©1999 Apsen Law & Business

The final regulations under Section 3121(v)(2), published in January 1999, set forth a special regimen for the FICA taxation of nonqualified deferred compensation. This article, the second of two, analyzes the final regulations' complex rules for determining FICA taxes on nonqualified deferred compensation, including when and what amount of wages must be taken into account and procedures for withholding. It focuses on opportunities that exist to make the regulations work practically for employers and to reduce FICA taxes, while exploring the background behind the drafters' decisions. Together with its companion article in the Autumn issue, it provides a comprehensive analysis of the final regulations under Section 3121(v)(2).

Section 3121(v)(2) of the Internal Revenue Code governs when nonqualified deferred compensation is subject to Social Security or "FICA" taxes. Although wages are generally subject to FICA taxes at the time they are paid or constructively received, Section 3121(v)(2) provides a "special timing rule" that typically accelerates when nonqualified deferred compensation is taxed for FICA purposes. The application of this special timing rule is detailed in Final Regulations that were published in January of this year.1 The Final Regulations revise the Proposed Regulations that appeared in January of 19962 and are generally effective beginning January 1, 2000.3

This article is my second in a series of two articles on the Final Regulations. The first, which appeared in the Autumn 1999 issue of the Journal, analyzed the definition of nonqualified deferred compensation (identifying the compensation arrangements to which the special timing rule applies), as well as effective date and transition rules. This article reviews the Final Regulations' provisions for applying the special timing rule to nonqualified deferred compensation, focusing on changes from the Proposed Regulations.


Under the special timing rule of Section 3121(v)(2), nonqualified deferred compensation (NQDC) is treated as wages subject to FICA on the later of: (1) the date on which the underlying services are performed, or (2) the date on which the deferred compensation is no longer subject to a substantial risk of forfeiture.4 Therefore, once the services are performed and the related NQDC has vested, NQDC is subject to FICA even though not currently payable. The effect of this is that an employee will often pay FICA taxes on deferred compensation while still working, rather than during retirement when the deferred amounts are paid. Acceleration of taxation to the working years is economically significant because it generally means taxation occurs when the FICA wage base (currently $72,600) is otherwise used up, rather than after retirement when it would not be. This wage base effect can reduce the tax rate on NQDC from 15.3 percent (the combined OASDI and Medicare portions on the employer and employee) to 2.9 percent (the Medicare portion on the employer and employee).

Because of this, the Final Regulations include provisions that are intended to prevent taxpayers from expanding the definition of NQDC to cover other types of compensation, for example, severance pay. However, in the case of compensation that is NQDC, there is much less at stake economically for the Treasury. First, the tax rate is generally only 2.9 percent. Second, because NQDC is generally increased by earnings or actuarially for later payment, there is little reason for Treasury to worry that taxation at a later date (rather than an earlier date) will materially reduce receipts by not reflecting the time value of money.

Recognizing these factors, the drafters of the Final Regulations took the opportunity to emphasize flexibility and the reduction of taxpayer burdens in drafting the provisions that relate to the mechanics of taxing NQDC. The resulting regulations are longer and have a steeper learning curve than a less flexible set might have, but they make it possible for far more employers to apply FICA taxes to NQDC in an administratively workable manner. In addition, while pursuing this desirable goal, the drafters have done what they could to ease the learning curve with numerous examples (including several new ones) in the Final Regulations.


The heart of the Final Regulations is the special timing rule of Section 3121(v)(2). As noted, under the special timing rule, amounts deferred under a nonqualified deferred compensation plan (a "Nonqualified Plan") will be subject to FICA taxes at the later of: (1) the date on which the underlying services are performed, or (2) the date on which the deferred compensation is no longer subject to a substantial risk of forfeiture.5 This contrasts with the "general timing rule," under which compensation is taken into account as wages when actually or constructively received.

For purposes of the special timing rule, the underlying services are considered performed when the employee has performed all of the services necessary, under the plan and the facts, to have a "legally binding right" to the deferred compensation.6 In determining if there is a legally binding right, the Final Regulations focus on whether (and if so, under what circumstances) the NQDC may be reduced or eliminated.7 If reduction or elimination is barred entirely or may occur only pursuant to objective provisions of the plan (such as an objective provision creating a substantial risk of forfeiture), there is a legally binding right. On the other hand, if the employer may unilaterally reduce or eliminate the NQDC after the services are performed, the employee does not have a legally binding right to the compensation. (Presumably, however, if the employer's right to reduce the NQDC is subject to objective limitations and a minimum amount is protected, the employee will be treated as having a legally binding right to the minimum.)

