This blog is part of a 12-part series entitled The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.
Even if nonqualified deferred compensation plan (NDCP) sponsors and participants successfully navigate safe passage through the compliance complexities of Internal Revenue Code section 409A, they both could still sink in a sea of taxes and penalties if they overlook applicable payroll taxes. High on the executive compensation enforcement initiatives of the Internal Revenue Service (IRS) is increased scrutiny of the Federal Insurance Contributions Act (FICA) taxes on NDCP benefits. The resulting penalties for a failure to pay appropriate FICA taxes affect both employers and executives and can be severe: back taxes, interest, fines, and even imprisonment if the misrepresentation or miscalculation of FICA tax amounts is proven to be willful.
Setting bearings straight on FICA taxes
FICA taxes have two components:
Social Security (Old-Age, Survivors, and Disability Insurance, or OASDI) taxes are currently paid by employers and employees at a rate of 6.2%. These taxes are imposed on the employee's wages up to the Social Security Taxable Wage Base (SSTWB), which is $118,500 for 2016.
Medicare Hospital Insurance (HI) taxes are paid by employees and employers, both at a rate of 1.45%, on all wages (i.e., no cap) paid to an executive. Beginning in 2013, the rate increased to 2.35% for certain high-income individuals (e.g., those filing taxes as a single individual with more than $200,000 in wages) but remained at 1.45% for the employer portion.
Regardless of whether the source is executive deferrals or employer contributions, NDCP benefits are considered wages and thus are subject to FICA taxes. However, while these taxes are imposed immediately on current compensation, separate rules determine when NDCP benefits become subject to FICA taxes and vary depending on whether the NDCP is an account balance or a non-account balance plan.
Account balance NDCPs
Also known as defined contribution-style NDCPs, these are plans in which participant salary deferrals and/or employer contributions are allocated to one or more accounts established on behalf of the participant. Such allocations accumulate over time and are typically adjusted to reflect either deemed or actual investment experience. Nearly all plans of this type provide 100% immediate vesting.
Account balance NDCPs that call for only participant deferrals offer smooth sailing when applying the FICA taxation rules. The NDCP benefits are generally subject to FICA taxation only to the extent they are vested (i.e., participants will not forfeit benefits because they terminate employment). In addition, the calculation and withholding of the tax mirrors that used for 401(k) deferrals: the FICA tax is applied to the participants total gross compensation prior to any reductions made as the result of a deferral. Like 401(k) deferrals, the FICA withholding for NDCP deferrals takes place at the payroll level.
The immediate application of the FICA tax to the NDCP deferrals also enables participants to take advantage of a non-duplication FICA tax rule. Under this rule, once a NDCP deferral is taxed for FICA purposes, neither that amount nor any earnings attributable to that amount is ever again treated as wages subject to FICA taxes. Accordingly, when the participant eventually receives a distribution from the NDCP, no FICA taxes apply to the entire account balance (i.e., sum of all deferrals plus investment growth).
However, for NDCPs that credit participants accounts with a flat interest rate or a rate attributable to deemed (instead of actual) investment experience, this favorable tax treatment is only available if such crediting rate does not exceed what the IRS considers a reasonable rate of interest. While not providing a specific definition of this term, IRS guidance offers acceptable alternatives and contains several ironclad restrictions that prevent creative plan designs intended to produce artificially inflated levels of return on participants accounts. To the extent that a NDCP credits such excess returns, the portion that is considered excess will not qualify under the non-duplication rule and thus be FICA taxed as additional deferrals.
Account balance NDCPs that include any employer contributions may encounter choppy waters, particularly if the sponsor is not familiar with the FICA tax timing rules for these contributions. The rules complexity will depend on the type of vesting selected and whether or not the sponsor is committed to affording its participants the tax advantage of the non-duplication rule. If contributions are 100% immediately vested, the FICA tax is due when they are deemed to be allocated to the participant's account. For example, if the NDCP states that the employer will credit the participant's account with 5% of compensation on the last day each calendar year quarter, the FICA tax liability will generally arise on March 31, June 30, September 30, and December 31 of each year. However, a rule of administrative convenience permits the actual payments to be made later.
If, however, as is often the case with employer contributions, the NDCP requires an employee to complete a specified period of service before vesting occurs, the FICA tax liability does not arise until then. For example, assume a plan provides no vesting until five years of service are completed and then 100% vesting thereafter. No FICA taxes are due until this requirement is met, at which time the participant's entire account balance (i.e., contributions and investment experience credited to the account to date) becomes subject to FICA tax. Contributions to the participant in ensuing years are then subject to FICA taxation as they are credited because all such contributions would be 100% vested when made. If this process is administered properly, any investment experience credited to the account after the initial vesting will escape FICA taxation courtesy of the non-duplication rule.
