Background

When an employee earns wages, both the employer and the employee are liable for a portion of Social Security taxes and Medicare taxes (collectively referred to as “FICA” taxes) on the compensation. Employees owe 6.2 percent for Social Security taxes on wages up to the Social Security wage base ($132,900 for 2019) and 1.45 percent for Medicare taxes on all wages (plus an Additional Medicare Tax of 0.9 percent on wages in excess of $200,000), while employers owe 6.2 percent for Social Security taxes on wages up to the Social Security wage base ($132,900 for 2019) and 1.45 percent for Medicare taxes on all wages (but no Additional Medicare Tax).

Employers are liable for withholding and remitting both the employer and employee portions of FICA. Typically, the FICA taxes are withheld and remitted by the employer at the time the compensation is distributed to the employee (i.e., the “General Timing Rule”). However, there is a “Special Timing Rule” that applies when the compensation is part of a nonqualified deferred compensation (“NQDC”) plan.

What is Nonqualified Deferred Compensation?

NQDC is compensation that an employee has a legally binding right to receive during a taxable year that, pursuant to the terms of a NQDC plan, is or may be payable to the employee in a later taxable year. An example of such a scenario would be a bonus payment that vests in one taxable year but is not actually paid until later in the next taxable year, or a restricted stock unit that vests in one taxable year but is not distributed until the following taxable year.

The definition of “plan” used in connection with NQDC plans is broad and includes individual agreements between the employer and employee. Examples of such agreements include salary deferral arrangements, incentive plans with deferred payouts, stock incentive plans with deferral features (i.e., retirement eligibility provisions), supplemental executive retirement plans (“SERPs”), etc. NQDC plans are governed by Internal Revenue Code section 409A and the Treasury Regulations thereunder. These rules provide that income tax recognition is deferred until actual receipt by the employee.

What is the Special Timing Rule?

The “General Timing Rule” is contained in Treasury Regulation section 31.3121(v)(2)-1(a)(1) and provides that wages are generally subject to FICA tax when actually or constructively received. However, Treasury Regulation section 31.3121(v)(2)-1(a)(2)(ii) provides that amounts deferred under a NQDC plan are subject to FICA tax at the later of (1) when the services required to create the legally binding right to compensation are performed, or (2) the date on which the substantial risk of forfeiture lapses. This is what is referred to as the “Special Timing Rule” and it applies to both employer and employee portions of the FICA taxes.

Under this Special Timing Rule, the tax timing is split for NQDC plans, with FICA being withheld at the lapse of substantial risk of forfeiture (i.e., at vest or once retirement eligibility criteria has been met), while income taxes are only withheld at distribution/payment. This impacts the different deferred compensation vehicles differently, depending on when the substantial risk of forfeiture is considered to have lapsed. For example, base salary deferrals are considered not subject to forfeiture at the time of deferral (i.e., FICA is withheld at deferral). Conversely, for deferred restricted stock units, substantial risk of forfeiture is considered to have lapsed at the earlier of vest or when retirement eligibility criteria is met (i.e., FICA is withheld at the earlier of the vest date or the date on which the retirement eligibility criteria has been satisfied, which may be at the grant date if the participant is retirement eligible at grant). Income taxes are only due when the amounts are actually paid to the employee.

How Should FICA be Reported on the Form W-2 Under the Special Timing Rule?

Because of the split between the FICA and income tax timing under the Special Timing Rule, amounts need to be reported on the employees’ Forms W-2 at two separate events: at vest / lapse of substantial risk of forfeiture for FICA and at distribution for income taxes. At vest / lapse of substantial risk of forfeiture, the employer needs to include the value of the vested award in Box 3 and Box 5 of the employee’s Form W-2 (but not Box 1), along with the amount of Social Security and Medicare taxes withheld in Boxes 4 and 6, respectively. Additionally, the employer may elect (but is not required) to report the value of the deferral in Box 12, Code Y.

For the reporting and taxation of deferred compensation distributions, the employer needs to include the value of the award being paid at that time in Box 1 of the employee’s Form W-2 (but not in Boxes 3 and 5), along with the applicable income tax withholding in Box 2 (along with any state and/or local reporting, as applicable). In addition, the employer needs to include the distribution amount in Box 11 of the employee’s Form W-2.

Is There Any Flexibility for When FICA is Recognized Under the Special Timing Rule?

Many companies provide for prorated retirement eligibility, in which case, the substantial risk of forfeiture lapses on a portion of the NQDC award incrementally as the employee provides services. In order to manage the administrative complexity of recognizing income for FICA tax purposes, the IRS allows employers to utilize the “Rule of Administrative Convenience” under Treasury Regulation section 31.3121(v)(2)-1(e)(5). Under this rule, an employer may delay FICA tax withholding associated with NQDC plans until December 31st of the year triggering the FICA withholding requirement.

In addition to making the withholding and remittance of FICA taxes more manageable, delaying FICA withholding required under a NQDC plan until December 31st could be advantageous when employees have already met the Social Security wage base), as the only remaining tax to apply is Medicare (and the additional Medicare tax, if applicable). If the employee has not met the Social Security wage base limit, then the Social Security tax must also be withheld up to the wage base. While December 31st is the last possible date to withhold FICA taxes in the year of a triggering event, employers can withhold on any prior date (subject to certain requirements to account for taxes due through year-end).