To determine whether there is a substantial risk of forfeiture for purposes of the special timing rule, the Final Regulations reference the principles developed under Section 83 and the related regulations. These are adopted intact, without any special gloss.8 This has the noteworthy advantage of using familiar rules that have an existing body of interpretation.

The satisfaction of these two conditions (services performed and risk of forfeiture ended) provides a precise point in time for when the special timing rule is met. The preamble to the Final Regulations emphasizes that the special timing rule is not elective, and that interest and penalties may be applied if FICA is paid late.9 However, the Final Regulations provide substantial flexibility to delay when NQDC results in FICA wages, even when both legs of the special timing rule have been satisfied. In noteworthy concessions to administrative constraints, the Final Regulations authorize delaying inclusion in wages when (1) the amount is deferred under a "nonaccount balance plan" and is not "reasonably ascertainable," and (2) pursuant to a rule of "administrative convenience."10 The Final Regulations also require delayed inclusion in wages until the plan providing the NQDC is formally established. These three special provisions are discussed below under "When Amounts Are Taken into Account—Special Rules."

An important corollary to the special timing rule under the Final Regulations is a "nonduplication rule," which avoids double taxation. Once a deferred amount is "taken into account" as wages under the special timing rule, the nonduplication rule provides that the deferred amount and income "attributable" to that amount will not later be taken into account again, for example, when payment to the employee occurs.11 Therefore, the nonduplication rule protects the acceleration of when deferrals are wages and any related tax-rate reduction that flows from the wage base effect. In addition, as noted below, it also permits the sheltering from FICA taxes of potentially substantial earnings on deferrals.

Deferrals Taken into Account

A deferred amount is taken into account for purposes of the nonduplication rule when it is included in computing FICA wages for a year, provided the resulting FICA tax (and any penalties and interest, if paid late) are actually paid before the year becomes closed under the statute of limitations.12 The Final Regulations provide, if any FICA taxes are not paid for a year, that the shortfall will be deemed to relate to NQDC to the extent possible.13 This maximizes Treasury's protection from the statute of limitations, because these amounts (to which the non-duplication rule is inapplicable) may then be taxed at payment, no matter how many years later.

If payment occurs before the statute closes on the year when a deferral should have been taken into account under the special timing rule, it appears an appropriate (and permissible) resolution would be to pay FICA, and any interest and penalties, with respect to the earlier year.14 This result seems most consistent with the preamble's reminder that the special timing rule is not elective, but to be safe payment should be made before the IRS assesses a liability on the payout.15 However, once the statute runs on the earlier year, a FICA liability attaches to payments of the deferral. If the statute has run and the special timing rule was not applied to a portion of a deferral, then a corresponding pro rata portion of the deferral is subject to FICA taxes in accordance with the general timing rule, that is, when received, actually or constructively.16 On the other hand, if the deferral was not included in wages during an earlier post-1993 year, the fact that the OASDI portion of FICA did not apply in that year because of the wage base will not exempt that portion from OASDI tax on its eventual payment (since some FICA, that is, the Medicare portion, should have been paid).17 Therefore, a common penalty for failing to take advantage of the special timing rule will be a jump in tax rates—from 2.9 percent to 15.3 percent under current levels of FICA.

Attributing Income: Account Balance Plans and Nonaccount Balance Plans

When the nonduplication rule applies, it protects the deferral and any income attributable to the deferral from later taxation. Attributable income is, therefore, never taxed. At a basic level this is unremarkable. A reasonable level of income merely adjusts the value of the deferral (which has been taxed) for the passage of time, resulting in an economic wash when this reasonable income is not taxed. However, the regulations permit certain plans to treat higher levels of earnings as attributable income. Separate sets of rules apply depending on whether a plan is deemed an "account balance plan" or a "nonaccount balance plan." It is with respect to the former that the greatest opportunity exists.