Unfortunately, if the NDCP uses graded vesting (e.g., 20% per year of service up to 100% after five years), applying the non-duplication rule becomes so complicated that the NDCP sponsor may need to seek expert assistance in calculating the correct amounts. This complexity exists because, as portions of the account balance and earnings on such portions become vested and are reported for FICA, they must then be tracked in separate buckets to avoid future FICA taxation. There are many variables that make such tracking cumbersome. For example, the contributions, vesting, and crediting rates may vary, contributions may be allocated and reallocated among several deemed investments, and/or there may be fluctuations in the account balance resulting from transfers between investments and/or scheduled distributions. More variables mean more buckets and a greater chance that the sponsor will be tempted to wave the white flag on trying to perform such calculations—especially because there is no IRS guidance in this area. Accordingly, if the sponsor lacks the internal resources to commandeer this bucket brigade, it will need to consult with its tax advisers to develop a viable alternative (e.g., outsourcing administration).
Non-account balance NDCPs
Amounts from defined benefit (DB) plans or non-account balance NDCPs also are subject to FICA taxation when they vest. However, because there is no account balance as with defined contribution or account balance NDCPs, the tax is applied to the present value of the accrued benefit as of the vesting date, determined by using any reasonable actuarial assumptions and methods.
Because many DB NDCP designs (e.g., plans with formulas linked to final average compensation and/or containing Social Security offsets) make ascertaining a true present value of the benefit difficult while the participant is still employed, the FICA rules permit the tax to be delayed until the benefits become readily ascertainable. The rules generally define this resolution date as the first date on which the amount, form, and commencement date of the benefit are known (i.e., when the present value calculation is dependent only on interest, mortality, and/or cost of living assumptions). Accordingly, depending on its plan design, a non-account NDCP may delay FICA taxation until the participant's termination of employment or, in some cases, commencement of benefits.
But this delay is not mandatory. NDCP sponsors have two early inclusion alternatives under which they may apply the FICA tax: (1) annually as the benefits accrue or become vested, or (2) at any time(s) between the date described in (1) and the resolution date. If the sponsor elects early inclusion, all or any portion of the vested benefit that is not yet reasonably ascertainable can be recognized earlier. Then when the benefit finally becomes reasonably ascertainable, its present value at that time will have to be calculated and a comparison analysis completed in order to assess whether additional FICA tax is owed.
Before implementing this early inclusion for any participants, NDCP sponsors should consider the risk of overpaying FICA taxes if their plans include features such as generous early retirement subsidies or qualified plan offsets. They could cause the value of the NDCP benefit to decrease over time. Executives should weigh the desire for tax savings against the risk they may be opting to prematurely pay tax on a benefit that they may never receive because of an employer's insolvency.
Other issues to keep aboveboard
Most NDCP sponsors encounter few problems handling FICA withholding on executive deferrals because they run it through the payroll system just as they do with 401(k) deferrals. However, when the FICA tax becomes due on any NDCP benefits derived from employer-provided allocations, some NDCP sponsors must grapple with substantial withholding amounts, even if only the HI tax is being paid. In these cases, the NDCP sponsor should arrange ahead of time for the executive to remit the withholding amount so that the sponsor can then transfer the funds to the IRS. Alternatively, the NDCP sponsor may reduce the participant's NDCP account balance or accrued benefit by the amount necessary to satisfy the obligation. NDCP sponsors also need to be mindful of the special rules that apply to Form W-2 reporting of deferred compensation and FICA taxes and the taxation and reporting of the FICA liability when a NDCP benefit is paid to a participant's beneficiary as the result of death or to the participant's former spouse in connection with a domestic relations order.
FICA compliance prevents capsizing benefits
NDCP sponsors and participants must fathom FICA to keep their benefits afloat for retirement. Every NDCP sponsor should take steps to ensure it has processes to accurately identify the portions of the NDCP benefits that become subject to FICA taxes each year and to correctly calculate the FICA taxes due. Equally important is documenting such procedures and ensuring that such documentation is easily accessible in case of an IRS audit. If in doubt, an internal audit may help to determine if FICA taxes have been paid on time and if sufficient evidence of such payments is available. Just as many sponsors were hesitant to battle 409A compliance without enlisting other resources, many NDCP sponsors may benefit from outside expertise. When in uncharted waters with no reliable compliance compass, NDCP sponsors should immediately send out an SOS for an external review of their existing programs rather than expose benefits to a flotsam fate from FICA penalties.
