest rate is set for a period of not more than five years and the rate was reasonable at the time it was established, it will be considered reasonable throughout the period.
In addition, the final regulations indicate that, while an employer's creditworthiness may be a factor that affects whether an employee actually will be paid his deferred compensation, it is not a factor that is taken into account in determining the reasonableness of the rate of interest credited under the plan. If additional amounts are credited to a participant's account other than on the basis of a predetermined actual investment or a reasonable interest rate, then the excess of the amount credited to the participant's account over the amount that would have been credited if income were measured by the mid-term applicable federal rate (AFR) is treated as wages for FICA tax purposes in the year credited.
Nonaccount balance plans are all plans that are not account balance plans. Accordingly, this type of plan includes traditional defined benefit excess plans, long-term incentive plans under which the amount payable to the employee is determined by reference to company performance or some other factor, and defined contribution plans that offer subsidized optional forms of payment.
The proposed rules dealing with nonaccount balance plans were widely perceived as being reasonable and practical; nevertheless, this aspect of the proposal raised the most questions. The final regulations retain much of the proposed rules, but address many of the issues raised by the proposed regulations.
The amount considered FICA wages for any year as a result of an employee's participation in a nonaccount balance plan is the increase in the present value of the employee's benefit under the plan over any amount previously treated as FICA wages. Recognizing, however, that an employee's benefit under a nonaccount balance plan may fluctuate from year to year, the IRS set forth a rule in the proposed regulations allowing an employer to defer treating any amounts as wages under a nonaccount balance plan until the date on which the only variables affecting the present value of an employee's benefit are interest, mortality and cost-of-living adjustments. (This date is referred to as the "resolution date.") Also recognizing, though, that deferring FICA taxation until the resolution date, while administratively convenient, could result in a large amount being treated as FICA wages as of that date, the proposed regulations allowed an employer to treat an employee's benefit under a nonaccount balance as FICA wages as of any earlier date on or after the time the employee has performed the relevant services and become vested in his benefit. (Any earlier date on which an amount is treated as FICA wages is referred to as an "early inclusion date.")
If it is determined as of the resolution date that the amount previously taken into account for FICA tax purposes (plus income on that amount) is less than the value of the benefit as of the resolution date, the difference must be made up at the resolution date (i.e., the employer must "true up" its FICA tax payments). If the total amount taken into account on all early inclusion dates is more than the value of the benefit as of the resolution date, the employer may be entitled to a refund for the excess taxes paid. The proposed regulations specified the manner in which the employer's true-up was to be calculated.
The final regulations retain these rules, with revisions in three key respects.
The definition of resolution date has been clarified if a nonaccount balance plan does not offer subsidized forms of distribution (i.e., if all forms of payment are actuarially equivalent), a resolution date does not fail to occur merely because the employee has not elected a form of payment or a commencement date. In such a case, the employee's FICA wages are calculated by reference to the normal form of benefit and the normal commencement date.
The true-up calculation methodology set forth in the proposed regulations exposed the employer and the employee to additional FICA tax liability as of the resolution date merely as a result of changes in interest rates after the early inclusion date(s). The final regulations modify this calculation to eliminate this exposure.
Although an employer may take an amount into account for FICA tax purposes prior to a resolution date, the employer may not take an amount into account prior to the time the employee's right to the amount has accrued. Compliance with this rule is essentially determined when the employer performs its true-up. Consequently, the final regulations set forth rules for determining the maximum amount that can be taken account as of any early inclusion date; in response to comments on the proposed regulations, these rules specifically address the situation where an employee's nonqualified benefit is determined by reference to a benefit payable under a qualified plan or any other plan.
Withholding and Paying FICA Taxes
Generally, FICA taxes must be withheld and paid at the time the deferred amounts are required to be taken into account pursuant to the rules described above. The final regulations retain, and in fact broaden, the rules in the proposed regulations designed to afford flexibility in this respect. Specifically, as under the proposed regulations, the final regulations allow an employer to withhold and pay taxes as of any date during the calendar year in which amounts are treated as wages and set forth two alternative methods for withholding and paying FICA taxes on deferred compensation.
Under the "estimated method," the employer may make a reasonable estimate of the amount required to be taken into account as of any date and withhold and pay FICA taxes accordingly. If the employer underestimated the amount required to be treated as wages, the shortfall can be treated as wages as of the date on which the estimate was made or as of any date within three months thereafter; income on any shortfall between the estimate date and the payment date is not considered FICA wages. If the employer overestimates the wage inclusion, the employer may be able to claim a refund for the resulting overpayment. Unlike the proposed regulations, the final regulations (1) permit an employer to use the estimated method regardless of whether the amount deferred can be reasonably calculated as of the estimate date, and (2) allow the estimate date to be any day, rather than only the end of a calendar year. If, though, the shortfall is determined in the calendar year after the year containing the estimate date and the employer chooses to treat the shortfall as wages as of the estimate date, or the employer overpaid any FICA taxes in the year containing the estimate date, the employer will be required to correct its Forms W-2, W-2c and/or 941 for the earlier year.
