Proposed Section 3121(v) regulations: application of employment taxes to nonqualified deferred compensation.

• Author: Shultz, Paul T.

In January 1996, the Internal Revenue Service gave employers and practitioners a belated holiday gift in the form of long-awaited guidance on the Social Security tax treatment of amounts deferred under a nonqualified deferred compensation plan. Proposed regulations under section 3121(v) of the Internal Revenue Code clarify many of the concepts involved in the determination of the taxability of these amounts. Generally, the proposed regulations are reasonable and even generous; they provide employers with significant flexibility both in determining the timing and amount of the FICA liability and in withholding and paying the tax on any amounts deferred under a nonqualified plan. In addition, the proposed regulations are quite thorough. This article describes the rules governing the FICA taxation of nonqualified deferred compensation under the proposed regulations.

Background

In 1983, when Congress last made broad amendments to the Social Security system, one if its changes was to impose Social Security-related (FICA) taxes upon cash-or-deferred arrangements under section 401(k) of the Code and upon nonqualified deferred compensation by adding section 3121(v) to the Code. Generally, an employee's wages are subject to FICA taxes when they are paid. Employers and employees are equally liable for FICA taxes, which consist of Old-Age, Survivors and Disability Insurance (OASDI) tax (at a rate of 6.2 percent of wages) and Hospital Insurance (Medicare) tax (at a rate of 1.45 percent of wages). Thus, subject to a cap on the amount of wages subject to the OASDI portion of the tax, employers and employees each pay a total tax of 7.65 percent of wages. "Wages" are defined broadly in section 3121(a) to include almost all remuneration provided for services rendered. Amounts deferred under a nonqualified plan, however, are subject to a special rule under section 3121(v). Under this rule, these amounts are subject to FICA taxes on the date on which the services giving rise to the amounts are performed or, if later, the first date on which the employee's rights to the deferred amounts are not subject to a substantial risk of forfeiture. Once an amount is subjected to FICA taxes, it and the income it earns are not taxed again (i.e., when actually paid).

Unfortunately, the statutory language says little more than this, leaving open a number of questions about the precise manner in which section 3121(v) is applied. Specifically, it has been unclear -

*What plans are subject to section 3121(v)

*What constitutes a 'substantial risk of forfeiture'

*How to determine the amount that is required to be subject to FICA tax for any year.

Before publication of the proposed regulations, there was virtually no elaboration on the application of these rules. The only meaningful guidance was the relevant legislative history, very few letter rulings,(1) some language in the instructions to Form W-2 (unrelated to FICA taxation), and a single decision of the U.S. Claims Court.(2) And the guidance provided by these documents was limited indeed: Apart from statements in the legislative history and in the letter ruling to the effect that a "substantial risk of forfeiture" is to be determined in accordance with the principles of section 83, the available guidance addressed only the first of the three issues described above.

For much of the period since the enactment of section 3121(v) in 1983, guidance on its application was largely unnecessary. Because nonqualified deferred compensation is typically paid to higher-paid employees, and because the inclusion of these amounts in the employee's wages subject to FICA tax frequently occurs while the employee is actively employed and typically earning wages in excess of the FICA taxable wage base, the rules of section 3121(v) had essentially no effect. When the cap on the amount of wages taken into account for purposes of the Medicare portion of the FICA taxes was increased to $125,000 in 1991 and then eliminated in 1994, however, clarification of section 3121(v) became critical to enable employers to determine, collect, and remit the taxes. Recognizing this fact, but nevertheless being unprepared to issue comprehensive instruction, the IRS published Internal Revenue Notice 94-96,(3) which permitted taxpayers to adopt any reasonable good-faith interpretation of section 3121(v) until the issuance of regulations. Those regulations have now been issued, in proposed form.

The Proposed Regulations

Plans Subject to Section 3121(v). Generally, any plan that provides for the deferral of compensation from one year to another -even if only for a brief period - is subject to section 312 (v).(4) The proposed regulations do, however, provide several exceptions to this rule.

First, amounts paid in accordance with an employer's ordinary payroll practice after the end of a calendar year and for the final pay period of the year or for a pay period that overlaps the year-end are not amounts deferred under a nonqualified plan. Hence, they are not subject to section 3121(v). (In other words, they are subject to FICA tax when paid.) Second, if amounts are paid within two-and-a-half months after the end of the calendar year in which the employee performed the services for which the payments are being made, the employer may elect to treat these amounts as not being subject to section 3121(v), if all employees and all similar plans are treated alike.(5) Finally, the regulations specifically exclude stock options, stock appreciation rights, stock value rights, awards of restricted property, welfare benefits, benefits provided in connection with certain impending terminations of employment or under a plan established after termination, and excess parachute payments from the scope of section 3121(v). Phantom stock plans, however, are considered deferred compensation plans subject to this section. This rule is consistent with the approach reflected in the instructions to Form W-2.(6)

This purported bright-line test produces some inconsistencies and, therefore, some planning opportunities. In particular, phantom stock arrangements are specifically identified as deferred compensation plans, but stock value rights, which are defined as devices that give an employee the right to the difference between the value of a share of stock and a specified amount greater than zero (apparently to distinguish them from stock appreciation rights), are not. If a stock value right pays the difference between market value and some nominal amount, what is the difference between that arrangement (which is not deferred compensation) and a phantom stock award (which is deferred compensation)?

Similarly, restricted property is specifically excluded from the definition of deferred compensation, but the proposed regulations state that an agreement to pay property in the future may give rise to deferred compensation. What is the difference between, for example, a current grant of restricted stock and an agreement to pay the same number of shares of unrestricted stock in the...