Even if nonqualified deferred compensation plan (NDCP) sponsors and participants successfully navigate safe passage through the compliance complexities of Internal Revenue Code section 409A, they both could still sink in a sea of taxes and penalties if they overlook applicable payroll taxes. High on the executive compensation enforcement initiatives of the Internal Revenue Service (IRS) is increased scrutiny of the Federal Insurance Contributions Act (FICA) taxes on NDCP benefits. The resulting penalties for a failure to pay appropriate FICA taxes affect both employers and executives and can be severe: back taxes, interest, fines, and even imprisonment if the misrepresentation or miscalculation of FICA tax amounts is proven to be willful.
Setting bearings straight on FICA taxes
FICA taxes have two components:
Social Security (Old-Age, Survivors, and Disability Insurance, or OASDI) taxes are currently paid by employers and employees at a rate of 6.2%. These taxes are imposed on the employee's wages up to the Social Security Taxable Wage Base (SSTWB), which is $118,500 for 2016.
Medicare Hospital Insurance (HI) taxes are paid by employees and employers, both at a rate of 1.45%, on all wages (i.e., no cap) paid to an executive. Beginning in 2013, the rate increased to 2.35% for certain high-income individuals (e.g., those filing taxes as a single individual with more than $200,000 in wages) but remained at 1.45% for the employer portion.
Regardless of whether the source is executive deferrals or employer contributions, NDCP benefits are considered wages and thus are subject to FICA taxes. However, while these taxes are imposed immediately on current compensation, separate rules determine when NDCP benefits become subject to FICA taxes and vary depending on whether the NDCP is an account balance or a non-account balance plan.
Account balance NDCPs
Also known as defined contribution-style NDCPs, these are plans in which participant salary deferrals and/or employer contributions are allocated to one or more accounts established on behalf of the participant. Such allocations accumulate over time and are typically adjusted to reflect either deemed or actual investment experience. Nearly all plans of this type provide 100% immediate vesting.
Account balance NDCPs that call for only participant deferrals offer smooth sailing when applying the FICA taxation rules. The NDCP benefits are generally subject to FICA taxation only to the extent they are vested (i.e., participants will not forfeit benefits because they terminate employment). In addition, the calculation and withholding of the tax mirrors that used for 401(k) deferrals: the FICA tax is applied to the participants total gross compensation prior to any reductions made as the result of a deferral. Like 401(k) deferrals, the FICA withholding for NDCP deferrals takes place at the payroll level.
The immediate application of the FICA tax to the NDCP deferrals also enables participants to take advantage of a non-duplication FICA tax rule. Under this rule, once a NDCP deferral is taxed for FICA purposes, neither that amount nor any earnings attributable to that amount is ever again treated as wages subject to FICA taxes. Accordingly, when the participant eventually receives a distribution from the NDCP, no FICA taxes apply to the entire account balance (i.e., sum of all deferrals plus investment growth).
However, for NDCPs that credit participants accounts with a flat interest rate or a rate attributable to deemed (instead of actual) investment experience, this favorable tax treatment is only available if such crediting rate does not exceed what the IRS considers a reasonable rate of interest. While not providing a specific definition of this term, IRS guidance offers acceptable alternatives and contains several ironclad restrictions that prevent creative plan designs intended to produce artificially inflated levels of return on participants accounts. To the extent that a NDCP credits such excess returns, the portion that is considered excess will not qualify under the non-duplication rule and thus be FICA taxed as additional deferrals.
Account balance NDCPs that include any employer contributions may encounter choppy waters, particularly if the sponsor is not familiar with the FICA tax timing rules for these contributions. The rules complexity will depend on the type of vesting selected and whether or not the sponsor is committed to affording its participants the tax advantage of the non-duplication rule. If contributions are 100% immediately vested, the FICA tax is due when they are deemed to be allocated to the participant's account. For example, if the NDCP states that the employer will credit the participant's account with 5% of compensation on the last day each calendar year quarter, the FICA tax liability will generally arise on March 31, June 30, September 30, and December 31 of each year. However, a rule of administrative convenience permits the actual payments to be made later.
If, however, as is often the case with employer contributions, the NDCP requires an employee to complete a specified period of service before vesting occurs, the FICA tax liability does not arise until then. For example, assume a plan provides no vesting until five years of service are completed and then 100% vesting thereafter. No FICA taxes are due until this requirement is met, at which time the participant's entire account balance (i.e., contributions and investment experience credited to the account to date) becomes subject to FICA tax. Contributions to the participant in ensuing years are then subject to FICA taxation as they are credited because all such contributions would be 100% vested when made. If this process is administered properly, any investment experience credited to the account after the initial vesting will escape FICA taxation courtesy of the non-duplication rule.
