IRS reminder on nonqualified deferred compensation
TAX BLOG |
In a December 2016 memorandum, the Office of Chief Counsel advised that IRS agents should not enter closing agreements with taxpayers that failed to use the special timing rule for payroll taxes related to nonqualified deferred compensation arrangements. The advice is not surprising because regulations already provide rules on correcting failures to use the special timing rule, but it serves as a good reminder for employers to ensure they fully understand the rules so they can comply with them.
The special timing rule under section 3121(v)(2) requires nonqualified deferred compensation to be taken into account for Federal Insurance Contributions Act (FICA) purposes at the later of when the services are performed or when there is no longer a substantial risk of forfeiture. In reality, this means that FICA applies at vesting rather than at payment, and by its very nature, nonqualified deferred compensation vests in a year earlier than it is paid. Employers often fail to apply the special timing rule because the general FICA timing rules apply at the time of payment, and income tax also applies at the time of payment so it is easy to overlook that the timing is different for this purpose.
If an employer fails to apply FICA in the year of vesting, the regulations require the employer to file an adjusted return if the statute of limitations is still open for the year in which the amount should have been reported under the special timing rule. If the statute of limitations has closed, though, an adjusted return cannot be filed. In these cases, the regulations require the employer to report the wages under the general timing rule because it was not properly taken into account under the special timing rule.
Typically, use of the special timing rule is beneficial for employers and employees. Although it results in payroll tax liability prior to receiving the money, growth that occurs after the date it is reported for FICA purposes never gets reported for FICA under the non-duplication rule. In addition, the wage base limits apply to the year the payment is reported for FICA purposes and most employees have already earned enough to be over the wage base in the year of vesting so the overall rate paid on the amount is much less. In contrast, many nonqualified deferred compensation arrangements are paid out in years in which the employee is retired and has no other wages subject to the wage base so a higher rate of FICA will apply. Thus, employers who realize FICA was overlooked but realize it outside the statute of limitations benefit from a closing agreement with the IRS that allows the application of FICA earlier than the year of payment. However, as the advice indicates, regulations already provide rules for an employer’s failure to use the special timing rule so it is not appropriate for the IRS to enter closing agreements to resolve the issue.
Therefore, employers must be careful to appropriately follow the special timing rule and to catch any mistakes in a timely manner or they risk a higher FICA liability for both the employee and the employer when it is applied in the year of payment. Normal payroll processes that wait until a payment is made to decide how it should be treated for FICA purposes will occur too late so a best practice is to review deferred compensation agreements in relation to the section 3121 timing rules at the time the arrangement is entered so that the proper controls can be put into place to ensure the amount is reported in the correct period.