FICA Inclusion

[Guest SCUDDESLER]

A top hat plan uses a rabbi trust to accumulate assets for later distribution. The rabbi trust satisfies the IRS model rabbi trust rules. The plan includes a graded vesting schedule. When a participant's status changes from unvested to partially vested, is the portion of his/her now vested account balance ("bookkeeping account balance") no longer subject to a substantial risk of forfeiture for (1) FICA and FUTA purposes and (2) income tax purposes?

No one seems to know if "becoming vested" is sufficient to eliminate an otherwise applicable substantial risk of forfeiture under Section 83.

If a status change from unvested to partially vested eliminates the substantial risk of forfeiture, how should the plan sponsor handle the future changes from say 20% vested to 40% vested to 60% vested and so on?

Lastly, how is it possible that deferred compensation may be subject to FICA and FUTA tax treatment before such amounts are subject to income tax treatment. If such amounts are only subject to FICA and FUTA tax treatment upon the later of (1) payment or (2) cessation of a substantial risk of forfeiture, then it seems to me that FICA, FUTA and income tax treatment would occur at the same time. Can the plan sponsor, just because it wants to, pay FICA and FUTA earlier than the later of (1) payment or (2) cessation of a substantial risk of forfeiture?

Thanks.

[Guest Harry O]

You need to work your way through the section 3121(v) regulations. But you need to ignore the rabbi trust for FICA purposes. It is a red herring.

Yes, the portion of the benefit that vests is subject to FICA tax in that year (I assume we are talking about an account balance plan). This is the case even though the benefit is not subject to income tax because it remains subject to the claims of the employer's creditors in the rabbi trust. This is a well-known issue -- NQ'd deferred comp is subject to FICA even though it is not subject to income tax.

Again, see section 3121(v) and the regulations for exhaustive detail on this.

[Guest EAKarno]

Section 83 does not apply to unsecured promises to pay cash in the future. Thus, there is no issue of a substantial risk of forfeiture for income tax purposes within a rabbi trust. So long as the participant's benefit is subject to the general claims of employer creditors, there is no constructive receipt. For FICA purposes, however, taxation generally occurs along with the vesting of participant benefits.

[pjkoehler]

I agree with EAKarno that an unfunded and unsecured promise to pay the NQDC Plan benefit in the future is not "property" for the purposes of Code Sec. 83. See Treas. Reg. Sec. 1.83-3(e). If the grantor of the trust is a taxable entity, then constructive receipt principles of Code Sec. 451 and the regs thereunder apply. Accordingly, the plan's treatment of the participant's benefit as "vested," i.e. no longer forefeitable in the event of the participant's failure to perform future services, is NOT a factor in determining whether or not the participant is in constructive receipt of the assets held in the rabbi trust.

FYI - on the other hand, if the grantor is a tax-exempt organization or a state or local government, then the principles of constructive receipt set forth in Code Sec 457 apply. Participants in a plan maintained by such an entity that is not an "eligible plan," would be taxable in the year in which their benefits "vest" under the plan.

Regarding FICA taxation, you will want to keep in mind that as far as account balance deferred comp plans are concerned, the participants benefit from the employer's application of the "special timing rule" under the regulations. The bad news is that this requires the employer to assess FICA taxation on the fully-vested salary deferrals in the year of the deferral plus any nonelective employer contributions that vest in the year in which they vest (although presumably the participants are only exposed to additional tax at the 1.45% medicare tax rate). The good news is that, on distribution, not only are the deferrals not again subject to FICA, but none of the investment earnings, which over a long deferral period could easily exceed the cumulative deferrals, is subject at all. Under the general timiing rule, the employer would not subject the deferrals to FICA taxation until the year of distribution, but that would include the investment earnings, as well as the cumulative deferrals.