Account Balance Plans

An account balance plan is a Nonqualified Plan (or portion thereof) whose terms define the benefit payable to an employee based solely on an account that is credited with one or more principal amounts and credited or debited for the income on each such principal amount.18 This portion of the definition carries over from the Proposed Regulations, and it implies that all payouts must be calculated based on the account balance. In other words, a lump sum and installments that are derived from the account balance could be offered, but a life annuity could not be. The Final Regulations, however, clarify that an account balance plan may provide annuity benefits if the annuity is the actuarial equivalent of the account balance using reasonable actuarial assumptions.19 These assumptions are discussed below under "Reasonable Actuarial Assumptions for Forms of Payment." The noteworthy point is that this clarification expands the arrangements that can qualify for the favorable attributable income rules that apply to account balance plans.

Under an account balance plan, income is attributable to a deferred amount that has been taken into account only if: (1) the income is an increase in the amount credited to the employee's account that, under the terms of the plan, is attributable to an amount previously taken into account, and (2) the income is based on a rate of return that does not exceed either:

  • the rate of return on a predetermined actual investment, or
  • if no predetermined investment has been specified, a reasonable rate of interest (such as a rate equal to Moody's Average Corporate Bond Yield).20

    If additional income is credited, any excess over a reasonable interest rate is considered an additional amount deferred in the year it is credited.21 The Final Regulations are more liberal here than the Proposed Regulations, which required the excess to be determined relative to what is called "AFR" (the mid-term applicable federal interest rate under Section 1274(d) for January 1 of each calendar year, compounded annually) or, in the case of a predetermined actual investment, the return on that investment if it is lower. This change reduces FICA taxes because a reasonable interest rate will often be somewhat higher than AFR, and it will sometimes be significantly higher than the return on an actual investment. Thus it will reduce the excess that has to be taken into account. If this excess is not taken into account, however, a different rule determines the ultimate liability. In this case, the attributable income is calculated based on interest at AFR, and any excess—as well as any income on the excess—is then taxed under the general timing rule.22

    The right to use any actual investment includes those not available to the general public (such as investment funds under the employer's 401(k) plan), and investments based on any stock index with positions traded on a national stock exchange (such as the S&P 500).23 If the actual investment is predetermined (that is, before the earnings period begins), its rate of return will be considered attributable, no matter how great. Consider then a relatively vanilla design under the Final Regulations — an account balance plan that credits earnings based on the full return of the S&P 500 (without reduction for the management fee that would apply to a mutual fund based on the S&P 500). Based on historic returns for equities, this should provide over time a return that exceeds that on high-quality bonds by more than 250 basis points. Because the bond return is probably a fair measure of the earnings that should be exempt (under economic principles) to account for the earlier taxation of the deferral, the differential that equities produce is an additional accretion that fully escapes FICA taxation.

    It may, however, be possible to do even better. The Final Regulations add a clarification that an artificial composite that provides the greater of two returns will not qualify as a predetermined actual investment.24 This disqualifies account earnings based on the greater of the rates of return on two mutual funds, or a mutual fund and a rate of interest (even if reasonable), or a particular stock and a 0-percent return (that is, earnings based on that stock with the qualification that no losses will be credited in any year). Because this kind of artificially fabricated downside protection is not permitted, the clarification discourages selecting especially aggressive and volatile investments—investments that might have the greatest upside potential. Still, in spite of this clarification, some downside protection appears possible based on an example that is retained in the Final Regulations and the above-described change the Final Regulations make to the Proposed Regulations.

    Example 8 under paragraph (d) of the Final Regulations addresses a plan in which account earnings are based on a stock designated by the board of directors in advance of each year. For the year 2004, the board designates Stock A, and earnings are accrued on that basis.25 For 2005, the board initially designates Stock B, but at year-end the board determines the return on Stock B is too low and provides that earnings will be based on the return on Stock C, which has a higher return for 2005. The example holds that the plan's return does not qualify as based on a predetermined actual investment for 2005 (because of the year-end switch to Stock C), but that it does qualify for 2004. The employer does not take into account any additional amount for the excess of the earnings credited under the plan over a reasonable rate of interest. The result is that the excess of the income credited over AFR is an additional amount deferred for 2005.

