FICA refund opportunities under sec. 3121(v) proposed regulations.

The IRS recently issued proposed regulations under Sec. 312(v)(2) outlining the FICA withholding rules for nonqualified deferred compensation plans. The employer-paid portion of the FICA tax consists of two parts: (1) the Old Age, Survivors' and Disability Insurance (OASDI) tax on an employee's wages up to the annual limitation (for 1996, 6.2% of wages up to $62,700) and (2) the Medicare or Hospital Insurance (HI) tax of 1.45% on all wages. The proposed regulations provide HI tax refund opportunities for employers that maintain nonqualified deferred compensation plans for their employees or that have paid employee bonuses within 2 1/2 months after the close of their tax year.

Nonqualified Defined

Contribution Plans

In general, Sec. 3121(v)(2) provides that FICA withholding is required on amounts deferred under a nonqualified deferred compensation plan on the later of when services are performed or when there is no substantial risk of forfeiture of the rights to such amount. When applied to a defined contribution deferred compensation plan (i.e., one to which contributions are made to a participant's account each year), determining the amount to be withheld is relatively simple. In addition, the Code and proposed regulations provide that, once FICA is withheld on amounts contributed under the plan, earnings on those contributions generally are not subject to FICA either when credited or paid (provided the rate at which those earnings are credited is reasonable). Note, however, that the proposed regulations provide that if the interest rate used is not one that charts a specific investment, or is otherwise determined by the Service to be unreasonable, additional FICA will be imposed on the interest credited in excess of the applicable Federal rate in the year in which earned.

Defined Benefit SERPs

For defined benefit deferred compensation plans, such as a defined benefit supplemental executive retirement plan (DB SERP) (i.e., plans that pay a benefit under a preexisting formula (e.g., $1,000 per month after retirement)), the amount of FICA that must be withheld in any year becomes more difficult to determine. Consider the following example that illustrates the opportunities for refund on FICA taxes paid.

Example 1: A DB SERP provides for executive E to receive a benefit beginning at age 65, in the form of a life annuity equal to 50% of final average pay. Assume that no substantial risk of forfeiture exists as to E's receiving that benefit, as he is immediately vested in the right to receive the annuity (i.e., if he terminates employment immediately, he will receive his accrued benefit nevertheless, commencing at age 65). Before the proposed regulations, it was believed the amount to be included in FICA wages each year was the increase m the participants vested benefit for the year, minus any interest credited on the prior years balance. At the end of 1994,E's vested benefit had a present value of $20,000, and at the end of 1995, a present value of $25,000. Assuming an annual interest rate for 1995 of 7.5%, E would have recognized 1995 FICA wages of $3,500 ($5,000 - ($20,000 x 7.5%)).

The above withholding method is one that meets the reasonable good-faith standard explicitly authorized by the IRS in Notice 94-96. The proposed regulations, however, have revealed several opportunities under which a refund may be available under Example 1. Also, a company with a plan similar to that in the example may be able to generate FICA tax savings on a going-forward basis. 1993 and earlier: In 1994, the cap on Medicare wages ($135,000 in 1993) was eliminated. As a result, employers providing nonqualified deferred compensation arrangements were suddenly faced with performing FICA wage calculations many had never before performed. This is because, as long as a participant had other earnings over the Medicare taxable wage base, no additional FICA tax would have been due with respect to the deferred compensation arrangement.

The proposed regulations provide that an employer that has a DB SERP, or that had a DB SERP in effect as of Dec. 31, 1993, can elect that amounts that would have been subject to FICA as of that date were, in fact, considered as included as FICA wages on that date. In other words, employers need pay no additional HI withholding on distribution of amounts accrued before l B@, or can obtain a refund if they have already done so, for amounts that should have been treated as subject to withholding as of Dec. 31, 1993. Thus, every sponsor of a DB SERP in effect on Dec. 31, 1993 should consider taking steps to calculate the present value of all accrued benefits through that date, to document that FICA withholding of that present value was deemed to have been taken into account in 1993 for FICA purposes.