Under the "lag method," an employer may treat an amount as wages as of any date within three months after the date the amount is otherwise required to be taken into account. Under this method, however, earnings during this lag period are treated as additional FICA wages. Again, the final regulations allow the lag method to be used as of any date, rather than only as of the end of a calendar year. Unlike the proposed regulations, however, the final regulations allow the employer to determine the amount of income treated as additional FICA wages using any reasonable interest rate, rather than on the basis of plan earnings.
The proposed regulations indicated that an employer could change withholding methods from year to year; the final regulations provide even more flexibility by stating that an employer is not required to be consistent in applying the alternatives with respect to different employees or amounts deferred. As noted above, the final regulations incorporate an even more significant practical improvement over the proposed regulations by allowing an employer to use either of these alternative methods (in particular, the estimated method) as of any date, rather than just as of the end of a calendar year. Thus, in a case where an employee terminates employment in the middle of a year and, as a result of his termination, has a resolution date, the change in the regulations will enable an employer to make an estimate of the employee's FICA tax liability and withhold it from any final payments due to the employee; the proposed regulations did not appear to allow such an approach.
It appears, however, that employers that withhold and deposit more than $50,000 of employment taxes per year (and thus are required to pay FICA taxes on a semiweekly basis) gain little additional time under the lag method, as compared to the estimated method. In addition, the cost of treating income on the deferred amount earned during the lag period as FICA wages could be significant; therefore, this alternative would likely be impractical for these employers.
Effective Date and Transition Rules
The final regulations apply to (1) amounts deferred on or after January 1, 2000, (2) amounts deferred before January 1, 2000, but which cease to be subject to a substantial risk of forfeiture or, if applicable, have a resolution date after January 1, 2000, and (3) benefits actually or constructively received after January 1, 2000. For earlier periods, however, the regulations provide flexible transition rules. As was the case under the proposed regulations, any determination of FICA tax liability made before January 1, 2000 will be considered to satisfy Code section 3121(v) if it is made in accordance with a reasonable good faith interpretation of the statute. Of course, any determination made in accordance with the final or proposed regulations will be considered to have been made on the basis of a reasonable, good-faith interpretation. Also consistent with the proposed regulations, the final regulations state that for any determination of FICA tax liability made before the effective date of the regulations in a manner inconsistent with the terms of the regulations, an employer may adjust its FICA tax determination, and, where applicable, seek a refund or credit of FICA taxes paid, before January 1, 2000, provided that the statute of limitations with respect to that determination has not run before the adjustment is made. (The regulations refer to such a payment as having been made in a "pre-effective-date open period.")
However, in what is perhaps the most notable feature of the final regulations, consistency requirements have been imposed, presumably to deal with actual or perceived abuses of the flexibility afforded by this rule.
The general consistency rules essentially allow an employer to seek a refund or credit for FICA taxes paid for an employee under a plan during a pre-effective-date open period, if the employee and the plan were treated in a manner different from the manner required by the regulations (i.e., where the employer treated a plan that is not a deferred compensation plan under the regulations as a deferred compensation plan, or vice versa), but only to the extent that the FICA taxes paid by the employer for the employee in connection with the plan for all pre-effective-date open periods exceed the amount that would have been paid for those periods if the employer had treated the plan consistently with the regulations.
In addition, the final regulations set forth a special rule for stock options, stock appreciation rights and similar awards. Under this rule, an employer that treats the exercise of such an award as not subject to FICA taxes on the theory that the grant of the award was nonqualified deferred compensation that was taken into account in a prior period will not be considered to be applying a reasonable, good faith interpretation of section 3121(v) if the employer did not treat that grant and all earlier grants as wages under section 3121(v) by reporting the current value of the awards as FICA wages on Form 941 filed for the quarter during which the grant was made (or, if later, for the quarter during which the award ceased to be subject to a substantial risk of forfeiture).
Federal Unemployment Taxes
Final regulations were also issued under Code section 3306(r), which sets forth for FUTA (i.e., Federal unemployment tax) purposes the same rule as Code section 3121(v) does for FICA purposes. 64 Fed. Reg. 4540 (Jan. 29, 1999); Treas. Reg. § 31.3306(r)(2)-1. These regulations provide that the rules in the final regulations under Code section 3121(v) are applicable for the purposes of Code section 3306(r) as well.
This article is intended to provide the reader with general information and should not be considered a substitute for specific legal advice or opinion. Readers are advised not to act upon this information without seeking professional counsel.
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