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Guest Article

(From the December 3, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Defines Salary Reduction Agreement for Purposes of 403(b) Plan FICA Exception

Payments public educational institutions and 501(c)(3) tax-exempt organizations make to purchase 403(b) annuity contracts for their employees generally are not included in wages for purposes of the Federal Insurance Contributions Act (FICA) rules. However, this FICA exception is not available for payments made under a “salary reduction agreement.” The breadth of the IRS’s proposed definition of “salary reduction agreement” has been criticized by some since the IRS issued it in 2004. But the IRS has just issued its 2004 proposed definition in final form, without changes. 72 FR 64939 (November 19, 2007).

Background

FICA taxes are imposed on all “wages received with respect to employment.” IRC § 3121(a) broadly defines wages as “all remuneration for employment,” subject to specific statutory exceptions. One of the exceptions is for “any payment made to, or on behalf of, an employee or his beneficiary ... under or to an annuity contract described in section 403(b), other than a payment for the purchase of such contract which is made by reason of a salary reduction agreement (whether evidenced by a written instrument or otherwise).” IRC § 3121(a)(5)(D).

Thus, payments an employer makes to purchase a 403(b) annuity contract on behalf of its employees generally are not “wages” for FICA tax purposes. However, any such payments an employer makes pursuant to a salary reduction agreement are “wages” for FICA tax purposes. By comparison, all employer payments to purchase 403(b) annuity contracts on behalf of its employees – including payments made pursuant to a salary reduction agreement – are not included in employees’ incomes for income tax purposes.

What constitutes a “salary reduction agreement” under IRC § 3121(a)(5)(D) has been the matter of some debate. The IRS’s 2004 temporary and proposed regulations on the subject created a stir because that guidance included more than just “cash or deferred elections” in the definition of “salary reduction agreement.” The temporary and proposed regulations also included in the definition the following:

A plan or arrangement whereby a payment will be made if the employee elects to reduce his or her compensation pursuant to a one-time irrevocable election made at or before the time of initial eligibility to participate in such plan or arrangement (or pursuant to a similar arrangement involving a one-time irrevocable election); and A plan or arrangement whereby a payment will be made if the employee agrees as a condition of employment (whether such condition is set by statute, contract, or otherwise) to make a contribution that reduces the employee’s compensation.

Final Regulations on Salary Reduction Agreement Definition

According to the preamble to the final regulations, commenters on the temporary and proposed regulations complained that a “salary reduction agreement” for purposes of IRC § 3121(a)(5)(D) should include only voluntary salary reductions. In other words, these commenters believe mandatory salary reductions – such as salary reductions that are required as a condition of employment – should not be part of the definition. Others argued that salary reductions made pursuant to a one-time irrevocable election – whether voluntary or mandatory – should not be included in the definition. The IRS rejected both suggestions and adopted the definition in the temporary and proposed regulations without change.

Thus, the final regulations define “salary reduction agreement” for purposes of IRC § 3121(a)(5)(D) as follows:

§ 31.3121(a)(5)-2 Payments under or to an annuity contract described in section 403(b). (a) Salary reduction agreement defined. For purposes of section 3121(a)(5)(D), the term salary reduction agreement means a plan or arrangement (whether evidenced by a written instrument or otherwise) whereby payment will be made by an employer, on behalf of an employee or his or her beneficiary, under or to an annuity contract described in section 403(b) – If the employee elects to reduce his or her compensation pursuant to a cash or deferred election as defined at § 1.401(k)-1(a)(3) of this chapter; If the employee elects to reduce his or her compensation pursuant to a one-time irrevocable election made at or before the time of initial eligibility to participate in such plan or arrangement (or pursuant to a similar arrangement involving a one-time irrevocable election); or If the employee agrees as a condition of employment (whether such condition is set by statute, contract, or otherwise) to make a contribution that reduces his or her compensation.

Effective Date

The final regulations are effective November 15, 2007, and apply only to contributions made to any 403(b) plan on or after November 15, 2007. The temporary and proposed regulations apply to contributions made to any 403(b) plan on or after November 16, 2004. However, according to the preamble to the final regulations the IRS will not apply the temporary and proposed regulations to contributions made to any 403(b) plan prior to November 16, 2004 for purposes of determining if such contributions were subject to FICA tax.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.

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