IRS finalizes regs. on FICA taxation of nonqualified deferred compensation.

On Jan. 28, 1999, the IRS finalized Regs. Sec. 31.3121(v)(2)-1, addressing the FICA taxation of nonqualified deferred compensation, which became effective on Jan. 1, 2000. These regulations are issued under Sec. 3121(v)(2), enacted as part of the Social Security Amendments Act of 1983.

Although the statutory changes were effective Jan. 1, 1984, Service guidance was not forthcoming immediately, because there was little, if any, need for such guidance. Nonqualified deferrals are combined with other FICA wages for the year to determine the overall amount subject to FICA taxation. Most individuals participating in nonqualified deferred compensation arrangements had other cash wage payments during the calendar year that equaled or exceeded the FICA taxable wage base. As a result, the requirement to take the nonqualified deferral into account in the year earned was of little practical significance, because it most commonly resulted in no additional FICA tax liability. However, the subsequent creation of a separate, higher cap on wages subject to the Medicare (HI) portion of FICA, followed by the later complete elimination of that cap, created a need for more specific guidance.

Analysis of the Regulations

FICA timing rules. Regs. Sec. 31.3121(v)(2)-1(a) addresses the time when a deferral is subject to FICA. Under the regulations, FICA is imposed under either the "general timing rule" or the "special timing rule."

The general timing rule applies for most purposes for FICA taxation. Under the general timing rule, an amount is subject to FICA at the time the employer actually makes a payment, in cash or in kind, of "wages" for FICA purposes. The special timing rule provides that FICA wages are taken into account for FICA purposes at the time the employee performs services creating the right to receive future compensation, or the date such an amount is no longer subject to a substantial risk of forfeiture. Regs. Sec. 31.3121(v)(2)-1(a)(2) provides that the special timing rule applies to "an amount deferred" under a "nonqualified deferred compensation plan."

In addition, Regs. Sec. 31.3121(v)(2)-1(a)(2)(iii), as required by the statute, provides a nonduplication rule, exempting from FICA taxation any amounts previously subjected to FICA and earnings attributable to those amounts.

The special timing rule is usually more advantageous, even though it results in an earlier payment of FICA tax. By applying the special timing rule, the nonqualified deferral is combined with other wages in determining the overall FICA tax liability. If an individual has other wages equal to the old age, survivors and disability insurance (OASDI) taxable wage base, the additional tax liability is limited to 2.9% (half payable by the employer and half by the employee) of the amount deferred. If the special timing rule did not exist, FICA would be imposed at the time the individual receives a distribution from the plan. This may occur at the time an individual receives no other wages subject to FICA. As a result, the distribution could be the sole or primary item of FICA wages, causing much or all of the distributions to be subject to both the OASDI portion of FICA at 12.4% and the HI portion at 2.9%, for a much larger overall liability.

The nonduplication rule confers an additional benefit by exempting the accrued income from FICA taxation. If the nonduplication rule. did not exist, the income accruing on the deferral would be subject to FICA taxation.

Arrangements subject to Sec. 3121(v)(2). An arrangement must be a "nonqualified deferred compensation plan" to be subject to Sec. 3121(v)(2). Regs. Sec. 31.3121(v)(2)-1(b) defines a nonqualified deferred compensation plan generally to include any plan (other than a qualified plan) established by an employer that provides for a "deferral of compensation." A plan can be set up unilaterally or negotiated between the parties. An otherwise qualifying plan is subject to Sec. 3121(v)(2) as of the latest of the date the plan is adopted or effective, or the plan's material terms are reduced to writing. Although the regulations require a written plan, Regs. Sec. 31.3121(v)(2)-1(b)(2)(iii) contains a transition rule allowing certain unwritten plans to qualify for Sec. 3121(v)(2), if the material terms of the plan are set forth in writing by Jan. 1, 2000. This special rule applies only to unwritten plans that had been adopted and were effective before March 25, 1996.

A plan must also provide for a "deferral of compensation." Under Regs. Sec. 31.3121(v)(2)-1(b)(3), a plan provides for a "deferral of compensation" if it provides an employee with a legally binding right during one calendar year to receive compensation in some future period. However, there is no "deferral of compensation" merely because the compensation is paid after the last day of the calendar year, such as under a payroll practice in which employees are paid for a payroll period on a date after the last day of the payroll period. Regs. Sec. 31.3121(v)(2)-1(b)(3)(iii) also gives the employer an option to treat certain "short-term deferrals" under arrangements that otherwise qualify as a nonqualified deferred compensation plan as not being subject to the special timing rule. An employer that elects this option in any particular year must apply it consistently that year to all "similar plans;" consistency from one year to another is not required. The final regulations clarify that a plan still provides for the "deferral of compensation" even if the benefit can be reduced on account of investment losses.

