“An individual is required to pay FICA tax on amounts he will never receive!" This headline was screaming at me when I opened my email. I read the digest of the case, Balestra v. United States, and had to agree — the outcome of the case was shocking. The bottom line is that an employee had FICA tax withheld on nonqualified deferred compensation (NQDC) he will never receive because the obligation to pay was discharged in the company’s bankruptcy. This isn’t just taxation without representation; it is taxation without corresponding compensation.
Let’s consider how this ruling happened.Normally, FICA is imposed on wages in the year the wages are paid by the employer to the employee. There is, however, a “special timing rule” where wages are deferred as part of a NQDC arrangement. In such a situation, the wages must be taken into account for FICA at the later of when the services are performed or when such deferred amounts become vested. So, similar to deferral of wages with a 401(k), FICA is generally withheld long before the income is actually received by the employee. If the NQDC vests immediately, FICA would be withheld in the year in which the employee performed the services.In the Balestra case, the employer, United Airlines, withheld FICA taxes based on the present value of the Mr. Balestra’s anticipated plan benefits at the time of his retirement (when his NQDC became vested). The trouble is the employer’s obligation to pay the majority of that income was discharged in bankruptcy. Not only did the court rule that the FICA amounts were properly withheld, but also determined that Mr. Balestra was not entitled to any refund corresponding to the benefits he never received.
Where is the positive in this story?
This individual worked for an airline that went bankrupt; failed to receive his NQDC; and paid a FICA tax on wages never received. The positive is not for him, unfortunately, but for the rest of us.
This case is a reminder that, for most of us, the “special timing rule” is a great aspect of NQDC plans. Here’s why. There is a wage cap on the withholding of FICA. The 6.2% FICA rate for both the employer and employee only applies to wages up to $117,000 (the Social Security “wage base”). Employees who are eligible to participate in a NQDC plan are typically highly-paid individuals and their annual wages often exceed the wage base. Consequently, the special timing rule saves these employees substantial FICA taxes. The NQDC may exceed the wage base, and not be subject to a FICA tax, yet they count for FICA income purposes. Once an amount is subject to FICA income, future payments, including interest or accruals on deferred amounts, are not subject to additional FICA. If, instead, these amounts were taxed during retirement, they would more likely be subject to the full FICA tax. This is a classic case of, “you can pay me now or you can pay me later.”A testimonial
I can vouch personally for the salutary effect of this special timing rule. I’ve contributed to a NQDC plan for years, and each year my deferred wages have counted for FICA, whether my taxable wages have actually exceeded the wage base or not. When I hit a particular birthday with a zero in it, per my election, half of the plan benefits are distributed. The plan balance has accumulated handsomely because of how the deferred amounts were invested. And yes, I paid income tax on the distribution including the growth in the account; but no new FICA withholdings applied. Income taxes were deferred, and FICA taxes were minimized. I’m confident my story is likely more typical of the tax benefits of a NQDC plan than that of Mr. Balestra. The special timing rule has some twists and turns. A different rule typically applies where the “service provider” (i.e. the person deferring income) is an independent contractor. And, while FICA has a wage cap, the Medicare employment tax does not. Nevertheless, a 6.2% tax is worthy of consideration when reviewing the advantages of a NQDC plan for key employees. With the right company, both employer and employee stand to gain.Tax planning sometimes involves decisions that are counter-intuitive; for example, it is good to pay FICA now on money you’ll receive in the future. And sometimes good decisions, thrown for a curve by outside factors, can have disastrous effects: your company goes bankrupt and you end up paying taxes on wages never received. Either way, we can learn from the Balestra case. Tax planning is not for the timid.
