IRS finalizes regs. on FICA taxation of nonqualified deferred compensation.

• Author: Pevarnik, Tom
• Position: IRS regulations

On Jan. 28, 1999, the IRS finalized Regs. Sec. 31.3121(v)(2)-1, addressing the FICA taxation of nonqualified deferred compensation, which became effective on Jan. 1, 2000. These regulations are issued under Sec. 3121(v)(2), enacted as part of the Social Security Amendments Act of 1983.

Although the statutory changes were effective Jan. 1, 1984, Service guidance was not forthcoming immediately, because there was little, if any, need for such guidance. Nonqualified deferrals are combined with other FICA wages for the year to determine the overall amount subject to FICA taxation. Most individuals participating in nonqualified deferred compensation arrangements had other cash wage payments during the calendar year that equaled or exceeded the FICA taxable wage base. As a result, the requirement to take the nonqualified deferral into account in the year earned was of little practical significance, because it most commonly resulted in no additional FICA tax liability. However, the subsequent creation of a separate, higher cap on wages subject to the Medicare (HI) portion of FICA, followed by the later complete elimination of that cap, created a need for more specific guidance.

Analysis of the Regulations

FICA timing rules. Regs. Sec. 31.3121(v)(2)-1(a) addresses the time when a deferral is subject to FICA. Under the regulations, FICA is imposed under either the "general timing rule" or the "special timing rule."

The general timing rule applies for most purposes for FICA taxation. Under the general timing rule, an amount is subject to FICA at the time the employer actually makes a payment, in cash or in kind, of "wages" for FICA purposes. The special timing rule provides that FICA wages are taken into account for FICA purposes at the time the employee performs services creating the right to receive future compensation, or the date such an amount is no longer subject to a substantial risk of forfeiture. Regs. Sec. 31.3121(v)(2)-1(a)(2) provides that the special timing rule applies to "an amount deferred" under a "nonqualified deferred compensation plan."

In addition, Regs. Sec. 31.3121(v)(2)-1(a)(2)(iii), as required by the statute, provides a nonduplication rule, exempting from FICA taxation any amounts previously subjected to FICA and earnings attributable to those amounts.

The special timing rule is usually more advantageous, even though it results in an earlier payment of FICA tax. By applying the special timing rule, the nonqualified deferral is combined with other wages in determining the overall FICA tax liability. If an individual has other wages equal to the old age, survivors and disability insurance (OASDI) taxable wage base, the additional tax liability is limited to 2.9% (half payable by the employer and half by the employee) of the amount deferred. If the special timing rule did not exist, FICA would be imposed at the time the individual receives a distribution from the plan. This may occur at the time an individual receives no other wages subject to FICA. As a result, the distribution could be the sole or primary item of FICA wages, causing much or all of the distributions to be subject to both the OASDI portion of FICA at 12.4% and the HI portion at 2.9%, for a much larger overall liability.

The nonduplication rule confers an additional benefit by exempting the accrued income from FICA...