IRS ADDRESSES FICA, FUTA RULES FOR NONQUALIFIED PLANS.

Notice 94-96

I. BACKGROUND

Section 3121(v)(2) of the Internal Revenue Code determines when amounts deferred under nonqualified deferred compensation plans are taken into account as wages for purposes of the Federal Insurance Contributions Act (FICA). Section 3121(v)(2)(A) provides that any amount deferred under a nonqualified deferred compensation plan shall be taken into account 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 the amount. Section 3121(v)(2)(B) provides that an amount taken into account as wages by reason of subparagraph (A) (and the income attributable to that amount) will not thereafter be treated as wages. Section 3121(v)(2)(C) defines the term "nonqualified deferred compensation plan." Section 3306(r)(2) provides parallel rules for purposes of determining when amounts deferred under nonqualified deferred compensation plans are wages for purposes of the Federal Unemployment Tax Act (FUTA).

Section 13207 of the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66) repealed the dollar limit on wages subject to hospital insurance (HI) tax under sections 3101(b) and 3111(b) of the Code, effective for 1994 and later years. This change increases the number of taxpayers who incur FICA tax liability on amounts deferred under nonqualified deferred compensation plans.

II. REASONABLE, GOOD FAITH INTERPRETATION

The Service and Treasury intend to publish guidance under sections 3121(v)(2) and 3306(r)(2) in a forthcoming notice of proposed rulemaking. The effective date of the proposed regulations will not be earlier than January 1, 1995. Thus, the Service will not challenge an employer's determination of FICA or FUTA tax liability with respect to a nonqualified deferred compensation plan for periods preceding the effective date, if the employer's determination is based on a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2). See Example 1 and Example 3, paragraphs (a) and (b).

Whether an employer has made a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2) will be determined based on all of the relevant facts and circumstances, including consistency of treatment by the employer. For example, one relevant circumstance could be an employer's effort to achieve more favorable FICA and FUTA tax treatment by using different methods to value the benefits of two participants who are subject to the same plan provisions. However, in no event will an employer's treatment of amounts deferred under a nonqualified deferred compensation plan be considered to be in accordance with a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2) if the employer treats these amounts, for FICA and FUTA tax purposes, as deferred compensation for services performed prior to the adoption of the plan (or the amendment to the plan) providing for the deferred compensation, i.e., if the employer includes these amounts in FICA and FUTA wages for periods prior to the adoption or amendment. See Example 2.

An employer's reasonable, good faith treatment of an amount as deferred compensation taken into account under sections 3121(v)(2)(A) and 3306(r)(2)(A) for periods preceding the effective date of the forthcoming regulations may not necessarily be determinative for purposes of applying sections 3121(v)(2)(B) and 3306(r)(2)(B) under the regulations for periods after their effective date. Thus, the regulations could provide that sections 3121(v)(2) and 3306(r)(2) will be applied to determine the amount to be taken into account as FICA and FUTA wages for periods after the regulations' effective date independent of the amount (if any) that the employer took into account as FICA or FUTA wages for periods preceding the effective date under its reasonable, good faith interpretation. See Example 3. However, in that event, it is anticipated that provision would be made so that any such application of the regulations would not require a taxpayer to pay more tax than would have been payable had the regulations been in effect since the effective dates of sections 3121(v)(2) and 3306(r)(2).

EXAMPLE 1. (a) An employer establishes a nonqualified deferred compensation plan in 1985 for the benefit of an executive. Under a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2), the employer determines that the amount deferred under the plan (and hence includible in FICA and FUTA wages) for each year from 1985 through 1994 is $50,000. However, since the executive's total wages (without regard to the amount deferred) are above the FICA and FUTA wage bases in 1985 through 1993, no FICA or FUTA taxes are paid on those amounts in those years. In 1994, the amount deferred is subject to the HI portion of FICA tax. Regulations are issued with an effective date of January 1, 1995. In accordance with the valuation rules provided for under the regulations, the amount deferred (and hence includible in FICA and FUTA wages) for each year beginning in 1985 would have been $60,000.

(b) Because the employer applied a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2), the Service will not challenge the employer's determination of the FICA and FUTA tax liability for 1985 through 1994. Accordingly, no FICA or FUTA taxes will be owed for 1985 through 1993, and no additional FICA or FUTA taxes will be owed for 1994.

