This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
Even if nonqualified deferred compensation plan (NDCP) sponsors and participants successfully navigate safe passage through the compliance complexities of Internal Revenue Code section 409A, they both could still sink in a sea of taxes and penalties if they overlook applicable payroll taxes. High on the executive compensation enforcement initiatives of the Internal Revenue Service (IRS) is increased scrutiny of the Federal Insurance Contributions Act (FICA) taxes on NDCP benefits. The resulting penalties for a failure to pay appropriate FICA taxes affect both employers and executives and can be severe: back taxes, interest, fines, and even imprisonment if the misrepresentation or miscalculation of FICA tax amounts is proven to be willful.
Setting bearings straight on FICA taxes
FICA taxes have two components:
• Social Security (Old-Age, Survivors, and Disability Insurance, or OASDI) taxes are currently paid by employers and employees at a rate of 6.2%. These taxes are imposed on the employee’s wages up to the Social Security Taxable Wage Base (SSTWB), which is $118,500 for 2016.
• Medicare Hospital Insurance (HI) taxes are paid by employees and employers, both at a rate of 1.45%, on all wages (i.e., no cap) paid to an executive. Beginning in 2013, the rate increased to 2.35% for certain high-income individuals (e.g., those filing taxes as a single individual with more than $200,000 in wages) but remained at 1.45% for the employer portion.
Regardless of whether the source is executive deferrals or employer contributions, NDCP benefits are considered wages and thus are subject to FICA taxes. However, while these taxes are imposed immediately on current compensation, separate rules determine when NDCP benefits become subject to FICA taxes and vary depending on whether the NDCP is an “account balance” or a “non-account balance” plan.
Account balance NDCPs
Also known as “defined contribution”-style NDCPs, these are plans in which participant salary deferrals and/or employer contributions are allocated to one or more accounts established on behalf of the participant. Such allocations accumulate over time and are typically adjusted to reflect either deemed or actual investment experience. Nearly all plans of this type provide 100% immediate vesting.
Account balance NDCPs that call for only participant deferrals offer smooth sailing when applying the FICA taxation rules. The NDCP benefits are generally subject to FICA taxation only to the extent they are vested (i.e., participants will not forfeit benefits because they terminate employment). In addition, the calculation and withholding of the tax mirrors that used for 401(k) deferrals: the FICA tax is applied to the participants’ total gross compensation prior to any reductions made as the result of a deferral. Like 401(k) deferrals, the FICA withholding for NDCP deferrals takes place at the payroll level.
The immediate application of the FICA tax to the NDCP deferrals also enables participants to take advantage of a “non-duplication” FICA tax rule. Under this rule, once a NDCP deferral is taxed for FICA purposes, neither that amount nor any earnings attributable to that amount is ever again treated as wages subject to FICA taxes. Accordingly, when the participant eventually receives a distribution from the NDCP, no FICA taxes apply to the entire account balance (i.e., sum of all deferrals plus investment growth).
However, for NDCPs that credit participants’ accounts with a flat interest rate or a rate attributable to deemed (instead of actual) investment experience, this favorable tax treatment is only available if such crediting rate does not exceed what the IRS considers a “reasonable rate of interest.” While not providing a specific definition of this term, IRS guidance offers acceptable alternatives and contains several ironclad restrictions that prevent “creative” plan designs intended to produce artificially inflated levels of return on participants’ accounts. To the extent that a NDCP credits such excess returns, the portion that is considered excess will not qualify under the non-duplication rule and thus be FICA taxed as additional deferrals.