    What is significant, however, is that the additional deferral is not determined by the excess over the return on the actual investment. The actual investment may have had a substantial loss for 2005, but it does not matter in the example. In effect, the example reflects downside protection in the form of an AFR minimum return. The example also supports using a reasonable interest rate as the downside protection, so long as any excess over that rate is taken into account for 2005. This attractive result is further supported by the Final Regulations' change in the rules for taking excess income into account. As noted above, the Final Regulations abandon the approach of determining the excess relative to the return on the actual investment when that is lower than the permitted interest rate. The clear import is that downside protection is possible.

    It bears noting, however, that the example reflects a case where downside protection is provided just once. What if this same approach to downside protection was done repeatedly, so that the effect over time was to credit the higher of the return on an actual investment or a reasonable rate of interest? This calls to mind the rule for a pattern of plan amendments that repeatedly add a "temporary" benefit to a qualified plan.26 The regulations under Section 411(d)(6) provide that the effect of the pattern is to convert a temporary benefit to a permanent one. In this context, a pattern of using the "greater of" approach (that is, the greater of the actual return or a reasonable interest rate) presumably would cause that to become the plan's basis for determining account earnings. Because such a basis for determining earnings does not qualify as a predetermined actual investment, the plan would have to treat any earnings credited above a reasonable interest rate as nonattributable, excess income.

    Therefore, routinely providing downside protection likely will not work, but it does appear possible to provide downside protection infrequently, as an escape valve. At the very least, based on Example 8 an employer should be able to do it once, and that alone is a comforting prospect—like having an insurance policy against catastrophe.

    Overall, what we see for account balance plans is that the Final Regulations have allowed relatively generous returns to be credited without tax, thereby eliminating the need to do year-by-year calculations of the excess over an economically reasonable interest rate. This reflects a decision by the drafters to shape the rules so that common plan designs will not face significant burdens in calculating FICA taxes under Section 3121(v)(2). They even permit an escape valve from an unacceptably bad return, as in Example 8, which is nice but not shocking. The revenue involved is not that great, and there was a strong desire to make the rules workable in real-world situations (which is just what Example 8 represents).

    Along these same lines, the Final Regulations added one other new area of latitude. For plans that credit a reasonable interest rate, the Final Regulations move away from the need to change the rate every year. Instead, a rate that is reasonable when first applied may be kept in force up to five years.27 Again, this could be exploited: a spike in interest rates could be locked in for a five-year period. In practice, however, that kind of opportunistic practice is unlikely. The more appropriate emphasis is that, with little revenue at issue, the drafters were able to provide additional latitude for legitimate designs that use a rate for more than one year on an ongoing basis.

    Nonaccount Balance Plans

    Any Nonqualified Plan (or portion thereof) that does not fit the definition of an account balance plan is considered a nonaccount balance plan.28 In a nonaccount balance plan, the income attributable to the amount taken into account is the increase, due solely to the passage of time, in the present value of any future payments to which the employee has a legal right, determined using reasonable actuarial assumptions for interest and, if appropriate, for mortality.29

    Therefore, in the case of a nonaccount balance plan, it is not possible to have the value of a deferral grow based on interest that exceeds what would be a normal economic adjustment for the time value of money. While this is less liberal than the rule for account balance plans, a more liberal rule was not necessary to accommodate common designs for nonaccount balance plans. A great many account balance plans use the returns on actual investments for adjusting accounts. Permitting this to be counted as attributable income helped avoid actuarial valuations that otherwise would not be necessary for an account balance plan. However, for nonaccount balance plans, actuarial valuations are routine and, moreover, they are probably the only way to value the deferral appropriately.

    If any actuarial assumption or method is unreasonable, then the income that is considered attributable to the amount taken into account is limited to the income that would be determined using the mid-term applicable federal rate and, if considering mortality is appropriate, the mortality table under Section 417(e), with each determined as of the beginning of the year. Any excess amount will not receive the benefit of the special timing rule, but rather will be included in wages under the general timing rule (that is, when received, actually or constructively).30

    Calculating the Amount Deferred

    The amount deferred is the amount that must be taken into account under the special timing rule, and its calculation depends on whether the Nonqualified Plan is an account balance plan or a nonaccount balance plan. Under an account balance plan, the amount deferred for an employee is the principal credited to the employee's account for the period, increased or decreased by the income attributable to that amount through the date the principal amount is included in wages.31