The regulations provide that to calculate the Dec. 31, 1993 present value, an employer can use any reasonable actuarial assumptions. This rule permits employers to maximize their estimate of the Dec. 31, 1993 present value by using reasonable interest and mortality tables that generate the most favorable result.

Example 2: Assume the vested benefit of E (from Example 1) was $12,000 as of Dec. 31, 1993. If the plan sponsor had withheld FICA on plan distributions received in 1994 or 1995 attributable to that $12,000 vested accrued benefit, a refund could be claimed on those 1994 or 1995 FICA taxes. The employer would also have to return to the employee any employee-paid FICA taxes for those years.

1994 and 1995: The proposed regulations provide that, if the amount of a benefit to be paid under a DB SERP is not "reasonably ascertainable" as of the date the amounts would be considered FICA wages, FICA need not be withheld until all of the amount deferred becomes reasonably ascertainable. In Example 2, the amount deferred is based on final average pay, which cannot be reasonably ascertainable until the participant actually retires. As such, FICA taxes need not have been paid in 1994 on the 1994 accrual or in 1995 on the 1995 accrual. Accordingly, an employer could claim a refund of those 1994 and 1995 FICA taxes, if they had been paid. Keep in mind, however, that this is a "pay now or pay later" choice, that depends primarily on each employer's circumstances and administrative preferences, so that not all employers may wish to obtain a refund under these circumstances. FICA taxes not withheld under this option eventually win become due when the benefit is reasonably ascertainable (i.e., generally, on retirement). 1996 and later: Taxpayers that maintain DB SERPs will have considerable flexibility in determining the accruals they will take into account for FICA wage purposes after 1995. An employer is permitted to choose between making a reasonable estimate of the FICA amount that win be due on the accrual even when the amount deferred is not reasonably ascertainable, or paying estimated FICA payments in the year the accrual occurs. Again, this determination should be based on the employers general policy regarding payment of an executive's FICA tax, although many employers may choose to delay FICA tax payments to avoid the expense of paying actuarial costs in estimating current FICA obligations. However, the flexibility this rule affords can prove helpful in years immediately prior to an increase in the HI tax rate.

Bonus Payments

Another interesting wrinkle in the proposed regulations involves its treatment of bonuses. Employers can treat bonuses paid within 2 1/2 months after the end of a tax year as deferred compensation subject to FICA in the prior year. Thus, a FICA refund opportunity exists as to employees who exceeded the Medicare taxable wage base in 1993 and were paid a 1993 bonus before Mar. 16, 1994. In addition, this rule is useful to generate FICA refunds relating to executives and other employees who receive post-year-end bonuses and whose total compensation exceeds the Social Security taxable wage base for a year, but who may fall below that level the following year in which their bonuses are paid (i.e., retiring employees or those who become part-time employees).

Severance Pay, SARs and

Termination Benefits

The proposed regulations also contain some interesting rules as to what type of payments either will or will not be considered deferred compensation subject to FICA under the special timing rule of Sec. 3121(v)(2). For example, the types of payments not treated as deferred compensation include stock appreciation rights (SARs), stock options and certain other stock-related rights. In contrast, an amount paid under a "phantom" stock plan that awards a right to a fixed payment equal to a specified number of shares is considered to be deferred compensation.

According to the proposed regulations, welfare benefits (such as vacation benefits, sick leave, disability pay and severance benefits) are not considered Sec. 3121(v)(2) deferred compensation. In addition, any termination payment, including a supplemental compensation plan established within 12 months of an employee's termination of employment, is not considered Sec. 3121(v)(2) deferred compensation. Therefore, employers should be forewarned that any "make-up" type of termination benefit plan established within this 12-month period will be subject to FICA when paid.

Fortunately, for any employers surprised by the above rules, the proposed regulations will (in most cases) permit the FICA withholding treatment chosen in previous years to remain, as long as based on a,,reasonable good@faith,, interpretation of the statute. Thus, employers that subjected such amounts to FICA in pre-1997 years (i.e., prior to the effective date of the proposed regulations) will not have to adjust their withholding for those years. No permanent refund opportunities should be generated for employers under these rules, however, as the proposed regulations require these benefits to be subject to FICA at a time later than had previously been believed.