Final FICA withholding regs. on nonqualified deferred compensation.

In January 1999, the IRS released final regulations on when and how employers must withhold FICA tax on non-qualified deferred compensation. Sec. 3121(v) provides that employers maintaining nonqualified deferred compensation plans must withhold FICA on deferred amounts as of the later of when the contribution is earned or when it is no longer subject to a substantial risk of forfeiture.

In a for-profit company, it may be years before an employee actually receives a distribution from a plan, even though FICA tax has already been collected. In a nonprofit organization, FICA and income taxes are generally due in the same year, the later of the year in which a deferred amount is earned or the year in which the deferred amount is no longer subject to a substantial risk of forfeiture.

Once an amount has been "taken into account" for FICA purposes, it need not be counted again when the amount is distributed. Also, any earnings attributable to an amount taken into account for FICA purposes need not be counted for FICA purposes on distribution. Thus, if the FICA amount (often only the Medicare portion, as many people receiving nonqualified deferred compensation are well above the OASDI Social Security limit) has been timely taken into account, no FICA taxes will be due on the distribution.

One important change in the final regulations is an extended period to correct the 1994 and 1995 years. There are still many employers that do not realize nonqualified deferred compensation is subject to FICA tax. Generally, the question does not even arise until distributions are about to begin and an employer calls a payroll or withholding specialist to ask how to report the distributions. If there has been no FICA tax withholding to date, an employer can generally take the position that an executive was over the FICA limits up through 1993. If so, the only issue is 1994 and later years. Because the Medicare cap was eliminated in 1994, any amounts deferred in that year or later years should have been reported on a Form W-2 as Medicare wages, and Medicare withholding should have been taken on the whole amount. Because 1994 and 1995 are closed years, employers had noway to remedy this, although they could send in amended Forms W-2 and 941 to take into account amounts deferred in later years. The final regulations give employers until April 1,2000 to correct a failure to report, even from 1994. Moreover, the method for correction appears easier than in the proposed regulations, because the missed 1.994 and 1995 amounts can be reported as FICA wages at any time until April 1, 2000.

The final regulations also cover treatment of a distribution as a death benefit. Most employers have taken the position that if an employee dies and payments from the nonqualified plan are to be made to a surviving spouse, the payments are death benefits not subject to FICA tax. The regulations provide that if an amount is merely a continuation of the amount that would have been paid to an employee, it is still subject to FICA. "Payments made under a nonqualified deferred compensation plan in the event of death are death payments ... but only to the extent the total benefits payable under the plan exceed the lifetime benefits payable under the plan." This excess is calculated by taking the present value of all benefits under the plan (other than disability payments) less the present value of the benefits payable to an employee, using the largest present value of the available options. A similar rule applies to disability benefits. The assumption is that this rule can be satisfied by taking the present value of "lifetime" benefits into FICA on the final Form W-2, to the extent an amount has not already been included on earlier Forms W-2. Otherwise, this rule raises the interesting problem of issuing Forms W-2 to a surviving spouse for many years, when other guidance specifically requires that such amounts be reported on Form 1099-R.

The final regulations make very few other major changes to the proposed regulations, but do contain a number of clarifications and extensions. The Service has not changed some of its proposed regulations' positions, including that phantom stock plans are nonqualified deferred compensation plans, while stock appreciation rights and stock option plans are generally not nonqualified deferred compensation plans.

The Service has taken a slightly stronger stance off the nature of Sec. 3121(v) in the final regulations. Based on the proposed regulations, some commentators were essentially telling employers that they could choose to either report FICA under Sec. 3121(v) or wait and withhold as each distribution was made. The final regulations and preamble state that Sec. 3121(v) is not elective; if the timing rules are ignored, not only may penalties and interest be due, but the nonduplication rule will not apply (thus subjecting all payments, presumably including earnings, to FICA).

The regulations provide additional guidance on how to calculate amounts in account balance and in nonaccount balance plans, including how to determine whether an amount is reasonably ascertainable and an interest rate stated in a plan is reasonable. For example, if an account plan has several distribution options, the plan may be treated as an account balance plan and, therefore, a reasonable FICA amount may be calculated, if the options are actuarially equivalent. Likewise, the regulations allow more flexibility in determining most of the benefit in a nonaccount balance plan once it becomes reasonably ascertainable, with a "true-up" at a later date. There are still questions on several of the nonaccount balance plan calculations. It is hoped these questions will be answered in further IRS guidance.

Effective Dates

The final regulations are effective as of Jan. 1, 2000. Before that date, any reasonable interpretation, including the proposed regulations, is acceptable. However, ignoring the statute until next year is not considered a "good faith" interpretation of the regulations. In addition, the regulations provide that treating stock options, stock accrual rights or other stock value rights as subject to Sec. 3121(v) at grant will not be a good-faith interpretation (unless the employer has always applied this method to stock grants).

FROM KAREN M. FIELD, J.D., WASHINGTON, DC