In providing nonqualified deferred compensation opportunities to certain members of the workforce, employers in the for-profit, tax-exempt, and public sectors may overlook a number of issues involving the application of the employment tax rules. With a new emphasis on nonqualified arrangements following the enactment of Sec. 409A and its subsequent interpretation, and the income tax rules of Sec. 457 for tax-exempt and public sector employers, the timing seems right to revisit several of these issues. Included in this overview are employment tax matters that affect the sponsorship and administration of state retirement systems and of "FICA replacement plans" that are part of retirement planning in the public sector. Here are several facets that are often overlooked in correctly applying employment tax rules.
FICA and FUTA tax treatment regarding "employer-sourced" contributions to Sec. 457(b) "eligible" plans of deferred compensation: In a Sec. 457(b) plan of nonqualified deferred compensation, any contribution, whether it is in the form of a deferral elected by an employee or a matching or "nonelective" contribution made by the employer, will be treated as a deferral and be subject to Federal Insurance Contributions Act (FICA) taxes and Federal Unemployment Tax Act (FUTA) taxes when the services are performed or the contribution is no longer subject to a substantial risk of forfeiture. Thus, if a Sec. 457(b) plan provides annual deferrals that are fully and immediately vested, these deferrals are subject to Social Security, Medicare, and FUTA taxes at the time of deferral. However, if the annual deferrals are not fully and immediately vested but are subject to a substantial risk of forfeiture, the annual deferrals (and their earnings) are generally taken into account for purposes of Social Security, Medicare, and FUTA at the time the amounts are no longer subject to a substantial risk of forfeiture.
Since public sector Sec. 457(b) plans usually permit participation by all eligible employees, whether highly compensated or not, special attention should be given to FICA taxation when employer matching or nonelective contributions are provided, particularly when those contributions are subject to a vesting schedule. This treatment should be differentiated from the rules that apply to qualified retirement plans, such as Sec. 401(k) plans, where employer matching and nonelective contributions are not taken into account for purposes of reporting and withholding FICA or FUTA taxes or taken into account for purposes of the qualified plan annual deferral limitation.
As an eligible "account" plan of deferred compensation, not only are any employer Sec. 457(b) matching and nonelective contributions treated as wages subject to FICA and FUTA, usually when they vest, but they also are usually counted toward the Sec. 457(b) annual deferral limit that is in effect for that year. The contributions are, essentially, treated as deferrals not when they are made to the plan, but when the services giving rise to the deferred compensation are performed and the deferral is no longer subject to a substantial risk of forfeiture.
The FICA and FUTA special timing rule applicable to nonqualified plans of deferred compensation paid to "top hat" employees in for-profit companies: When nonqualified deferred compensation is provided to a "select group of management or highly compensated employees" (i.e., the "top hat group") of a for-profit business and vesting is scheduled to occur many years before the permissible payment event of actual or constructive receipt of the benefit, special attention must be given to the special timing rule of Sec. 3121(v). Especially in the case of "nonaccount" plans, which often feature an annuity payment stream of at least 10 years beginning many years after the vesting of the benefit, clients have occasionally missed out on the benefits of complying with this rule, which requires taking into account the present value of the benefit at the time of vesting for reporting and payment of the FICA and FUTA taxes.
By taking into account and paying the FICA and FUTA obligation at that time, the employer and employee also take advantage of the benefits of the nonduplication rule. This rule generally provides that once deferred compensation is taken into account for FICA and FUTA purposes, neither the amount taken into account nor the income attributable to that amount is treated as wages for FICA and FUTA tax purposes at any time thereafter. In some situations, clients have been able to file Forms 941X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, and W-2C, Corrected Wage and Tax Statement, to recapture the benefits of the special timing rule for deferred compensation vested in a prior open tax year. When compared with the amount of compensation that must be taken into account for FICA and FUTA purposes at actual or constructive receipt under the general timing rule, employers and employees are often missing out on substantial employment tax savings.
FICA-HI taxation attributable to wages, including contributions made to certain public sector Sec. 457(b) FICA replacement plans. Since 1951, Sec. 218 of the Social Security Act has authorized states to enter into voluntary agreements with the federal government to provide Social Security coverage to their public employees. Today, a number of public sector Sec. 457(b) plans qualify and operate as FICA replacement retirement systems and are not covered by a Social Security Act Section 218 Agreement.
If a public employer maintains a qualifying "FICA replacement retirement system" for its employees and has not obtained a Section 218 Agreement, it is not required to pay the Old-Age, Survivors, and Disability Insurance (OASDI) portion of Social Security on its employees' wages. However, the public employer must still properly report and withhold the Medicare portion of FICA (HI, or Hospital Insurance), even given the existence of FICA replacement plan status. Again, to the extent possible, clients have been able to submit Forms 941X and W-2C for prior open years, taking into account wages and vested deferred compensation for purposes of reporting and paying the FICA-HI tax.
Interplay between public retirement systems and the Social Security Act Section 218 Agreement: Effective July 2, 1991, Congress made Social Security coverage mandatory for state and local government employees who are neither covered by an SSA Section 218 Agreement nor are qualifying participants in a public retirement system. Under this law, states can provide these otherwise mandatorily covered employees with membership in a public retirement system as an alternative to Social Security coverage. Employees may also be covered by both a public retirement system and Social Security if the public entity enters into a Section 218 Agreement. Although these rules are complex, it is important to remember that as a starting point, when a public entity fails to obtain a Section 218 Agreement for its public retirement system, it will not be permitted to provide Social Security coverage to those employees covered under the public retirement system.
A public employee may not voluntarily pay Social Security taxes without a Section 218 Agreement. In that case, the public entity may not take into account the wages earned by those public employees for FICA-OASDI purposes. The public entity must voluntarily elect to be double-covered by entering into a Section 218 Agreement while continuing to pay into the public pension plan. Even if a Section 218 Agreement is not obtained, and the employees of the public entity are covered only under a public retirement system, Medicare tax (FICA-HI) must still be reported and withheld for employees hired on or after April 1, 1986.
Occasionally, a public entity still has failed to obtain a Section 218 Agreement for one of its retirement systems, but the entity continues to withhold for FICA-OASDI for members of that system. In that instance, the entity will want to correct the oversight by obtaining a Section 218 Agreement for the public retirement system and permitting the members of the system to elect to receive refunds of the FICA-OASDI tax paid in the prior open years.
The FICA and FUTA rules attendant with the sponsorship of deferred compensation, and particularly those involving public sector retirement plans, are often overlooked. They usually require advanced planning and close scrutiny. With recent emphasis in Congress and the press addressing the crisis in Social Security and Medicare funding, the IRS is becoming more aggressive in addressing these employment taxation issues through examination. It makes good sense to include a discussion involving the application of the FICA taxation rules in the establishment or maintenance of a nonqualified deferred compensation program or a public sector retirement system.
EditorNotes
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
