The Federal Insurance Contributions Act (FICA) tax is comprised of a Social Security tax, currently at a 6.2 percent rate for each of the employer and employee on wages up to $117,000 (the Social Security "wage base") and a Medicare tax, currently at a 1.45 percent rate for each of the employer and employee on all wages (with no cap). The employer collects the employee portion of FICA by withholding from the employee's wages and remits such amount, together with the employer's portion, to the government. Starting last year, employees are subject to an additional Medicare tax of 0.9 percent on wages in excess of $200,000.
In general, FICA tax is imposed on wages in the year they are actually or constructively paid by an employer to an employee. However, a "special timing rule" requires that wages deferred under a nonqualified deferred compensation plan must be taken into account as of the later of (1) when services are performed, or (2) when there is no substantial risk of forfeiture of the rights to the amounts (i.e., when the amounts are vested). Due to this special timing rule, FICA tax generally applies to nonqualified deferred compensation before a taxpayer receives the amounts - i.e., when amounts are credited to the plan or when they become vested, if later. If the plan is an account balance plan, FICA taxes are payable on the principal amount credited to the employee's account, increased only by any earnings on the account balance before the date it is subject to FICA tax. If the plan is a non-account balance plan, the amount deferred is the present value of the future anticipated payments. The special timing rule generally saves employees a lot of FICA tax because once an amount is taken into income under the special timing rule, future payments, including interest or accruals representing a market rate of earnings on deferred amounts, are not subject to FICA tax. In light of the fact that participants in nonqualified deferred compensation plans generally will have income in excess of the Social Security wage base at the time amounts are contributed or vested, their FICA tax rate on deferred amounts generally will be limited to the Medicare portion of the tax (which has no cap), unlike during retirement when they are less likely to receive wages in excess of the Social Security wage base and would otherwise be subject to the full FICA tax. However, the special timing rule can occasionally be disadvantageous if deferred amounts are never paid, because the Treasury regulations do not allow employees to recover FICA taxes paid on deferred amounts that they never receive.
The Court of Federal Claims, in Balestra v. United States, recently held that the special timing rule applied to subject the plaintiff's nonqualified deferred compensation to FICA tax upon his retirement (when he became vested in the amounts), even though his company's obligation to pay the majority of the deferred compensation amount had been discharged in bankruptcy. The plaintiff's employer withheld FICA tax from his nonqualified deferred compensation based on the non-account balance plan present value calculation at the time of his retirement. As a result, the plaintiff paid FICA tax on amounts he will never receive. The Treasury regulations with respect to the special timing rule make clear that the present value of nonqualified deferred compensation cannot be discounted for factors including: (1) the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan, (2) the risk associated with any deemed or actual investment of amounts deferred under the plan, (3) the risk that the employer, trustee or another party will be unwilling or unable to pay, (4) the possibility of future plan amendments or changes in the law affecting benefits, or (5) any other similar risks or contingencies. Nor do Treasury regulations include any type of a true-up feature in the event that deferred payments are not received or turn out to be substantially less than the anticipated value subjected to tax. The Balestra court held that the special timing rule was properly applied to the benefits promised to the plaintiff and that the applicable statutory provisions required the benefits to be calculated and taxed when the plaintiff became vested in the benefits without any risk-adjusted discount rate. The court also concluded that the plaintiff is not entitled to any refund corresponding to the benefits he will never receive.
Many employers forget to include deferred amounts in income for FICA tax purposes at the time of contribution or vesting, which may subject employees to substantial additional FICA taxes during retirement. It is important for employers and employees to be aware of the nuances of the special timing rule and to remember that it applies not just to voluntary deferrals but also to company contributions, matches and deferred incentive or performance awards.