United States

Nonqualified deferred compensation plans and payroll tax withholding

The impact of section 3121(v)(2)

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Nonqualified deferred compensation (NQDC) plans are a flexible way to attract, retain, and motivate executives, management teams, and other key employees. While NQDC plans have fewer restrictions than “qualified” broad-based retirement plans, they must satisfy a number of conditions. Some of the frequently asked questions with regard to NQDC plans can be reviewed here. However, one of the most common issues overlooked by employers relates to the special timing rule in section 3121(v)(2), which addresses when amounts deferred under NQDC plans are taken into income for purposes of the Federal Insurance Contributions Act (FICA) withholding. Let’s take a deeper dive into these rules.

Under section 3121(v)(2) any amount deferred under a NQDC plan shall be taken into income for FICA withholding (FICA wages) at the later of when (i) services are performed or (ii) when there is no substantial risk of forfeiture of the rights to such amounts, even though the amounts may not be distributed and subject to federal income taxation until a later year.1

Any amount taken into income for FICA wages shall only be taxed once. Under the regulations, this means that if the section 3121(v)(2) ‘special timing rule’, as it is often referred, is applied (and thus deferred amounts are taken into FICA wages prior to the later payment date), neither the deferral amount nor any reasonable earnings on the deferral amount are taken into FICA wages at the future payment date.

Although the special timing rule is stated as a statutory requirement, the IRS and Treasury added an alternate timing mechanism (known as the ‘general rule’) to the regulations, mostly to prevent statute of limitations battles. Under Reg. section 31.3121(v)(2)-1(d)(1)(ii)(A), if the employer fails to take the amounts deferred into FICA wages under the special timing rule, the regulations revert to the general FICA timing rule, and the employer must do FICA withholding when the deferred amounts are actually or constructively paid. The important distinction between the special timing rule and the general rule is that if the amounts are taken into FICA wages at the time of payment the employer must include the deferred amounts and all earnings on such deferred amounts as FICA wages at the time of payment.

Thus, the employer essentially has a choice to use the special timing rule or general timing rule but using the later FICA wage inclusion date may generally cause the FICA liability to be higher as compared to the liability at the date when such NQDC is earned or vests. This is partly because the FICA liability at the time of vesting is typically just Medicare (and possibly Additional Medicare) because the employee has other wages that have already put him or her over the Social Security wage base. Payments made at a later date, especially if paid after an employee’s separation from service, may be subject to both Social Security and Medicare. In addition, the FICA taxable wage base goes up each year.

However, one important distinction to note, is that this special timing rule does not apply to a “short term deferral” plan, which pays out the benefit within the year of vesting or no later than 2 ½ months after the year of vesting. Under a short term deferral plan, the employer has the option to apply payroll tax withholding at the time of distribution if the employer does so for all employees covered by the NQDC plan and all similar plans.

Example:

Employee A deferred $30,000 under a NQDC plan in tax year 2018. Employee A is not vested in those amounts until June 30, 2019, and payment will occur June 30, 2025, after he retires. Employee A’s other taxable compensation in 2019 is $180,000 and the NQDC has earned $5,000 in earnings by this date. Another $20,000 of earnings applies to the NQDC by 2025 so the total distribution is $55,000 on June 30, 2025.

Application of the special timing rule:

No amount is included in taxable wages for income or FICA purposes in 2018 because the amount is unvested. Employee A is still working full time on June 30, 2019, when the $30,000 deferred compensation is no longer subject to a substantial risk of forfeiture. If the employer follows the special timing rule under section 3121(v)(2), the $30,000 deferred amount plus $5,000 of earnings on such deferral while such amount was unvested, will be taken into FICA wages for the tax year ended Dec. 31, 2019. The employer chooses to take the $35,000 into FICA wages in December 2019, when Employee A will be above the Social Security taxable wage limit for the year.

Employee A retires in 2024 and takes the distribution on June 30, 2025. The total distribution is $55,000. The entire $55,000 is reported as taxable compensation and is subject to federal and state income tax withholding in 2025 (and reportable on a Form W-2 because it relates to his prior status as an employee). However, because the deferral and the earnings as of the date of vesting were taken into FICA wages during the vesting year, the $55,000 is not subject to FICA.

Alternative application under the general timing rule:

The employer didn’t take the deferred amount into FICA wages under the special timing rule in 2019 when the substantial risk of forfeiture lapsed. When the employer pays out the deferred amount and all earnings on such deferral, the total of $55,000 is taken into FICA wages for the tax year ended Dec. 31, 2025. Employee A no longer has other wages from the employer to consider when calculating the FICA liability due because Employee A retired in 2024. Therefore, both Employee A and the employer will be liable for withholding on up to the full Social Security taxable wage limit for that year as well as Medicare wages.

Impact:

Taking a deferral into account for FICA wages in the year of vesting is not always the “best” choice. If a payment is based on a value that could fluctuate over time (such as a share price), payment at a later date when the value is lower could result in Employee A and the employer paying less FICA tax in the distribution year. Additionally, taking the FICA tax (as applicable) out of Employee A’s other wages for each vesting year could cause a hardship for the individual because his take-home pay for the year is reduced by the FICA tax withheld to pay for the longer-term deferred amount of which he has not yet received in cash.

In the event an employer has not been utilizing the section 3121(v)(2) special timing rule for amounts deferred under its NQDC plans, they can still change their approach to some extent. The employer can correct reporting for any affected participants for the statute of limitation period, which is generally the past three years.

Correction includes filing Forms 941-X and Forms W-2c to report the correct FICA wage income inclusion on Form W-2c, Box 5, Medicare wages and tips (and Box 3 if someone happened to not be over the Social Security wage base, but this is unlikely). It’s important to note the correction on Form W-2c would not impact Box 1 wages and thus would not change taxable income for participants during any affected year because income tax applies in the year of payment. However, the correction would change the amount of FICA tax due for each respective period. Since the “employee share” of these amounts would be due for participants who may no longer be with the employer, either the employer can cover the liability for the participant (which would be taxable compensation to the participant during the current year, subject to income and FICA wage withholding), withhold the liability from future distributions, or they can require the participant to write a check to cover the liability. When the participant is still with the employer, the answer is simpler because there are current wages to withhold any “employee share” of the tax liability due.

Alternatively, an employer can choose a different approach and start using the special timing rule for all participants, aside from affected participants whose amounts were not corrected under the statute of limitations rule discussed above. In which case, these affected participants would remain under the general rule approach and would require separate tracking so that those amounts, and any earnings or increase in value on those amounts will still be subject to the FICA wage inclusion on the distribution date.

KEY TAKEAWAY

The special timing rule is not always better than the general rule from an overall tax liability perspective. However, many employers simply do not know about the special timing rule and unknowingly may be missing opportunities to lower overall tax liability. Based on these considerations, we generally recommend that an employer understand the special timing rule and communicate their approach and any potential impact, in writing, to NQDC plan participants. If you would like to discuss the impact of both the special and general timing rule as they relate to the specific facts of your NQDC plan, please reach out to your tax advisor.

The special timing rule as discussed herein typically applies to account balance plans (a plan where the employee’s benefit consists of any amounts deferred plus earnings on such deferral tracked in hypothetical accounts). Non-account balance plans must first have amounts that are reasonably ascertainable before the special timing rule applies. Further discussion of account vs. non-account balance plans is outside of the scope of this article. 

 

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