Many employers reward key executives and employees by offering non-qualified deferred compensation plans, which allow them to contribute unlimited amounts of compensation on a tax-deferred basis. This is a significant enticement for upper-tier employees, as they are generally highly compensated and can easily max out their qualified compensation plans — such as 401(K) plans, which are currently limited to annual contributions of $18,500 for individuals under age 50 and $24,500 for those 50 and over.
Employers offering non-qualified deferred compensation plans to select employees understand that expenses in the plan are not deductible until paid out to the employee, and the employee is not taxed for federal income tax purposes until they receive the deferred compensation in the future.
However, what many employers may not understand is the special-timing rule for Federal Insurance Contributions Act (FICA) tax purposes as it relates to these plans. This rule can make FICA tax applicable earlier than employers may think and, if ignored, could result in IRS penalties and employee litigation down the road.
The general timing rule related to FICA states FICA wages are to be reported when paid or constructively received. However, the special-timing rule, which applies to non-qualified deferred compensation plans, states FICA wages are reported at the later of when:
This second point essentially means that wages could be subject to FICA taxes well before the employee actually receives the deferred compensation — for example, when the deferred compensation becomes fully vested (and therefore is no longer at a substantial risk).
The IRS states that there is a substantial risk of forfeiture when the ability to receive the full amount of the funds depend on:
It is not uncommon for an employer to have a non-compete agreement as part of the deferred compensation arrangement. IRS regulations make it clear a non-compete agreement is generally not enough to be considered a substantial risk of forfeiture. Therefore, even if a non-compete is in place, once the deferred compensation becomes vested and the amounts are readily determined, they become subject to FICA taxes. By the time the amount vests, an employee's current wages are typically over the Social Security component of FICA ($128,400 for 2018). This actually works in favor of the employee, as the vested amounts will generally be subject only to the Medicare portion of FICA tax, which is 1.45% for the employee portion.
Non-qualified deferred compensation plans are considered either account balance or non-account balance plans. Note this has nothing to do with the funding of the plan; an account balance plan can be unfunded.
An account balance plan is defined as one in which the principal amount deferred and earnings on that principal are credited to a specific individual’s account. FICA wages for account balance plans are the vested amounts plus vested earnings in the account.
All other plans are considered non-account balance plans, for which the benefit is calculated differently. For these plans, the amount of FICA wages is determined by taking the actuarial present value of the vested benefit during the year. The FICA wage amount cannot be calculated, however, until three things are known about the distribution to the employee:
For example, a non-account balance plan could state a payout of $500,000 (amount) will occur over a 10-year period (form) at a certain age, or employment termination or retirement date (commencement date).
Since all three factors must be known, regulations offer a modified special-timing rule for non-account balance plans only. It allows employers to defer the FICA tax until a commencement date has been identified, such as an employee’s retirement date, giving employers additional time after funds are vested to begin paying FICA tax.
The important thing to remember is that the FICA special-timing rule is not elective; if missed the employer will be paying FICA taxes as the deferred compensation is paid out under the general timing rule. This could leave the employer subject to IRS penalties and even potentially lawsuits by unhappy employees who are paying higher FICA taxes than required had the special-timing rule been applied.
Please contact a member of your service team, or contact Lisa Loychik at lloychik@cohencpa.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.