Certain transactions or arrangements are exempted from Sec. 3121(v)(2) as not providing for a "deferral of compensation." These include:

* Stock option grants. Regs. Sec. 31.3121(v)(2)-1(b)(4)(ii) provides that the grant of a stock option does not constitute a deferral of compensation. The final regulations add a further statement that amounts received from the exercise of a stock option do not result from a deferral of compensation.

* Stock appreciation rights. A stock appreciation right allows an employee to exercise an option to receive payment from the employer of an amount equal to the difference in the price of a specified number of shares of employer stock between the date of grant and the date of exercise. This arrangement is described in Rev. Rul. 80-300. However, a phantom stock plan, which provides the employee with a payment equal to the value of stock at a given time, is treated as a deferral of compensation under the regulations.

* "Other stock value rights." Other stock value rights under Regs. Sec. 31.3121(v)(2)-1(b)(4)(ii).

* Restricted property. The receipt of restricted property subject to taxation under Sec. 83, not currently includible in income under the rules of that section, is not a deferral of compensation. However, a plan that gives an employee the right to receive payment in the form of property can qualify as a nonqualified deferred compensation plan.

* Welfare benefits, such as vacation benefits, sick leave, compensatory time, disability pay, severance pay and death benefits. Regs. Sec. 31.3121(v)(2)-1(b)(4)(iv) should be consulted for details.

* Benefits provided in connection with the employee's impending termination of employment (with an exception for certain "window" benefits payable before 2000). Regs. Sec. 31.3121(v)(2)-1(b)(4)(v) should be consulted for details.

* Short-term deferrals. As previously noted, short-term deferrals, at the option of the employer, can be treated as a plan of deferred compensation.

Types of plans and calculation of the dextral amount. To calculate the correct amount of FICA, it is necessary to calculate the "amount deferred." This calculation will vary depending on whether the plan is an "account balance plan" or a "nonaccount balance plan."

An "account balance plan" is a plan to which an employee is credited a specified principal amount, and under which the employee's benefit is based solely on the principal balance and any income attributable to that principal amount. Under the regulations, FICA is generally imposed at the time the principal is credited (or when the employee's rights become vested, if later). However, if FICA is not imposed at this time or if the employer is permitted to choose not to pay FICA immediately and exercises this choice, FICA will apply to the total of the original amount credited plus income accrued to that point. Although the regulations generally require the benefit in an account balance plan to be based on the account's balance, Regs. Sec. 31.3121(v)(2)-1(c)(1)(iii)(C) clarifies that an employer may pay the benefit in the form of an annuity actuarially equivalent in value to the account's value.

A "nonaccount balance plan" is defined as any plan that is not an account balance plan. In a nonaccount balance plan, FICA is imposed on the actuarial present value of the employee's benefit. Regs. Sec. 31.3121(v)(2)-1 (c)(2)(ii) states that the assumptions used to determine actuarial equivalence must be reasonable and that the value of benefits may not be discounted for such contingencies as the possibility that the employer will be unable to pay benefits when due. No attempt is made to offer guidance on what interest, mortality and other permissible assumptions fall within the range of "reason." Regs. Sec. 31.3121(v)(2)-(c)(2)(iii)(A) specifically addresses how to determine actuarial equivalence when more than one form of benefit is provided and the effect if actuarial equivalence ceases to be reasonable. It should be consulted for details.

Determining attributable income and applying the nonduplication rule. The nonduplication rule provides that any amount subject to FICA and the related income are not later subject to FICA taxation. However, any income accruing before FICA is imposed is included in the amount subject to FICA taxation.

To use the nonduplication rule, the special timing rule must be applied. Regs. Sec. 31.3121(v)(2)-1(d)(1)(ii)(A) states that, if an employer fails to take a deferral into account in a timely manner, the special timing rule ceases to be available, and the general timing rule applies. Regs. Sec. 31.3121(v)(2)-1(d)(1)(ii)(B) also contains special rules for determining how to apply the special timing rule if an employer takes into account only part of a deferral.

