Employers know that wages are generally subject to the Federal Insurance Contributions Act ("FICA"), and that both employers and employees are liable for a portion of FICA on those wages. In most circumstances, the employee and employer portion of FICA are paid when the compensation is paid to employees-but there is a "special timing rule" that applies when compensation is subject to a non-qualified deferred compensation ("NQDC") arrangement. Not knowing this special timing rule can cause real headaches for both employers and employees.
NQDC Plans Come in Different Flavors
An NQDC arrangement is really any kind of compensation that has been earned by an employee, but that the employee will not receive until a later tax year. This could be as simple as a bonus earned in one year and payable in a later year, or as complex as an equity-based incentive, phantom stock, supplemental executive retirement plan, or other NQDC arrangement.
Special Timing Rule for FICA
Employers that operate any kind of NQDC arrangement typically are aware that amounts under the NQDC arrangement are not subject to income tax until they are actually paid to the employee. There is a mismatch, however, between the timing of income taxes and the payment of FICA taxes with respect to NQDC under the special timing rule.
FICA taxes are due on NQDC on the later of: (1) when the employee provides the related services, or (2) when the compensation is no longer subject to a substantial risk of forfeiture (i.e., when the amounts vest). In other words, FICA taxes could be due before the NQDC is actually paid to the employee.
For a typical employer contribution-based cash plan or phantom stock plan, this rule means that FICA taxes will be due in the year when any deferred compensation (and any earnings) vest. This can become complex to track when there is an extended vesting schedule to ensure that the appropriate amount of FICA is paid by the employer and employee when each tranche of the compensation (and earnings) vest.
For a plan where employees are deferring salary or bonus, FICA tax will be due in the year when the employee makes the deferral.
For formula-based plans, FICA taxes are reported and paid once the benefit amount is both vested and reasonably ascertainable (i.e., when the employer can calculate the actual benefit under the plan).
Corrections and Penalties
The special timing rule is not optional. Therefore, employers have an obligation to correct the failure to follow the special timing rule in tax years that fall within the statute of limitations (which will generally be the last three years). This requires the employer and employee to pay any past-due FICA taxes now. For closed years, FICA must be reported and withheld when the amounts are paid to the employee. The IRS may impose penalties and interest for underpayment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.