Employers with Nonqualified Deferred Compensation Plans Must Timely Withhold FICA Taxes
Employers maintaining nonqualified deferred compensation plans should remember to apply the IRS's "special timing rule" in order to take advantage of the "non-duplication rule."
Under the special timing rule, nonqualified deferred compensation plan benefits are generally subject to FICA taxes (i.e., Social Security and Medicare employment taxes) when the services are performed or, if later, when the benefits vest. Once FICA taxes are withheld, the non-duplication rule prohibits future FICA taxation on these amounts (or any earnings on these amounts).
While many employers fail to timely withhold FICA taxes on nonqualified deferred compensation amounts, such withholding is required and benefits both the participant and the employer as follows:
- Once FICA taxes are withheld, under the non-duplication rule, any future earnings on the nonqualified deferred compensation benefits are not later subject to FICA taxes.
- If, as is typical, FICA taxes are withheld in a year when the participant's earnings have already exceeded the Social Security taxable wage base, the participant can completely avoid payment of the Social Security portion of the FICA taxes (the Medicare employment tax portion, however, cannot be avoided).
- Once FICA taxes are withheld, the participant is protected from having to pay any increased FICA taxes in the event the FICA tax rate is increased in the future.
- Like the participant, once FICA taxes are withheld, the employer is protected from any FICA tax rate increases on those amounts.
- Courts will hold employers liable to participants for failure to timely withhold FICA taxes on nonqualified deferred compensation. By withholding at the appropriate time, the employer is able to better protect itself from participant claims for failure to withhold and any liability in connection with that failure.
Employers should review their tax withholding and reporting procedures for each nonqualified deferred compensation arrangement that they maintain.
This FICA special timing rule is just one of the many issues that sponsors of nonqualified deferred compensation plans must address. Plan sponsors should review this Benefit Alert and address the action step listed above as soon as possible.