EXAMPLE 2. (a) An employer establishes a severance pay plan on January 1, 1994. The plan covers an executive who has ten years of service as of that date. The plan provides that, in consideration of the executive's outstanding services over the past ten years, the executive will be paid a $500,000 lump sum upon termination of employment at any time. On January 15, 1994, the executive's employment with the employer terminates. The employer treats the $500,000 as deferred compensation for services performed in 1993 and earlier years (i.e., treats the amount as having been included in FICA and FUTA wages for those years).

(b) Because 1993 and earlier years are prior to the adoption of the plan, the employer's treatment is not in accordance with a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2).

EXAMPLE 3. (a) In 1985, an employer establishes a nonqualified deferred compensation plan for participants A and B. Prior to the effective date of the regulations, and in accordance with a reasonable, good faith interpretation of sections 3121(v)(2) and 3306(r)(2), the employer treats the plan as a nonqualified deferred compensation plan under sections 3121(v)(2) and 3306(r)(2). Each year, consistent with this treatment, the employer determines the amount that it will treat as deferred in that year and accordingly includes that amount in FICA and FUTA wages for that year. The employer also determines that each participant's total wages (without regard to the amount deferred) exceed the applicable FICA and FUTA wage bases for each of those years. Consequently, neither the employer nor either participant pays any FICA or FUTA taxes on the amounts that are determined to be deferred. Participant A ceases performing services for the employer in 1988, while participant B continues performing services beyond the effective date of the regulations. Plan payments to participant A begin in 1989 and are expected to continue after the effective date of the regulations. In accordance with its treatment of the plan as a nonqualified deferred compensation plan, the employer does not treat the payments in 1989 through 1994 as FICA or FUTA wages for those years.

(b) PRE-EFFECTIVE DATE PERIODS. Because the employer's determination of its FICA and FUTA tax liability for 1985 through 1994 was made in accordance with a reasonable, good faith interpretation, neither the employer nor either participant will be subject to FICA or FUTA tax for those years.

(c) POST-EFFECTIVE DATE PERIODS -- Classification of plan. If, under the regulations, the plan did not constitute a nonqualified deferred compensation plan within the meaning of sections 3121(v)(2) and 3306(r)(2), the regulations could provide that, even though the employer treated amounts under the plan as having been deferred in pre-effective date periods (and hence, in the case of participant A, as includible in FICA and FUTA wages in 1985-1988), those amounts would not be treated as having been included in wages for those periods for purposes of applying sections 3121(v)(2) and 3306(r)(2) to periods after the effective date. Under this approach, any payments made after the effective date would be includible in FICA and FUTA wages under sections 3121(a) and 3306(b) when they are paid. (If instead of continuing after the effective date, all payments to participant A were completed prior to the effective date, the regulations would have no effect on FICA or FUTA tax liability with respect to participant A under the plan because the employer followed a reasonable, good faith interpretation.)

(d) POST-EFFECTIVE DATE PERIODS -- Valuation of amounts deferred. Alternatively, if, under the regulations, the plan did constitute a nonqualified deferred compensation plan within the meaning of sections 3121(v)(2) and 3306(r)(2), but the employer's valuation of amounts deferred prior to the effective date (though based on a reasonable good faith interpretation) differed from the valuation that would have resulted if the regulations were applied, the regulations could provide that the amounts includible in FICA and FUTA wages for participant B for post-effective date periods would be determined without regard to the valuation the employer used for pre-effective date periods.

III. WITHHOLDING

An employer must withhold the applicable FICA and FUTA taxes with respect to nonqualified deferred compensation treated as wages under sections 3121(v)(2) and 3306(r)(2) on the date or dates it treats such amounts as paid. For this purpose, the employer may choose to treat amounts deferred under a nonqualified deferred compensation plan as wages paid on a pay period, quarterly, semi- annual, annual, or other basis, provided that the amounts are treated as paid no less frequently than annually. The employer must deposit the withheld taxes under the regular rules for tax deposits.

The principal author of this notice is David Pardys of the Office of Associate Chief Counsel (Employee Benefits and Exempt Organizations). For further information regarding this notice, contact David Pardys on (202) 622-4606 (not a toll-free call).