Deferred compensation/FICA proposed regs. released.

The IRS and Treasury have issued the much-anticipated proposed regulations under Sec. 3121 (v) (2) on when amounts deferred under or paid from certain nonqualified deferred compensation plans are taken into account as "wages" for purposes of the employment taxes imposed by FICA.

Under Sec. 3121 (v) (2) (A), any amount deferred under a nonqualified deferred compensation plan must be taken into account as wages for FICA purposes as of the later of (1) when the services are performed or (2) when there is no substantial risk of forfeiture of the rights to such amount. This is referred to as the "special timing rule." Sec. 3121 (v) (2) (B) provides that, once an amount deferred under a nonqualified deferred compensation plan has been "taken into account" as wages, neither that amount nor the income attributable to that amount is again treated as FICA wages. The effect of this rule is to subject amounts to FICA prior to their receipt.

A nonqualified deferred compensation plan is any plan or other arrangement established by an employer for one or more employees that provides for the deferral of compensation.

Prop. Regs. Sec. 31.3121 (v) (2)-1 (c) differentiates between account balance plans and nonaccount balance plans in making the determination of how much compensation has been deferred. Under an account balance plan, the amount deferred for a period equals the principal amount credited to the employee's account for the period, increased or decreased by any income attributable to the principal amount through the date the principal amount is required to be taken into account as FICA wages. A plan will be deemed an account balance plan if under the terms of the plan, a principal amount (or amounts) is credited to an individual account for an employee, the income attributable to each principal amount is credited or debited to the individual account, and the benefits payable to the employee are based solely on the balance credited to the individual account.

If a nonqualified deferred compensation plan is not an account balance plan, the amount deferred for a period equals the present value of the additional future payments to which the employee has obtained a legally binding right during that period. The regulations give employers the flexibility of using any reasonable actuarial assumptions and methods to determine the present value amount.

Deferrals subject to   Deferrals not subject to
Sec. 3121 (v) (2)      Sec. 3121 (v) (2)

Phantom stock          Payroll overlapping year-end
                       Short-term deferrals (if elected)
                       Stock appreciation rights (SARs)
                       Restricted stock
                       Vacation pay
                       Sick leave
                       Severance pay
                       Death benefits
                       Excess parachute payments
                       Early retirement window benefits

Per Prop. Regs. Sec. 31.3121 (v) (2)-1 (d), an amount deferred is treated as "taken into account" and thus exempt from future FICA taxation when it is included in computing the amount of FICA wages, but only if any additional FICA tax for the year that results from the inclusion is actually paid before the period of limitations is closed for the year. For years before 1994, the amount deferred will be treated as taken into account even if its inclusion does not result in any additional FICA tax liability. For example, if, in 1993, an employee participating in a nonqualified deferred compensation plan had other wages at least equal to the applicable FICA and Medicare wage bases for 1993, the inclusion in wages of an amount deferred would not have resulted in any additional FICA tax liability for that year. Nonetheless, the amount deferred would have been considered taken into account as wages for purposes of Sec. 3121 (v) (2).

As discussed, the nonduplication rule of Sec. 3121 (v) (2) (B) precludes the taxation of amounts deferred or the related income if the amount deferred is taken into account as wages under the special timing rule. If an amount deferred is not taken into account as wages under the special timing rule, the benefits attributable to that amount must be included as wages when actually or constructively paid.

Prop. Regs. Sec. 31.3121 (v) (2)-1 (d) (2) (i) defines "income attributable to the amount taken into account" under an account balance plan as any increase or decrease in the amount credited to an employee's account that is attributable to an amount previously taken into account, but only if the income is based on a rate of return that does not exceed either the actual rate of return on a predetermined actual investment or, if no predetermined actual investment has been specified, a reasonable rate of interest. If the rate of return is not reasonable, the income attributable to the amount taken into account is limited to the mid-term applicable Federal rate for the first day of the calendar year.

For nonaccount balance plans, Prop. Regs. Sec. 31.3121 (v) (2)-1 (d) (2) (ii) defines "income attributable" as the increase, due solely to the passage of time, in the present value of any future payments to which the employee has obtained a legally binding right determined under reasonable actuarial assumptions and methods.

Under the special timing rule, an amount deferred is taken into account for FICA purposes as of the later of when (1) the services are performed or (2) the right to the amount deferred is no longer subject to a substantial risk of forfeiture. Services creating the right to an amount deferred are considered performed as of the date on which the employee has performed all of the services necessary to obtain a legally binding right to the amount deferred. A substantial risk of forfeiture is defined pursuant to the Sec. 83 regulations.

The regulations further state that an amount deferred under a nonaccount balance plan will not be required to be taken into account as wages under the special timing rule until the first date on which all of the amount deferred is reasonably ascertainable. This occurs when the only assumptions regarding future events or circumstances needed to determine the amount deferred are interest, mortality and cost-of-living assumptions. This standard does not, however, bar an employer from taking into account an amount at an earlier inclusion date.

As a means of administrative convenience, Prop. Regs. Sec. 31.3121 (v) (2)-1 (e) provides that an employer may treat an amount deferred as required to be taken into account by the end of the calendar year in which the above tests are met. For example, if an employee obtains a legally binding right to an amount deferred mid-year, the employer may take the amount deferred into account on any later date within the same year (e.g., December 31).

An amount deferred under a non-qualified deferred compensation plan is treated, for purposes of withholding and depositing FICA tax, as wages paid by the employer and received by the employee at the time it is taken into account. If the amount cannot be readily calculated, the regulations provide two alternative methods to determine the appropriate withholding. Under the first alternative method, an employer may make a reasonable estimate of the amount deferred. If the employer underestimates the amount deferred, the employer may treat the shortfall as wages in the first year or in the first quarter of the second year. If the employer overestimates the amount deferred, the employer may claim a refund or credit pursuant to Secs. 6402 and 6413.

Under the second alternative method, or lag method, the amount deferred may be calculated on any date in the first quarter of the succeeding calendar year and treated as wages paid by the employer and received by the employee on that date. The amount deferred under this method includes income attributable to the amount deferred through the date on which that amount is taken into account.

These regulations are effective for amounts deferred and benefits paid on or after Jan. 1, 1997. Consistent with Notice 94-96, the regulations confirm that an employer may rely on a reasonable, good faith interpretation of Sec. 3121 (v) (2) in determining FICA tax liability prior to the effective date of the regulations (which includes a determination in accordance with the proposed regulations). Four transition rules are provided.