Recovery of excess FICA taxes paid for foreign employees

Editor: Mark G. Cook, CPA, CGMA

On May 8, 2023, the IRS Office of Chief Counsel (OCC) issued Chief Counsel Advice memorandum (CCA) 202323005, providing guidance with respect to U.S. employers who overpay their foreign national employee’s portion of tax imposed under the Federal Insurance Contributions Act (FICA).

In CCA 202323005, the IRS provided more clarity as to its position in response to a taxpayer’s closed transaction claim asserting that it was entitled to a refund of tax withholdings related to overpayments of a non-U.S. citizen employee’s share of FICA tax who was assigned to work in the United States and for whom the employer used a tax equalization program to adjust the tax payments.

The CCA centers on whether an employer is eligible to receive a refund for an overpayment of FICA tax paid on behalf of an employee on a foreign assignment in a year after the calendar year in which wages were paid, without the employer’s first repaying or reimbursing the employee the employee’s portion of Social Security tax. Additionally, the IRS aimed to address whether the employee’s consent to the allowance of the claim for refund is necessary where the employer uses a tax equalization program to adjust the employee’s pay.

According to Internal Revenue Manual Section 33.1.2.2.3.4, CCAs convey legal interpretations and positions developed by the OCC to personnel in the IRS function responsible for executing the relevant program. They may address topics such as tax law interpretation, Internal Revenue Code application, administrative procedures, and litigation strategies. While CCAs are primarily meant to guide IRS staff in their decision-making, they are also made available to the public and can offer valuable insight into how the IRS interprets and applies tax laws. However, a CCA is not considered legal precedent, and taxpayers cannot rely on it as such. In other words, a CCA cannot be used or cited as authority in tax disputes.

What is FICA?

FICA was established as part of the Social Security Act in 1935 during President Franklin D. Roosevelt’s administration. These acts introduced a social insurance program that was designed to pay retired workers aged 65 or older a continuing income after retirement. The Social Security Act was amended in 1965 under the administration of President Lyndon B. Johnson to include Medicare, providing health insurance for individuals aged 65 and older and for certain disabled individuals.

FICA taxes are mandatory U.S. payroll taxes shared by employees and employers to fund Social Security and Medicare. The FICA tax rate for both employers and employees is defined under Secs. 3101(a) and (b) and Secs. 3111(a) and (b) as totaling 7.65% on employees’ wages. The tax is broken out as 6.2% to fund the Old-Age, Survivors and Disability Insurance Program (OASDI) and 1.45% for Medicare, for both the employee and employer.

OASDI applies an annual wage base limit to employees who pay Social Security taxes. This means that gross income above a certain threshold is exempt from this tax. The wage limit changes almost every year based on inflation and is released by the Social Security Administration at ssa.gov. For 2023, the wage base limit is $160,200.

FICA for foreign national employees

The practice of correctly tracking, preparing, and processing a U.S. employer’s ongoing payroll tax reporting is enough of a struggle when dealing only with U.S. employees. In an increasingly globalized world, it is much more common for businesses to employ non-U.S. employees, which, in turn, materially increases payroll reporting obligations. To simplify payroll matters, employers may choose to compensate their employees with remuneration arrangements subject to FICA taxes. Such arrangements, while aimed to provide equity in employment of foreign nationals, inevitably raise a series of complex payroll tax issues related to the taxable earnings of these foreign employees.

Generally, prior to assigning foreign national employees to a U.S. office, a U.S. employer may agree to engage in a practice known as a tax equalization program (TEP). Under a TEP, the employer agrees to pay the employee a stated amount of remuneration net of applicable payroll taxes (including FICA tax). This arrangement is intended to create a compensation structure equivalent to the after-tax compensation that the foreign national employee would otherwise receive if they had remained in the employee’s country of citizenship instead of accepting a foreign assignment.

When using a TEP, as a matter of practice, the U.S. employer reduces the employee’s salary by an approximated hypothetical tax and pays the required FICA taxes throughout the year in which remuneration is paid to the employee. Under the TEP, after the hypothetical tax is deducted from the employee’s pay, the employer assumes sole responsibility for paying all payroll taxes, including FICA taxes, on tax-equalized pay. It is important to note that this is effectuated without deducting any additional amount from the agreed-upon remuneration or later adjusting such pay.

Issues arising from excess FICA tax payments

Given that a TEP uses a hypothetical figure, issues can arise when a U.S. employer has paid excess FICA taxes on behalf of its foreign national employees. Overpayment or underpayment of FICA taxes may occur from an array of circumstances including employer miscalculations, an employee having multiple employers for which payroll taxes are withheld, or remunerations that exceed the wage base limit for Social Security taxes.

