FICA tax is normally collected through withholding at the time the underlying compensation (“wages”) is received. Under a special rule in the Internal Revenue Code, however (the “special timing rule”), FICA with respect to deferred compensation is collected (generally by withholding from the employee’s non-deferred compensation) at the later of: i) the time the services for which the deferred compensation is earned are provided; or ii) the time that the employee’s right to the deferred compensation becomes “non-forfeitable.” In a recent case, application of the special timing rule resulted in an employee having to pay FICA tax on deferred compensation that he will never receive.
Mr. B. was employed by United Airlines as a pilot. When he retired in 2004, Mr. B. became entitled to retirement benefits under a non-qualified plan valued at just under $290,000, to be paid over time. Pursuant to the special timing rule, United withheld FICA tax on the entire amount in 2004. United went into bankruptcy, as a result of which its obligation to pay Mr. B.’s non-qualified pension was limited to about $63,000. Mr. B. sought refund of the FICA taxes collected with respect to the unpaid amount in the Court of Federal Claims.
In a decision marked “Not for Publication,” the court granted summary judgment for the government. The court’s review of the statute and underlying regulations indicated that the requirement that the compensation be non-forfeitable was satisfied once Mr. B. was no longer required to perform substantial services in order to earn the compensation and was not dependent on United’s ultimate ability to pay it. The court also rejected Mr. B.’s arguments to the effect that FICA tax can only be imposed on “income,” pointing to statutory differences between the definition of “wages” for FICA purposes and the same term as used for income tax withholding purposes.
The court also rejected Mr. B.’s argument that it was not reasonable for his deferred compensation to be valued without regard to the possibility that United would be unable to pay it, especially where, as in this case, United was in bankruptcy at the time the compensation became non-forfeitable. Absent a statutory mandate as to how the compensation was to be valued, the court held that the regulations that valued the compensation without regard to the employer’s ability to pay were within the Treasury Department’s interpretive authority and were not irrational.
Note 1. Because the amount of wages subject to the social security portion of the FICA tax is capped ($117,000 in 2014), the special timing rule is generally seen as advantageous to employees receiving deferred compensation. Indeed, because Mr. B. had reached the social security limitation in the year his deferred compensation was taxed he paid only the medicare portion of FICA (1.45%) rather than the 7.65% that would have been applicable to wages below the limitation.
Note 2. The special timing rule is not applicable to most qualified retirement benefits. But, it does apply to deferrals under a §401(k) plan. Thus, for example, an employee who makes a before tax contribution of $5,000 to her §401(k) plan in 2014 would pay FICA tax on that $5,000.