Deferred Compensation – Special Fica Tax Rules

FICA taxes (technically consisting of “social security taxes” and “regular and additional Medicare taxes”) apply to wages paid by an employer to its employees with respect to their employment with the employer. The definition of “wages” for this purpose is quite broad and includes, with limited exceptions, all remuneration for services. FICA taxes imposed on an employee’s wages are shared by the employee and employer. The employee’s portion of FICA taxes is withheld from the employee’s wages.

General Timing/Special Timing FICA Tax Rules

In general, wages are subject to FICA taxes when the wages are actually or constructively paid (known as the “general timing rule”). However, compensation in the nature of “nonqualified deferred compensation” (“NQDC”) is subject to a different FICA tax timing rule. NQDC is subject to FICA tax and must be “taken into account” for FICA tax purposes as of the later of (i) when the services are performed, or (ii) when there is no substantial risk of forfeiture of the rights to such NQDC (i.e., when the amount “vests”). This rule, which accelerates the FICA tax applicability date, is known as the “special timing rule.” Once an amount of NQDC is taken into account under the special timing rule, neither such amount nor any future earnings attributable to that amount is later treated as wages subject to FICA tax. This avoidance of the imposition of FICA tax at the later time of payment, where the wage amount was previously taken into account at an earlier date pursuant to the special timing rule, is known as the “nonduplication rule.” Due to the impact of the nonduplication rule, the application of the special timing rule generally results in a smaller amount of FICA tax payable than would be the case if FICA tax was paid pursuant to the general timing rule.

Recent FICA Tax Ruling

In a recent IRS Chief Counsel Memorandum (AM2017-001, 12/19/2016) (the “GCM”), the IRS addressed the impact of failing to initially pay FICA tax on NQDC pursuant to the special timing rule. If an employer fails to initially report and pay its FICA tax liability with respect to NQDC in accordance with the special timing rule, but amends its employment tax returns and pays any additional FICA taxes attributable to such compensation within the applicable statute of limitations, then the favorable nonduplication rule applies. However, if such amendment and adjustment of FICA taxes due is not made before the statute of limitations period closes, the FICA tax will apply pursuant to the general timing rule.

In this GCM, the IRS was asked if it would enter into a binding closing agreement with an employer to allow the employer to pay FICA tax in a taxable year prior to the year of payment of NQDC, even though the statute of limitations had run with respect to the taxable year for which the special timing rule would have otherwise applied to such NQDC. Such closing agreement would enable the employer (and affected employees) to benefit, to some extent, from the application of the nonduplication rule in calculating the FICA tax due. The IRS concluded that, as a matter of tax policy, a closing agreement in such instance would not be appropriate in determining the amount of FICA tax owed where the statute of limitations period had closed, and accordingly, the general timing rule for determining FICA tax due on the NQDC would apply.

Conclusion

The above analysis and IRS ruling in the GCM highlight the important need for employers to be diligent and compliant with the special timing rule as applied to the reporting and payment of FICA taxes on NQDC.