If it is available, the nonduplication rule applies to the amount subjected to FICA ("taken into account") and its related interest. Regs. Sec. 31.3121(v)(2)-1(d)(2)(i)(C) provides rules that prevent the employer from overstating interest, which would have the effect of sheltering excessive amounts under the nonduplication rule. If the earnings rate is determined to be unreasonably high, the overstated portion of the earnings is treated as an additional amount deferred, separately subject to the special timing rule.

For an account balance plan, a reasonable return is based either on a predetermined actual investment or a reasonable interest rate. Regs. Sec. 31.3121(v)(2)-1(d)(2)(i)(C)(2) significantly expanded the rules applicable for determining reasonable rates of return. If actual investment performance is to be used, no assets need be set aside for this purpose. However, an employer is not permitted to choose between the greater of two returns on two separate investments. If a fixed rate is specified and is initially reasonable, it is deemed to continue to be reasonable for a five-year period, after which its reasonableness must be reevaluated.

For a nonaccount balance plan, income attributable to the amount deferred is defined as the increase due solely to the passage of time, in the present value of the payments to be made to the employee. This present value is determined on the basis of "reasonable actuarial assumptions and methods," including "reasonable" interest rates. Regs. Sec. 31.3121(v)(2)-1(d)(2)(ii) provides no guidance as to what constitutes a reasonable interest rate or which actuarial assumptions are reasonable for this purpose.

When deferrals are treated as FICA wages. Nonqualified deferrals are generally considered FICA wages as of the date the employee performs the services giving rise to the rights, or when the amount is no longer subject to a substantial risk of forfeiture. For this purpose, the existence of a substantial risk of forfeiture is determined based on principles that apply for Sec. 83 purposes. For example, if the employee must perform additional services to "vest" in his right to the deferral, a substantial risk of forfeiture exists. However, Regs. Sec. 31.3121(v)(2)-1(e)(4) provides two special rules that allow the nonqualified deferral to be treated as FICA wages on a later date.

The first special rule applies only to nonaccount balance plans. Employers may apply the general rule described above, or may choose to treat the amount as FICA wages at the time the benefit becomes "reasonably ascertainable." Under Regs. Sec. 31.3121(v)(2)-1(e)(4)(i)(B), a benefit is "reasonably ascertainable" on the first date on which the amount, form and commencement date are known, and the only actuarial assumptions needed to value the benefit are interest, mortality and, if applicable, cost-of-living adjustments. This is known as the resolution date.

The resolution date is later than the date the benefit is "earned." However, Regs. Sec. 31.3121(v)(2)-1(e)(4)(ii) allows an employee to treat the deferral as FICA wages at any date prior to the resolution date. If an employer makes this election, the amount treated as FICA wages will be equal to the actuarial present value of the benefit, determined at that time. The employer will then be required to make a "true-up" calculation as of the resolution date. The true-up calculation is necessary if the employer determines on the resolution date that the actual benefits the employee will receive are different from the estimated benefits determined as of the early inclusion date. Any required true-up calculation may be based on the same actuarial assumptions used on the early inclusion date.

A second special rule regarding the timing of FICA is the rule of administrative convenience. Under Regs. Sec. 31.3121(v)(2)-1(e)(5), when deferred compensation is required to be included in FICA wages during a particular year, the employer may elect to postpone the date of inclusion to any later date in the same calendar year. In this event, income on the original amount deferred is also subject to FICA.

Withholding requirements. The special timing rule and the nonduplication rule apply to deferred compensation only if the employer withholds FICA in the proper amounts at the proper times. In general, withholding should occur when the nonqualified deferral is considered FICA wages. However, Regs. Sec. 31.3121(v)(2)-1(f) provides two alternatives for later withholding, recognizing that the employer may not be able to precisely calculate the amount subject to FICA at the time or that there is no cash payment that can serve as a source for the withholding at the time. These special rules allow the employer to withhold FICA later than the amount would be treated as FICA wages, even after an employer uses the "rule of administrative convenience" if it so chooses.

Regs. Sec. 31.3121(v)(2)-1(f)(2) allows the employer to estimate the amount required to be taken into account, and to be withheld on that basis. In this event, it provides for adjustments if the employer has either undercalculated or overcalculated the amount. The regulations also allow the employer to withhold on any date that is no more than three months after the date the amount is required to be taken into account. This special rule, combined with the rule that allows the employer to treat the amount as wages at any time during the calendar year, allows the employer to withhold potentially as late as the following March 31 and still be timely regarding withholding.

FROM TOM PEVARNIK, J.D., WASHINGTON, DC, TOM VEAL, J.D., CHICAGO, IL, AND MARVIN MICHELMAN, CPA, NEW YORK, NY