Since the passage of the American Jobs Creation Act of 2004, P.L. 108-357, which enacted Sec. 409A, a great deal of attention has been given to the design, administration, and income taxation of nonqualified deferred compensation for both for-profit and not-for-profit employers. The main emphasis, for good reason, has been on avoiding the draconian income tax treatment for deferred compensation arrangements that fail to comply with the complex rules of Sec. 409A. Less attention has been given to the special employment tax rules that apply to these types of arrangements. With the passage of the Patient Protection and Affordable Care Act, P.L. 111-148, which provided for an increase in the Medicare tax rate for certain high earners who are members of the ERISA "top hat" group, and recent discussions about the status of Social Security and Medicare funding, it is appropriate to review the rules in Sec. 3121(v)(2) governing Federal Insurance Contributions Act (FICA) taxation.
The regulations interpreting Sec. 3121(v)(2) prescribe when amounts deferred are "taken into account" for FICA tax purposes and the value of the benefit to be taken into account. In general, two types of deferred compensation plans are addressed in the regulations: account balance and non-account balance plans. An account balance plan is any nonqualified deferred compensation plan where the employee's benefit consists solely of a principal amount credited to the employee's account balance, plus income credited to the principal. An example of an account balance plan is a "mirror" or "shadow" 401(k) plan that allows a deferral much like that of a qualified Sec. 401(k) plan to executives who wish to defer, in a nonqualified setting, compensation that would ordinarily be considered to exceed qualified plan limitations.
A non-account balance plan is any nonqualified plan that is not an account balance plan, essentially, one that calculates benefits on some other basis than deferred principal plus accumulated income. Included in this category would be most supplemental executive retirement plans (SERPs) and other plans that base benefits on formulas similar to those used in qualified defined benefit plan designs. In these types of plans, the nonqualified plan benefit could also be determined in part by an offset to the qualified plan benefit.
To the extent that the deferral constitutes wages, FICA taxation is subject to a special timing rule (see Regs. Sec. 31.3121(v)(2)-1(a)(2)). Under its terms, an amount deferred under a nonqualified deferred compensation plan must be taken into account as wages for FICA tax purposes as of the later of the date on which the services creating the right to that amount are performed or the date on which the right to that amount is no longer subject to a substantial risk of forfeiture. Whether a deferral is subject to a substantial risk of forfeiture, as well as when that risk ceases, is determined in accordance with Sec. 83, which deals with the transfer of property in connection with performing services.
In an account balance plan, the amount deferred is equal to the principal amount that is credited under the plan to the executive's account. In a non-account balance plan, the amount deferred is the present value of the future payments to which the executive has obtained a legally binding right under the plan for the period in question.
Nonqualified deferred compensation that has been properly taken into account under the special timing rule becomes subject to a "nonduplication rule." Under this rule, once an amount deferred is taken into account under the special timing rule, neither the amount taken into account nor the income attributable to it will be treated as wages for FICA tax purposes at any time thereafter. Income attributable to amounts not properly taken into account does not receive this benefit.
The nonduplication rule provides an important advantage for executives receiving, and companies providing, deferred compensation benefits, since the vested amount of the benefit will be the only amount taken into account for the purposes of FICA taxation; in a non-account balance plan setting, the present value taken into account may also be considerably less than the benefit payable at a later date. In addition, any increases in the FICA tax rate that occur between the time of the reporting and payment of FICA taxes under the special timing rule and the commencement of the benefit in a later year will not apply to the deferral already taken into account.
The special timing rule is not elective, and if an employer does not take the correct amount into account and pay the FICA taxes at the proper time as required by Sec. 3121(v)(2), interest and penalties may be imposed. Moreover, as indicated above, to the extent that the amount deferred is not taken into account in accordance with the special timing rule, all of the benefits of coming under the nonduplication rule will not apply. For the purpose of calculating FICA wages, amounts taken into account as deferred compensation are combined with other amounts paid to the employee that constitute wages for that tax year, and FICA taxes are imposed on this combined amount. Therefore, to the extent that the combined wages exceed the annual Social Security tax cap, no additional Social Security taxes are paid for that year. This, of course, is not the case for Medicare tax, for which there is no cap. And the deferrals do not have to be taken into account on the precise date upon which a substantial risk of forfeiture is removed; an employer may postpone recognition to any later date in the same calendar year.