When it comes to foreign employees, however, another situation might lead to an overpayment in FICA withholding — nonresident alien employees might be exempt from FICA taxes under certain conditions. Such arrangements include international social security agreements entered into by the United States with certain foreign nations, referred to as “totalization agreements.” The purpose of totalization agreements is specifically to eliminate dual social security taxation on a foreign employee’s income.

Totalization agreements must be considered when determining whether an individual is subject to U.S. Social Security/Medicare tax, or whether a U.S. citizen or resident is subject to the social security taxes of a foreign country. The question remains in these instances when there is an overpayment of FICA taxes: How are such funds recovered and who is entitled to them?

Generally, the IRS recognizes the potential for overpayment of FICA taxes and provides mechanisms for employers to claim refunds. Under Regs. Sec. 31.6413(a)-2(c)(2), an employer can correct an overpayment of income tax withholding due to an “administrative error.” An administrative error involves the inaccurate reporting of the amount withheld due to a transposition or math error on the employment tax returns. In other words, an administrative error occurs when the amount the employer reported as withheld on the employer’s employment tax return does not agree with the amount actually withheld from the employee’s wages.

Generally, an employer may correct overpayments of FICA tax after an error has been ascertained, using the adjustment process under Sec. 6413 or the refund claim process under Sec. 6402. An error is ascertained when the employer has sufficient knowledge of the error to be able to correct it.

The U.S. employer may not generally receive a refund of overpaid FICA tax without making reasonable efforts to protect its employees’ interests with respect to OASDI. In accordance with Regs. Sec. 31.6402(a)-2(a)(1)(ii), the employer must first repay or reimburse its employee or secure the employee’s consent to the allowance of the claim for refund before filing a claim for credit or refund for an overpayment. However, this requirement does not apply to the extent that the taxes were not withheld from the employee or, after the employer makes reasonable efforts to repay or reimburse the employee or secure the employee’s consent, the employer cannot locate the employee or the employee will not provide consent. For FICA tax overcollected in a prior year, the employer must also secure the employee’s written statement confirming that the employee has not made any previous claims (or the claims were rejected) and will not make any future claims for refund or credit of the amount of the overcollected FICA tax.

Exceptions to employee consent

In the scenarios where an employer has chosen to operate under a TEP with its foreign national employee as discussed above, the tax payments made on behalf of an employee are included in the employee’s gross income, even if the accounting processes used by the U.S. employer under its TEP do not identify the payments as being withheld. This is because the employee has agreed to accept a lower salary in advance in exchange for the employer’s agreement to pay all taxes on the employee’s behalf.

As such, regardless of any internal accounting, the taxes paid on the employee’s behalf are deemed to have been withheld from the employee under Rev. Rul. 86-14. The U.S. employer, therefore, does not fall into the exception to the requirement to reimburse its employee or secure an employee’s consent before receiving a credit or refund for an overpayment of FICA taxes because the tax liability incurred on behalf of an employee is included in the employee’s gross income. The exception applies only to situations in which taxes were not withheld from the employee. Additionally, excess FICA taxes withheld by an employer may be recovered through a claim for credit or refund only after the employer first repays or reimburses its employee or secures the employee’s consent to the allowance of the claim for refund. In CCA 202323005, the IRS views these payments have been withheld, thereby disqualifying a U.S. employer from claiming the exception.

US reporting of FICA overpayments

U.S. employers report FICA taxes withheld and remitted to the IRS using Form 941, Employer’s Quarterly Federal Tax Return. This form is used to report an array of payroll tax items including income taxes withheld and both the employer and employee portions of FICA taxes. In addition to preparing and filing Form 941 quarterly, employers are also required to prepare and provide to each employee the employee’s share of FICA taxes on Form W-2, Wage and Tax Statement.

In instances when an overpayment is confirmed and the employer has determined it has the right to do so, the employer can claim a refund. To do so, the employer must file Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. This form allows employers to correct mistakes made on the originally filed payroll tax return form, including overpayment of FICA taxes.

However, as noted above, before filing Form 941-X, the employer must first attempt to adjust the overpayment with the employee, as FICA taxes involve both employer and employee contributions. If the employee consents to the adjustment or if the employer cannot locate the employee, the employer may then proceed to file Form 941-X. The IRS will issue the refund check to the U.S. employer, provided that all conditions for a refund are met.

Seeking refunds

Generally, excess FICA taxes withheld by an employer may be recovered through a claim for credit or refund only after the employer first repays or reimburses its employee or secures the employee’s consent to the allowance of the claim for refund of the FICA taxes.

CCA 202323005 is a significant development from the perspective of global mobility tax compliance and subsequently for the federal income tax reporting and withholding tax obligations of certain employers. It is important to note that the interpretation and application of any CCA should be considered on a case-by-case basis and in tandem with other authority and legal precedent. Employers that believe they may be entitled to a refund of overpaid FICA taxes can consult with a trusted tax professional.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.