In AM 2017-011 the IRS National Office was asked whether the IRS should enter into closing agreements with certain entities that discovered they had not included nonqualified deferred compensation as wages subject to FICA/Medicare tax when there was no substantial risk of forfeiture of the rights to the amount.
Generally, amounts an employee has rights to receive under a nonqualified deferred compensation arrangement are considered part of FICA/Medicare wages at the time provided in IRC §3121(v)(2)(A):
(2) Treatment of certain nonqualified deferred compensation plans
(A) In general
Any amount deferred under a nonqualified deferred compensation plan shall be taken into account for purposes of this chapter as of the later of—
(i) when the services are performed, or
(ii) when there is no substantial risk of forfeiture of the rights to such amount.
The preceding sentence shall not apply to any excess parachute payment (as defined in section 280G(b)) or to any specified stock compensation (as defined in section 4985) on which tax is imposed by section 4985.
However, Reg. §31.3121(v)(2)-1(d)(1)(ii) provides for a solution where the IRS does not end up never collecting FICA/Medicare taxes if an employer fails to report at the time specified above.
Reg. §31.3121(v)(2)-1(d)(1)(ii) provides:
(ii) Amounts not taken into account
(A) Failure to take an amount deferred into account under the special timing rule. If an amount deferred for a period (as determined under paragraph (c) of this section) is not taken into account, then the nonduplication rule of paragraph (a)(2)(iii) of this section does not apply, and benefit payments attributable to that amount deferred are included as wages in accordance with the general timing rule of paragraph (a)(1) of this section. For example, if an amount deferred is required to be taken into account in a particular year under paragraph (e) of this section, but the employer fails to pay the additional FICA tax resulting from that amount, then the amount deferred and the income attributable to that amount must be included as wages when actually or constructively paid.
(B) Failure to take a portion of an amount deferred into account under the special timing rule. If, as of the date an amount deferred is required to be taken into account, only a portion of the amount deferred (as determined under paragraph (c) of this section) has been taken into account, then a portion of each subsequent benefit payment that is attributable to that amount is excluded from wages pursuant to the nonduplication rule of paragraph (a)(2)(iii) of this section and the balance is subject to the general timing rule of paragraph (a)(1) of this section. The portion that is excluded from wages is fixed immediately before the attributable benefit payments commence (or, if later, the date the amount deferred is required to be taken into account) and is determined by multiplying each such payment by a fraction, the numerator of which is the amount that was taken into account (plus income attributable to that amount determined under paragraph (d)(2) of this section through the date the portion is fixed) and the denominator of which is the present value of the future benefit payments attributable to the amount deferred, determined as of the date the portion is fixed. For this purpose, if the requirements of paragraph (c)(2)(iii)(B) of this section are satisfied, the present value is determined by assuming that payments are made in the normal form of benefit commencing at normal commencement date. In addition, if the employer demonstrates that the amount deferred was determined using reasonable actuarial assumptions as determined by the Commissioner, the present value of the future benefit payments attributable to the amount deferred is determined using those assumptions. In any other case, see paragraph (d)(2)(iii) of this section.
The fact that the amounts are included as FICA/Medicare wages when paid turns out to be a major negative for the employee and employer normally. That’s because:
- These amounts often vest in years when the employee has wages in excess of the FICA limit but are paid out in years when the taxpayer no longer has other wages in excess of the FICA limit. Had it been included when vested only Medicare taxes would have been due, but the later payment means that some or perhaps even all of the deferred compensation will be subjected to the much higher FICA tax.
- The amount on which the tax is paid when vested is the present value of the future payments. Thus, a portion, quite often substantial, of the total payout is never subjected to either a FICA or Medicare tax. When the tax is imposed on the actual payment all amounts will be subjected to FICA/Medicare taxes.
Not surprisingly, some employers upon discovering years later that such taxes were not timely paid have wanted to go back and fix the erroneous filings. The employers are willing to pay the tax due, along with interest and penalties, even though the year is closed for assessment under the statute of limitations. The question being answered in this memorandum is whether the IRS should agree to such an arrangement.
The memorandum describes the employer’s request as follows:
These closing agreement requests have been submitted by employers who have discovered, after the applicable statute of limitations has expired, that they did not comply with the special timing rule in § 31.3121(v)(2)-1(a)(2) of the Employment Tax Regulations. These employers have asked to enter into closing agreements to resolve the taxation of NQDC for statutorily barred tax years and indicate that they are willing to both waive the right to argue that the assessment of such tax is statutorily barred, as well as agree to comply with the special timing rule prospectively.
The memorandum concludes that since the regulation provides for an alternative treatment for those who failed to comply with the rules, the IRS should not enter into such an agreement with these employers.
As the memorandum notes:
Because the applicable regulations provide the mechanism for the payment of FICA taxes in the case of NQDC which is not timely taken into account under the special timing rule in § 31.3121(v)(2)-1(a)(2), as a policy matter, a closing agreement should not be entered into if it that has the effect of avoiding application of this regulatory mechanism. The existence of the special transition rule in the regulations for years for which the period of limitations had expired at the time the regulations were finalized reinforces the importance of adhering to the rules contained in § 31.3121(v)(2)-1(d)(1)(ii) for determining the FICA tax due upon payment of amounts that were deferred in prior years and that should have been taken into account under § 3121(v)(2) in such prior years but for which the period of limitations has since expired.