Lastly, employers can also take advantage of the “Lag Method” under Treasury Regulation section 31.3121(v)(2)-1(f)(3), which allows collection of taxes to be delayed for up to three months after vesting (but requires the addition of interest on the taxes owed). When used in conjunction with the Rule of Administrative Convenience, the Lag Method can allow employers to delay tax collection into the next taxable year. Delaying the tax collection may be beneficial because it means that the employer can withhold the FICA amounts from employee bonuses or equity distributions.

What About FICA Taxes When NQDC is Distributed?

A frequent question that arises when discussing the Special Timing Rule is whether there is any additional FICA tax owed at distribution, particularly, if the value of the NQDC payment has increased between when FICA was withheld and when the payment is ultimately made.

In order to account for this, the IRS provides for the “Non-Duplication Rule” under Treasury Regulation section 31.3121(v)(2)-1(a)(2)(iii). The Non-Duplication Rule provides that, for the taxation of deferred compensation distributions, if an amount of deferred compensation was previously “taken into account” (i.e., subjected to FICA taxation), then neither the amount taken into account nor the income attributable to that amount is treated as wages for FICA tax purposes at any time thereafter (so long as the income attributable is considered “reasonable” under the IRS guidance). This generally results in less FICA tax being paid, as employers do not need to subject increases in account balances to FICA taxes.

What if an Employer Fails to Follow the Special Timing Rule?

If an employer does not follow the Special Timing Rule, Treasury Regulation section 31.3121(v)(2)-1(d)(1)(ii) provides that failure to abide by the Special Timing Rule results in the application of the General Timing Rule. This means that FICA taxes must be withheld and remitted when the compensation is actually or constructively received. In addition, the Non-Duplication Rule does not apply, resulting in the full balance of the NQDC payment at the time of distribution being subject to FICA. This generally results in more FICA tax being paid, as account balances have likely grown between vest and distribution, and employees may be receiving distribution payments in retirement when they are less likely to have met the Social Security wage base.

Prior to 2017, employers could request a settlement agreement with the IRS that allowed them to remit in the current year the amount that should have been withheld in accordance with the special timing rule, preserving the applicability of the Non-Duplication Rule, and not having to restate reporting for prior years. In December 2016, the IRS released a Chief Counsel Memorandum (AM2017-001) which eliminated a program that allowed for settlement agreements for noncompliance with the Special Timing Rule. The Chief Counsel Memorandum rationalized that the corrective provisions of Treasury Regulation section 31.3121(v)(2)-1(d)(1)(ii) were sufficient, and therefore settlement agreements would no longer be available for these situations.

Any Other Concerns for Noncompliance? Davidson v. Henkel Corporation

Although the consequences for noncompliance with the Special Timing Rule are relatively low from the regulatory perspective (chiefly, the amount of taxes ultimately owed might increase if account balances have grown via earnings and the participant has not met the Social Security wage base), as illustrated in a recent court case on the matter, an employer may still have liability to employees if they do not apply the Special Timing Rule, depending on the terms of the NQDC plan document.

In Davidson v. Henkel Corporation, a former employee receiving distributions from his employer’s NQDC plan, sued when the company began withholding FICA tax from his distributions. Mr. Davidson alleged not that the company was not required to withhold FICA, but that the company should have withheld FICA sooner (i.e., at vest) under the Special Timing Rule. His argument was that because the company failed to properly withhold FICA tax in accordance with the Special Timing Rule, Mr. Davidson lost the benefit of the Non-Duplication Rule, increasing his ultimate tax burden. Since Mr. Davidson received his nonqualified deferred compensation plan distributions in retirement, the FICA being applied on his distributions included Social Security taxes because in retirement he did not meet the Social Security wage base and the FICA being applied included gains that accrued since deferral.

The court noted that the company violated no law or regulation by waiting to withhold FICA tax (reaffirming that the failure to apply the Special Timing Rule results in the application of the General Timing Rule). However, the language in the NQDC plan document stated that, for each plan year, the company would withhold applicable taxes on deferral contributions (i.e., apply the Special Timing Rule). The court ruled that the company “committed a FICA error in violation of the Plan.”

Based on the court’s decision, while noncompliance with the Special Timing Rule only results in the application of the General Timing Rule, language in a plan document may require a company to apply the Special Timing Rule, exposing the company to additional liability for any negative tax consequences to participants.

Alvarez & Marsal Says:

Applying the Special Timing Rule can be tricky for employers, particularly when an employer’s payroll system is not set up to handle the additional complexity of split tax recognition timing. In order to process FICA and income tax withholding correctly, the employer will need to set up pay codes for each event, so that correct FICA taxes are withheld and reported at vest, and then only income taxes are withheld and reported at distribution.

While the relatively limited consequences for failing to abide by the Special Timing Rule requirements may not concern some employers, as the General Timing Rule is generally easier to administer, the potential for a higher overall tax burden for employees can negate the tax-advantaged benefits of a NQDC plan in the first place. Additionally, the IRS requirements are not the only consideration in determining how to tax NQDC plans; provisions in the applicable NQDC plan documents may require an employer to utilize the Special Timing Rule even if not administratively practicable.

As such, we recommend our clients take all reasonable efforts to correctly apply the Special Timing Rule, and the Compensation & Benefits experts at Alvarez & Marsal can assist in educating payroll personnel, establishing processes and controls to correctly implement the Special Timing Rule, and reviewing and/or drafting plan language for NQDC plans to avoid language that is not in sync with your company’s procedures and capabilities.

Please contact us for a review of your pay NQDC plans and payroll processes to determine if your company is complying with the Special Timing Rule and the terms of your NQDC plan.