    Under a nonaccount balance plan, the amount deferred for a period equals the present value of the additional future payments to which the employee has become legally entitled during that period.32 In determining present value, the regulations permit the use of any actuarial assumptions and methods that are "reasonable" as of the date the deferral is taken into account as wages. "Reasonable" is largely undefined, which permits employer flexibility.33 However, the regulations effectively treat certain assumptions and methods as unreasonable. A discount for pre-retirement mortality is not permitted to the extent benefits do not forfeit at death. Also, discounts for the following are never permitted: (1) the risk that payments will not be made because of the plan's unfunded status or because the employer or another party will not pay, (2) the risk associated with plan investments, and (3) the risk of a change in the plan or relevant law.34

    Reasonable Actuarial Assumptions for Forms of Payment

    To facilitate determining the amount deferred under a nonaccount balance plan, the Final Regulations include a new provision that results in the employer valuing only the normal formal form of benefit at the normal commencement date if all other payments would be actuarially equivalent (and are required to be under plan terms in effect when the deferral is made).35 For this purpose, actuarial equivalence must be determined in accordance with one of the following:

    • Based on assumptions that are reasonable at either the time the payment option is selected or the time the option commences (that is, not at the time the deferral is made);
    • Based on assumptions that reflect market rates from time to time (for example, if the plan specifies using the Section 417(e) interest rate and mortality table); or
    • Based on assumptions specified in the plan, if the plan provides for their revision if they cease to be reasonable.

      Under a special rule, the plan may use a fixed mortality assumption that is reasonable when the deferral is made.36 However, this has limited value because an extra deferral amount is triggered if using this rule results in a mortality assumption that is not reasonable at the time the optional form is selected. A similar adjustment must be made if for any other reason it turns out the assumptions are not actually reasonable at the time the optional form is selected or payments commence (notwithstanding the plan's language to the contrary).37

      In the case of an account balance plan, these same rules for actuarial equivalence apply in evaluating any annuity that the plan promises. If the annuity would be actuarially equivalent based on assumptions that meet these standards, then offering the annuity benefit will not cause the plan to cease to be an account balance plan.38 As noted above, this has the advantage of letting a broader array of plans qualify for the favorable attributable income rules that apply to account balance plans.

      When Amounts Are Taken into Account—Special Rules

      The time when deferred amounts are taken into account is generally based on the special timing rule, that is, at the later of: (1) the date on which the services are performed that create the right to the deferred compensation, or (2) the date on which the deferred compensation is no longer subject to a substantial risk of forfeiture. The Final Regulations, however, include three special rules that may delay when an amount is taken into account. The first is mandatory and is derived from the definitional elements for NQDC. In addition, to ease administration, the Final Regulations include two additional rules that permit the employer to delay discretionarily when amounts deferred are taken into account.

      Plan Must Be Established

      As discussed in the prior article, one of the requirements for a deferral to constitute NQDC is that it must be made under a Nonqualified Plan that has been "established." To be considered established, the Nonqualified Plan (and any amendment increasing benefits) must have been adopted, it must be effective, and its materials terms must have been set forth in writing.39 In general, this serves as a documentation requirement to prevent after-the-fact claims that compensation is subject to the special timing rule.

      As a result of this rule, even if an employee has a legally enforceable right to a deferral, the deferral may not be taken into account under the special timing rule until the related Nonqualified Plan is considered established.40 When this rule comes into play, it usually delays taking a deferral into account until the Nonqualified Plan has been reduced to writing. However, a special transition rule discussed in the prior article may come into play in this case, that is, a plan that was effective and adopted before March 25, 1996 can be considered established retroactively if it is reduced to writing before January 1, 2000.41

      Amounts Deferred That Are Not Reasonably Ascertainable

      In the case of nonaccount balance plans, the Final Regulations permit delaying when an amount deferred is taken into account until the earliest date it is considered "reasonably ascertainable." (This date is referred to as the "resolution date.") This rule responds to the variability of benefits that can occur when a Nonqualified Plan's ultimate benefits are tied to such factors as final compensation, benefits under a qualified plan, and the applicability of early retirement subsidies. Such latitude is permitted even though the variability does not amount to a substantial risk of forfeiture.42