Because of this, the special timing rule will often force FICA taxation of deferred compensation primarily during an executive's working career. This will result, presumably, in little or no Social Security tax payments ever being attributable to the compensation deferred. This may not be the case if the executive's deferred compensation benefit was taken into account for FICA on constructive receipt of the benefit, which presumably would take place during the executive's retirement years—another advantage of the special timing rule.
In determining when the deferred compensation must be taken into account under the special timing rule, some special rules apply to non-account balance plans. Under these rules, an employer may (but is not required to) delay taking into account the present value of a deferral until the amount of the deferral is reasonably ascertainable. That "resolution date"—the latest date on which deferrals under a non-account balance plan may be taken into account—is the earliest time when the amount, form, and commencement date of the benefit is known, so that its present value can be determined with the use of any assumptions besides the interest rate, mortality, and cost-of-living increases.
If the deferred compensation arrangement makes available different options for the form and the commencement date of benefits, that fact alone will not prevent their value from being reasonably ascertainable, if all forms of the benefit are actuarially equivalent. And, if there is a cost-of-living adjustment to the benefit, the benefit will not fail to be reasonably ascertainable, but future increases based on the cost of living must be considered in calculating the amount deferred.
"Present value" for the purposes of determining the amount to be taken into account in a non-account balance plan means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the condition or conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. For purposes of Regs. Sec. 31.3121(v)(2)-1(c)(2)(ii), the present value must be determined as of the date the amount deferred is required to be taken into account as wages, using actuarial assumptions and methods that are reasonable as of that date.
In calculating the present value of a benefit under a non-account balance plan, a discount is permitted for the probability that an employee will die before commencement of benefit payments, but only to the extent that benefits will be forfeited upon death. In addition, the present value cannot be discounted for the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan; the risk associated with any deemed or actual investment of amounts deferred under the plan; the risk that the employer, the trustee, or another party will be unwilling or unable to pay; the possibility of future plan amendments; the possibility of a future change in the law; or similar risks or contingencies. Nor is the present value affected by the possibility that some of the payments due under the plan will be eligible for one of the exclusions from wages in Sec. 3121(a).
The use of assumptions in determining the present value of the vested benefit is very important, since any assumption that is found to be unreasonable must be recomputed using the midterm applicable federal rate as the interest assumption and, if applicable, the mortality table prescribed in Sec. 417(e). The result is that the employer is treated as having taken only a portion of the amount deferred into account under the special timing rule, with the remaining value of the benefit being taken into account under the general timing rule. If the amount deferred for a period is determined using a reasonable interest rate and other reasonable actuarial assumptions and methods, and the amount is taken into account under the special timing rule, then, under the nonduplication rule, none of the future payments attributable to that amount will be subject to FICA tax when paid.
Finally, it is important to note that the rules of Sec. 3121(v)(2) appear not to be entirely consistent with the rules of Sec. 457(f) in determining the timing of income taxation for "ineligible" nonqualified deferred compensation plans provided to executives of not-for-profit organizations. Under Sec. 457(f), those deferred benefits are, like FICA, subject to income tax at the time of deferral unless they are subject to a substantial risk of forfeiture—again, as defined in Sec. 83. In Technical Advice Memorandum 199903032, concerning a plan involving governmental schoolteachers but relevant to this discussion, the IRS concluded that for income tax purposes, Sec. 457(f) provides no basis for postponing the resolution date for taking the deferred compensation into account on the basis of not being reasonably ascertainable at the time of the removal of the substantial risk. Therefore, in a Sec. 457(f) setting, while a not-for-profit organization may elect to take advantage of the FICA rule permitting postponement of the FICA resolution date for taking into account the amount of the benefit as wages until the amount is reasonably ascertainable, this option would not be available for purposes of income taxation.
These rules, often overlooked by for-profit and not-for-profit organizations alike, require close scrutiny. With recent emphasis in Congress and in the press on the crisis in Social Security and Medicare funding, the IRS is becoming more aggressive in addressing these employment tax issues. In any discussion concerning establishing a nonqualified deferred compensation plan, it makes good sense to include the application of the FICA taxation rules of Sec. 3121(v)(2) along with the income tax provisions of Sec. 409A.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP