The Federal Insurance Contributions Act, better known as FICA, is the statute that imposes a tax on compensation to fund Social Security (under the Old Age, Survivors and Disability Program or “OASDI”) and Medicare’s Hospital Insurance (“HI”) Program. Under the OASDI component, employers and employees each pay the current tax rate of 6.2% of wages on a maximum of $128,400 of compensation (the “social security wage base” in 2018). The Medicare program’s tax rate is 1.45% paid by employers and employees, but with no maximum wage limit. In addition, employees who earn more than $200,000 (for taxpayers filing as single; $250,000 for joint filers) must pay an additional 0.9% Medicare tax. The employer does not pay this additional tax.
When an employer pays wages to its employees, the employee portion of the FICA tax is subject to withholding at the time the compensation is paid. An employer’s contributions to a non-qualified deferred compensation (“NQDC”) plan are also subject to FICA withholding, but they are covered under some special rules. NQDC plans include any plans that provide for the deferral of compensation unless specifically excluded under the Internal Revenue Code (the “Code”). Examples of plans under which employer contributions are not subject to FICA tax include plans that are under Code sections 401(a), 403(b), or 457(b) (for governmental, but not tax-exempt employers).
The Code provides a special timing rule for FICA tax on contributions to an NQDC: such contributions are subject to FICA tax at the time that the services to which the deferrals relate are performed, or, if later, when the deferrals are no longer subject to a substantial risk of forfeiture (that is, when they are fully vested). That means that if the contribution is vested when it is made to the plan, FICA tax should be withheld at that time. If FICA tax is timely withheld, then no FICA tax is due when the employee takes a distribution from that plan. This can result in a significant benefit for the employee, because it means that none of the earnings on the account will be subject to FICA tax.
On the other hand, if FICA tax is not withheld at the time the contribution vests, it must be withheld at the time that the employee takes a distribution from the plan. If that is the case, the FICA tax will be calculated on the earnings in addition to the contributions. This will likely cause both the employee and the employer to pay additional FICA taxes. While no additional OASDI tax will be due if the employee’s income in the year of the distribution is in excess of the social security wage base, additional Medicare tax would still be due because there is no cap on the amount of compensation for the Medicare component of FICA tax. And if the employee’s wages are over the threshold for the additional Medicare tax, the employee will owe even more FICA tax. We are aware of at least one lawsuit brought by an employee against an employer for failing to withhold FICA tax when contributions were made to an NQDC plan, which resulted in higher taxes for the employee at the time the distribution was taken from the plan.
Best Practices for Employers Sponsoring NQDC Plans
Review your payroll practices to determine whether FICA tax is being withheld at the time that contributions to the plan vest. In our experience, it is not unusual to find FICA tax properly withheld on employee elective deferrals to the NQDC plan, but that the FICA withholding is overlooked when the contributions are from the employer. This is because employer contributions often do not go through payroll and are outside of the normal withholding process.
Review your plan document to determine if there is any specific language governing the payment of FICA tax. It is better to have language in the plan that does not require you to pay the FICA taxes when the contributions vest, so that if you inadvertently fail to do so you are not in violation of the plan and potentially liable to participants for any increase in their FICA tax at distribution.
If you determine that FICA tax has not been withheld properly for previous periods, you will likely want to correct the error so that FICA will not be due on distribution. The IRS allows you to correct the failure to file the correct amount of FICA on an interest free basis for any tax year that is still open (generally, three years from the date that the original returns were due). You will need to file a corrected FICA tax return, and issue a corrected W-2 to affected employees. A more limited correction period applies to the additional Medicare tax: it can be corrected on an interest free basis only until the end of the calendar year of the failure. If the employee had earned wages in excess of the social security wage base in the year being corrected, there will not be any additional FICA tax due for the OASDI component. However, there will be tax due under FICA’s Medicare component.
For tax years that cannot be corrected because they are closed, you will want to determine what portion of the account under the NQDC plan will be subject to FICA tax upon distribution from the plan, and make certain to have controls in place to withhold properly when the participants take withdrawals from their accounts.
© Boutwell Fay LLP 2017, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of November 30, 2017.