This is the second in a series of articles by which the Spencer Fane LLP Employee Benefits Practice Team will explain key changes made in the employee benefits area by the Tax Cuts and Jobs Act (Public Law 115-97), which was signed into law on December 22, 2017. In addition to establishing new rules for transportation fringe benefits (see our first article in this series), the Act makes a number of changes that may affect how employers structure their executive compensation programs. This article describes the Act’s impact on for-profit employers, and outlines options that those employers should consider for their compensation arrangements.
Despite rumors to the contrary, the tax bill introduced into the House of Representatives by the Republican Party leadership would do nothing to restrict employees’ ability to make pre-tax deferrals to 401(k), 403(b), or 457(b) plans. Trial balloons had suggested that pre-tax deferrals might be limited to only half of the overall annual deferral limit (or even less), with any remaining deferrals made only on a “Roth” (after-tax) basis. But at least for now, “Rothification” appears to be dead.
What the House bill would do, however, is perhaps even more surprising. A slew of tax-favored fringe benefits would be eliminated. And nonqualified deferred compensation as we now know it would be entirely transformed. Incredibly enough, most of these changes would take effect as of January 1, 2018 – less than two months after the bill’s introduction.
A recent IRS Chief Counsel Memorandum (AM 2017-01) raises the stakes for employers that fail to apply the proper FICA taxation rules to nonqualified deferred compensation. An option previously available to those employers has been taken off the table. Under this option – which required a formal “Closing Agreement” with the IRS – both employer and employee FICA taxes could be minimized by voluntarily paying those taxes for years as to which IRS assessments were otherwise barred under the Tax Code’s three-year statute of limitations. Without this correction option, employers have an even greater incentive to apply the proper FICA taxation rules to their deferred compensation arrangements.
Deferred compensation arrangements that are not “tax-favored” retirement plans under Code Sections 401(a), 403(b), or (in the case of a governmental employer) 457(b) are generally referred to as “nonqualified” plans. So long as a nonqualified plan is “unfunded” (meaning the amounts deferred remain the property of the employer, and subject to the employer’s general creditors, until paid), the amounts deferred are generally not taxable until they are “paid or otherwise made available” to the employee.
A recent decision by a Michigan federal trial court serves as a warning to employers that their failure to shield participants in nonqualified deferred compensation plans from adverse tax consequences may subject the employers to unanticipated liability. Although this decision (in Davidson v. Henkel Corporation) involved FICA taxation, the court’s reasoning would seem to apply equally to the 20% penalty tax and interest assessments triggered by a violation of Code Section 409A.
Although the compensation that an employer pays to an employee is generally subject to FICA taxation at the time the compensation is paid, there are special rules for the FICA tax treatment of amounts payable under nonqualified deferred compensation plans (such as long-term incentive plans or supplemental retirement programs). These rules affect both the timing, and the amount, of the FICA tax that is payable with respect to such compensation (which tax is typically shared 50/50 by the employer and employee). In the recent case of Davidson v. Henkel, an employer that failed to heed those special rules found itself facing the prospect of bearing substantial additional tax liability – for both the employer’s and the employee’s share of the FICA tax. This case serves as a reminder that employers should pay special attention to when amounts deferred under a nonqualified plan are properly taken into account as “wages” for purposes of FICA taxes.