Deferred compensation and employment taxes

One of the more misunderstood employee benefit related issues involves the treatment of the employment tax rules as they apply to deferred compensation programs maintained in the for-profit, tax-exempt and governmental sectors. The timing is right for employers and service providers to focus on certain FICA and FUTA taxation issues as they apply to the granting and payment of nonqualified deferred compensation, including the administration of public retirement systems and “FICA Replacement Plans” in the public sector. Listed below are a few issues that are of particular interest in this area.

FICA and FUTA tax treatment regarding employer-sourced contributions to section 457(b) “eligible” plans of deferred compensation

Typically sponsored by governments and tax-exempt entities, section 457(b) retirement plans are similar to 401(k) plans. In a section 457(b) plan of nonqualified deferred compensation, any contribution, whether its source being in the form of a deferral elected by an employee, or a matching or non-elective contribution made by the employer, will be treated as wages and subject to FICA and FUTA taxation when the services have been performed and the contribution is no longer subject to a substantial risk of forfeiture. In section 457(b) plans sponsored by governmental employers, where participation is usually open to all employees (whether highly compensated or not), special attention should be given to FICA taxation when employer matching or non-elective contributions are also provided; subject to a vesting schedule.

Calculating FICA and FUTA in a section 457(b) plan uses different rules than those that apply to qualified retirement plans (such as 401(k) plans) where employer matching and non-elective contributions are not taken into account for purposes of reporting and withholding of such taxes. As an eligible account plan of deferred compensation, not only are employer section 457(b) matching and non-elective contributions treated as wages subject to FICA and FUTA (usually when they vest) but they are also counted toward the annual deferral limit in effect for that respective year. These are treated as deferrals, not when contributed to the plan, but when the services are performed and no longer subject to a substantial risk of forfeiture.

The FICA and FUTA timing rules applicable to nonqualified plans of deferred compensation paid to “top hat” employees in for-profit companies

When nonqualified deferred compensation is provided to a “select group of management or highly compensated employees” (i.e., the “top hat group”) and vesting occurs many years prior to the time of the actual or constructive receipt of the benefit, special attention must be given to a special timing rule. This rule uses the present value of the benefit at the time of vesting for reporting and payment of the FICA and FUTA taxes. In many cases, since retirement would occur many years after vesting, a substantial tax savings may occur. In some cases, amended Forms 941 and W-2c’s can be filed to recapture the benefits of this special timing rule.

FICA-HI taxation attributable to wages, including contributions made to certain public sector section 457(b) “FICA replacement plans”

Since 1951, states have been able to enter into voluntary agreements with the federal government to provide Social Security coverage to their public employees. Today, there are a number of public sector section 457(b) plans that qualify and are operating as “FICA Replacement Retirement Systems” and are not covered by this Social Security Act Section 128 Agreement. If a public employer maintains a qualifying “FICA Replacement Retirement System” in place for its employees, and has not obtained a Section 128 Agreement, it is not required to pay the old-age, survivor, disability portion (OASDI) of Social Security on the wages of its employees. However, the public employer must still properly report and withhold for the Medicare portion of FICA (Medicare FICA-HI), even given the presence of “FICA Replacement Plan” status. In certain circumstances, amended Forms 941 and W-2C can be prepared for open years, taking into account wages and vested deferred compensation, for purposes of reporting and paying the Medical FICA-HI tax.

Interplay between public retirement systems  and the Social Security Act “Section 218 Agreement”

Effective July 2, 1991, Congress made social security coverage mandatory for state and local government employees who are neither covered by a “SSA Section 218 Agreement” nor qualifying participants in a public retirement system. Under this law, states can provide mandatorily covered employees with membership in a public retirement system as an alternative to social security coverage. Employees may also be covered by both a public retirement system and social security if the public entity enters into a Section 218 Agreement.

Although these rules are complex, it is important to remember that as a starting point, when a public entity fails to obtain a Section 218 Agreement for its public retirement system, it will not be permitted to provide social security coverage to those employees covered under the public retirement system and therefore may not take into account the wages earned by those public employees for FICA-OASDI purposes. The public entity must voluntarily elect to be double-covered by entering into a Section 128 Agreement while continuing to pay into the public pension plan. Even if a Section 128 Agreement is not procured, and the employees of the public entity are covered under a public retirement system, Medicare FICA-HI must still be reported and withheld for employees hired on or after April 1, 1986.

Conclusion

The FICA and FUTA rules attendant with the sponsorship of deferred compensation and public sector retirement plans are often overlooked by for-profit, not-for-profit, and public sector organizations alike and often will require planning and close scrutiny. With recent emphasis in Congress and in the press addressing the crisis in Social Security and Medicare funding, the Internal Revenue Service is becoming more aggressive on addressing these employment taxation issues through examination. It is important to include the application of the FICA taxation rules in any discussion concerning the establishment or maintenance of a nonqualified deferred compensation program or a public sector retirement system.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.


The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.