While February is usually the month for valentines and candy conversation hearts, I hope you will use this month to give a little love and attention to one of the often overlooked “other” taxes applied to payments from nonqualified deferred compensation plans (NQDC Plans)—FICA taxes! Companies commonly fail to implement the unique FICA tax rules applied to NQDC Plans and these special rules can create confusion for participating executives. This can result in the company’s potential exposure to IRS penalties, higher tax liabilities for the company and the employees, and unhappy employees. Confirming proper FICA tax treatment for your NQDC Plans is time well spent.
A Refresher: What are FICA Taxes?
FICA taxes (often referred to as “payroll taxes”) are a combination of the Social Security tax (6.2 percent tax applied up to a wage base limit—$132,900 for 2019) and the Medicare tax (1.45 percent tax on all wages). Higher-paid employees may also owe an additional 0.9 percent Medicare surtax on wages above a certain threshold. These FICA taxes must be reported to the IRS by employers and paid by both the employer and the employee on all wages. Wages generally include any compensation paid by an employer to an employee for the employee’s services, even if those amounts are ultimately paid to an individual after he or she terminates employment. The nature of the payment, and not the timing of the payment, affects how amounts should be reported to the IRS and what taxes are due (for a related discussion, see our prior article about how to properly report compensation paid to former employees).
The standard rule is that FICA taxes must be withheld from the employee and paid by the employer at the time the wages are actually paid to the employee.
Nonqualified Deferred Compensation Plans Use a Special Timing Rule for FICA Taxes
Most employers and employees understand that amounts properly deferred under a NQDC Plan are not subject to federal income taxes until the amounts are actually paid to the employee. However, FICA taxes apply a “special timing rule” for NQDC Plans, which could make those FICA taxes due to the IRS before the underlying deferred compensation is actually paid!
The Special Timing Rule. FICA taxes are due on deferred compensation amounts on the later of (i) when the employee provides the related services, or (ii) when the compensation is no longer subject to a substantial risk of forfeiture (meaning: when the amounts are vested). For typical NQDC Plans— where the employee is only entitled to receive employee salary deferrals and/or employer contributions (plus any earnings) that are credited to his or her plan account—this special timing rule means that FICA taxes must be reported to the IRS and withheld as follows:
Formula-Based NQDC Plan Benefits. If a NQDC Plan uses a formula to determine a participant’s benefit under the plan (similar to a benefit formula for a defined benefit pension plan), then FICA taxes need to be reported and withheld once the benefit amount is vested AND “reasonably ascertainable.” Typically, this means that employers cannot calculate the employee’s actual benefit under the NQDC Plan when the benefit vests. Instead, the employer must wait until the individual terminates employment and the employer can finalize all of the numbers necessary to calculate the formula (e.g., final years of service and compensation). As a result, under a formula-based NQDC Plan, FICA taxes may be deferred until the year in which the employee terminates employment.
Advantages of the Special Timing Rule. There are two benefits to having this special timing rule for NQDC Plans, which generally result in a lower overall FICA tax obligation for both the employer and the employee:
Now That I Know About FICA Taxes and the Special Timing Rule, What Next?