Unfortunately, if the NDCP uses graded vesting (e.g., 20% per year of service up to 100% after five years), applying the non-duplication rule becomes so complicated that the NDCP sponsor may need to seek expert assistance in calculating the correct amounts. This complexity exists because, as portions of the account balance and earnings on such portions become vested and are reported for FICA, they must then be tracked in separate buckets to avoid future FICA taxation. There are many variables that make such tracking cumbersome. For example, the contributions, vesting, and crediting rates may vary, contributions may be allocated and reallocated among several deemed investments, and/or there may be fluctuations in the account balance resulting from transfers between investments and/or scheduled distributions. More variables mean more buckets and a greater chance that the sponsor will be tempted to wave the white flag on trying to perform such calculations—especially because there is no IRS guidance in this area. Accordingly, if the sponsor lacks the internal resources to commandeer this bucket brigade, it will need to consult with its tax advisers to develop a viable alternative (e.g., outsourcing administration).
Non-account balance NDCPs
Amounts from defined benefit (DB) plans or non-account balance NDCPs also are subject to FICA taxation when they vest. However, because there is no account balance as with defined contribution or account balance NDCPs, the tax is applied to the present value of the accrued benefit as of the vesting date, determined by using any reasonable actuarial assumptions and methods.
Because many DB NDCP designs (e.g., plans with formulas linked to final average compensation and/or containing Social Security offsets) make ascertaining a true present value of the benefit difficult while the participant is still employed, the FICA rules permit the tax to be delayed until the benefits become readily ascertainable. The rules generally define this resolution date as the first date on which the amount, form, and commencement date of the benefit are known (i.e., when the present value calculation is dependent only on interest, mortality, and/or cost of living assumptions). Accordingly, depending on its plan design, a non-account NDCP may delay FICA taxation until the participant's termination of employment or, in some cases, commencement of benefits.
But this delay is not mandatory. NDCP sponsors have two early inclusion alternatives under which they may apply the FICA tax: (1) annually as the benefits accrue or become vested, or (2) at any time(s) between the date described in (1) and the resolution date. If the sponsor elects early inclusion, all or any portion of the vested benefit that is not yet reasonably ascertainable can be recognized earlier. Then when the benefit finally becomes reasonably ascertainable, its present value at that time will have to be calculated and a comparison analysis completed in order to assess whether additional FICA tax is owed.
Before implementing this early inclusion for any participants, NDCP sponsors should consider the risk of overpaying FICA taxes if their plans include features such as generous early retirement subsidies or qualified plan offsets. They could cause the value of the NDCP benefit to decrease over time. Executives should weigh the desire for tax savings against the risk they may be opting to prematurely pay tax on a benefit that they may never receive because of an employer's insolvency.
Other issues to keep aboveboard
Most NDCP sponsors encounter few problems handling FICA withholding on executive deferrals because they run it through the payroll system just as they do with 401(k) deferrals. However, when the FICA tax becomes due on any NDCP benefits derived from employer-provided allocations, some NDCP sponsors must grapple with substantial withholding amounts, even if only the HI tax is being paid. In these cases, the NDCP sponsor should arrange ahead of time for the executive to remit the withholding amount so that the sponsor can then transfer the funds to the IRS. Alternatively, the NDCP sponsor may reduce the participant's NDCP account balance or accrued benefit by the amount necessary to satisfy the obligation. NDCP sponsors also need to be mindful of the special rules that apply to Form W-2 reporting of deferred compensation and FICA taxes and the taxation and reporting of the FICA liability when a NDCP benefit is paid to a participant's beneficiary as the result of death or to the participant's former spouse in connection with a domestic relations order.
FICA compliance prevents capsizing benefits
NDCP sponsors and participants must fathom FICA to keep their benefits afloat for retirement. Every NDCP sponsor should take steps to ensure it has processes to accurately identify the portions of the NDCP benefits that become subject to FICA taxes each year and to correctly calculate the FICA taxes due. Equally important is documenting such procedures and ensuring that such documentation is easily accessible in case of an IRS audit. If in doubt, an internal audit may help to determine if FICA taxes have been paid on time and if sufficient evidence of such payments is available. Just as many sponsors were hesitant to battle 409A compliance without enlisting other resources, many NDCP sponsors may benefit from outside expertise. When in uncharted waters with no reliable compliance compass, NDCP sponsors should immediately send out an SOS for an external review of their existing programs rather than expose benefits to a flotsam fate from FICA penalties.