A fundamental but sometimes overlooked aspect of implementing a non-qualified deferred compensation (NQDC) plan is the issue of FICA payment. We have encountered a few situations recently where employers have set up NQDC plans with everything, including an exhaustive Section 409A analysis, executed in a seemingly perfect fashion, with one glaring exception: the deferrals were not included in income for FICA purposes at the time of vesting. Unfortunately, it appears that, despite everyone’s best intentions, this important step can fall through the cracks at the time of implementation.
In a typical NQDC arrangement, a senior executive is provided with a right to a payment or series of payments upon retirement, death, or disability. Generally, the executive vests in these payments (in other words, the payments are no longer subject to a substantial risk of forfeiture) many years before they are actually paid. If the plan is properly set up, which includes complying with the intricate requirements of Section 409A, income taxation can be deferred until the amounts are paid.
However, while proper care can defer income tax, FICA is subject to different rules. The vesting date, which may not be relevant to income taxation, is a critical triggering point for FICA purposes. FICA, which stands for Federal Insurance Contributions Act, imposes two taxes:
- Social Security tax on compensation up to the taxable wages base ($118,500 in 2016). The tax rate is currently 6.2% on both the employer and employee, for a total of 12.4%.
- Medicare tax on all compensation. The tax rate is currently 1.45% on both the employer and the employee. Compensation over $250,000 is also subject to an additional tax of 0.9% on just the employee. Thus, the total tax rate ranges from 2.9% to 3.8%.
- FICA taxation applies at the time of vesting. The vested amount, as discussed below, is added to the executive’s FICA wages for the year in question. Often, the executive’s other compensation in the year of vesting exceeds the Social Security taxable wage base, so the vested amount is subject only to Medicare tax.
- If FICA is not paid on the deferrals prior to payment, then the payments are subject to FICA. Because executives typically receive these payments in retirement, when they do not have other earnings from the employer, the payments are subject to both Social Security and Medicare tax. Therefore, the tax rate can be much higher than if the deferrals had been taxed for FICA purposes at the time of vesting.
- In the case of an “an account balance plan,” the taxable amount for FICA purposes is the amount contributed to the account. An “account balance plan” is one where the benefit consists solely of a principal amount credited to the employee, plus income credited to the principal. Subsequent earnings on the contributed amount are not subject to FICA.
- In the case of a “non-account balance plan,” defined as anything other than an account balance plan, the taxable amount for FICA purposes is the present value of the vested future payments.
How can this overlooking of FICA tax be avoided? In most cases, the key is to make sure that the people who handle the payroll process are kept in the loop. Sometimes, whether due to a desire for confidentiality or otherwise, there is a lack of communication between the plan’s implementation team and the people within the company who do the basic blocking and tackling relative to payroll taxes. It is important to make sure that the addressing of FICA is added to any list of basic steps to be followed when implementing a non-qualified deferred compensation plan.