Guest Article

(From the June 16, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Employee Not Entitled to FICA Tax Refund Where Deferred Compensation Plan Is Terminated Prior to Benefit Payment

Drawing an analogy to a poor investment choice, the IRS Office of Chief Counsel has advised that an employee whose nonqualified deferred compensation plan was terminated before the benefits were fully paid is not entitled to a refund of the FICA taxes previously imposed on the unpaid benefit amounts. IRS Chief Counsel Advice Memorandum, No. 200823001 (June 6, 2008).

Background

Several employers maintained nonqualified deferred compensation plans for the purpose of supplementing the qualified retirement plans of their highly compensated employees. The plans were designed as non-account balance plans under which an employee's accrued benefit was not precisely known until retirement. At retirement, the covered employee was notified of the value of the accrued benefit and that, although distribution would be made in the form of monthly payments for life, the present value of the accrued benefit was subject to FICA tax in the year of retirement.

The employer paid both the employer- and employee-portion of the FICA taxes, and would recoup the employee-portion by withholding amounts from the retired employee's monthly benefit payments. The employer would cease withholding when the employee-portion of the FICA taxes had been repaid.

Before receiving all of their benefits under the deferred compensation plan, the employer filed for Chapter 11 bankruptcy and terminated the plan. Numerous retired employees filed claims for a refund of the employee-portion of the FICA taxes they paid. (The majority of the claims related to the Medicare tax.) The retirees requested a refund of the difference between the FICA tax they paid and the FICA taxes they would have been assessed on the benefit they actually received.

IRS Chief Counsel Advice

The Advice Memorandum reasoned that the FICA taxes had been imposed at the correct time. While wages are generally subject to FICA taxes when they are actually or constructively paid, a special timing rule applies for nonqualified deferred compensation. Under the special timing rule, which is provided in IRC § 3121(v)(2), deferred compensation must be taken into account as wages for FICA purposes as of the later of when the services are performed or when there is no substantial risk of forfeiture. However, where the deferred compensation is provided under a non-account balance plan, the amounts are not required to be taken into account under the special timing rule until the amount deferred is "reasonably ascertainable." Treas. Reg. § 31.3121(v)(2)-1(e)(4)(i)(A). Since these plans were non-account balance plans and the amount of the deferred compensation was not "reasonably ascertainable" until the employee's retirement date, the present value of the accrued benefit properly became subject to FICA taxes at that time.

The Memorandum went on to advise that no provision exists for the refund of properly paid FICA taxes if deferred compensation benefits are not ultimately paid. The legislative history of IRC § 3121(v)(2) indicates that Congress was attempting to create parity between the FICA tax treatment of remuneration which employees receive in cash and remuneration which is deferred. Failure to subject such deferred amounts to FICA tax might enable the employee to control the amount of remuneration includable in the social security wage base, making the system partially elective and potentially undermining the FICA tax base.

Analysis

The advice is not surprising, but certainly drives home the need for employees to accurately assess the financial risks inherent with deferred compensation. A risk that the compensation may not be paid is coupled with the risk that FICA tax may have already been imposed on that compensation. The analogy to an investment choice is apt, the lesson being that FICA tax amounts should be included in the calculation of the amount at risk.

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, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.