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.
Applicable FICA Taxation Rules
Unlike current compensation – on which FICA taxes (both Social Security and Medicare) are generally due when the compensation is received – nonqualified deferred compensation is subject to a number of special FICA tax rules. These are found in Section 3121(v)(2) of the Tax Code and related IRS regulations.
For instance, under a “special timing rule,” nonqualified deferred compensation is generally subject to FICA once it vests. This may be years before it is paid out (which is when income taxes are generally due).
Once deferred compensation has been subjected to FICA taxation under the special timing rule, a “non-duplication rule” then insulates that compensation – including all subsequent earnings – from FICA taxation when it is later paid to the participant. For a deferred compensation amount that vests several years before its distribution date, the FICA-tax-free earnings could actually exceed the deferred compensation, itself.
Moreover, the Social Security portion of the FICA tax (6.2% for both employees and employers) generally applies to only a specified level of compensation. For 2017, this “Social Security taxable wage base” is $127,200. Because active participants in nonqualified plans typically receive salaries that exceed this wage base, the combined effect of the special timing and non-duplication rules is to allow nonqualified deferrals to entirely escape the Social Security portion of FICA.
A simple example may help to illustrate the advantages of complying with the special timing and non-duplication rules. Assume that a company’s CEO earns $500,000 per year. The company sets aside an additional $50,000 per year as deferred compensation, on a fully vested basis. Those deferred amounts, plus earnings, are to be paid to the CEO in 10 annual installments, starting with the calendar year immediately after her retirement. By the time the CEO retires, her account balance has grown to $1 million. She therefore receives a payment of $100,000 per year for each of the next 10 years.
Under the special timing rule, each year’s nonqualified deferral would entirely escape the 6.2% FICA tax. This is because the CEO’s current compensation ($500,000) exceeds the Social Security taxable wage base. And due to the non-duplication rule, the post-retirement payments would also escape this FICA tax.
By contrast, if the CEO’s employer had failed to apply the special timing rule, then the non-duplication rule would also not apply. Instead, the deferred compensation would be subject to FICA taxation under the “general rule” – i.e., upon receipt. As a result, both the CEO and her employer would owe this 6.2% FICA tax on an additional $1 million (the ten payments of $100,000 each).
As explained in our articles of January 21, 2014, and March 23, 2015, this type of adverse tax treatment has even lead to private-party litigation. Those articles described a case in which multiple participants in an employer’s nonqualified deferred compensation plan successfully sued their employer for failing to apply the special timing rule – thereby exposing them to FICA taxes on their deferred compensation pay-outs.
So what can an employer do now if it has failed to apply the special timing rule to nonqualified deferred compensation?
- Apply the General Rule? One option, of course, is to do nothing. That is, FICA taxes would be withheld and paid under the general rule – as the deferred amounts are actually paid out. To the extent that the recipients of those payments complain, the employer might consider helping them pay their additional FICA taxes.
- Request a Closing Agreement? Nope. Until this recent Chief Counsel Memorandum, another option open to employers in this situation was to ask the IRS for permission to make retroactive payment of FICA taxes under the special timing rule. This was done by negotiating a Closing Agreement between the employer and the IRS. As a part of that Closing Agreement, the IRS would agree to the employer’s reliance on the non-duplication rule to avoid withholding or paying FICA taxes at the time the deferred compensation was paid out.
Although the Tax Code grants the IRS broad authority to enter into Closing Agreements, one condition for doing so is that “the United States will sustain no disadvantage through consummation of such an agreement.” The recent Chief Counsel Memorandum cites this condition in concluding that the IRS will no longer enter into Closing Agreements that allow employers to claim retroactive reliance on the special timing rule. The IRS supports this new position by describing the rule’s typical FICA tax benefits to employers and their employees. This translates, of course, to a loss of tax revenue for the IRS – the type of “disadvantage” that makes a Closing Agreement inappropriate.
- File Form 941-X? One other correction option does remain available to employers failing to apply the special timing rule – though only for tax years that are still open under the three-year statute of limitations. IRS regulations under Section 3121(v)(2) specifically allow an employer to file an amended FICA tax return (on Form 941-X) for any open years, retroactively applying the special timing rule for those years (and paying any additional FICA taxes that might be required under that rule). By doing so, the employer and affected employees gain the benefit of the non-duplication rule.
In general, the three-year statute of limitations for a tax year begins to run on the date an individual’s tax return is due for that year. So any employer that has not been properly applying the special timing and non-duplication rules to its nonqualified deferred compensation arrangements has until April 15, 2017, to file an amended Form 941-X for the 2013 tax year.
Of course, regardless of whether an employer elects to take corrective action for the past, immediate steps should be taken to comply with the special timing and non-duplication rules for all future tax years. The members of Spencer Fane’s Employee Benefits Practice Group can advise employers on such compliance.