      An amount deferred is considered reasonably ascertainable on the first date the only actuarial or other assumptions regarding future events that are needed to determine such amount are interest, mortality, the form of payment, the time of payment, and cost of living assumptions.43 Thus, for example, if the present value of the deferred amount depends on a qualified plan offset or the employee's future pay, the amount deferred is not reasonably ascertainable. The Proposed Regulations had stated that if the form of payment or the time of payment were undetermined then the deferred amounts would not be reasonably ascertainable, but the Final Regulations modified this position in the case of payments that meet the actuarial equivalence standards for optional forms discussed above, thus allowing more deferred amounts to be reasonably ascertainable.44

      An employer may treat all of a deferral as not reasonably ascertainable so long as any part of the deferral is not reasonably ascertainable. If, for example, only an early retirement subsidy is not reasonably ascertainable (because the employee has not yet terminated and, therefore, the applicability or extent of the subsidy is unresolved), the entire deferral may be treated as not reasonably ascertainable.

      Rather than delaying taking a deferred amount into account until the entire deferral is reasonably ascertainable, an employer may elect to take an amount into account earlier (but not earlier than would apply under the usual requirements of the special timing rule). This earlier date is referred to as the "early inclusion date." Because taking an amount into account before it is reasonably ascertainable has a large potential for miswithholding, there is a "true up" on the resolution date.45 If the benefit payments attributable to the amount taken into account on the early inclusion exceed the payments that would be actuarially equivalent to the amount taken into account, the employer takes the difference into account on the resolution date.46 On the other hand, if too much is taken into account on the early inclusion date, the employer may seek a refund or credit for the FICA overpayment to the extent the year is still open.

      Also, under the Proposed Regulations, an amount could be required to be taken into account on the resolution date solely because the reasonable actuarial assumptions, used on the resolution date, are different from the reasonable actuarial assumptions that were used on the early inclusion date. To eliminate this result, the Final Regulations compare the actual amount payable on the resolution date (at the applicable time of payment and in the applicable optional form) with the amount taken into account on the early inclusion date, adjusted to the applicable actual time and form of payment using actuarial assumptions that are reasonable as of the early inclusion date.47 If the plan provides for actuarially equivalent optional forms, so that the present value of the deferral is based on the normal form at the normal commencement date, then the comparison of the early inclusion amount and the resolution date amount is based on such normal form. This rule prevents employers from being required to include an amount at the resolution date solely because a reasonable, variable factor for determining optional forms has varied since the early inclusion date.

      As noted above, account balance plans are allowed to have more favorable provisions for attributable income, but the "not reasonably ascertainable" rule gives nonaccount balance plans much greater latitude with respect to when a deferral must be taken into account. As a result, with a nonaccount balance plan, deferrals can be taken into account in years when cash flow makes it more convenient for the employee to pay the withholding. In some cases, it might be very desirable to have this same latitude for an account balance plan. Because of this, it should be kept in mind that the addition of an annuity benefit can "flip the switch" and turn an account balance plan into a nonaccount balance plan. So long as the annuity does not meet the standards for actuarial equivalence (for example, if it is determined using a fixed 7-percent interest rate rather than a variable interest rate), its addition will cause the plan—or just the affected part of the plan—to be a nonaccount balance plan. In deciding whether to do this, the value of the attributable income rules applicable to account balance plans have to be weighed against the value of having greater flexibility on when amounts are taken into account, but there are cases where this greater flexibility will be more attractive.

      Rule of Administrative Convenience

      The rule of administrative convenience permits an employer to take a deferred amount into account later than, but in the same calendar year, as the date it would otherwise be taken into account under the foregoing rules. This permits an employer to routinely use December 31 as the date all deferred amounts are taken into account for a year.48 While this rule provides much less timing latitude than the "not reasonably ascertainable" rule above, it has the important effect of making it possible to calculate FICA on NQDC only one time a year.

      Time of Withholding

      The Final Regulations apply the general FICA rule that an amount is subject to withholding at the time it is taken into account as wages.49 Two optional withholding methods are also provided—the estimated method and the lag method.

      The estimated method involves two steps. First, the employer reasonably estimates the amount of wages paid and treats them as paid on the last day of the year in which the deferred amount is taken into account. The resulting FICA withholding is deposited on the schedule applicable to the employer. Second, in the following year, the employer determines if it has paid in too little or too much. If the employer has paid in too much, then the employer may claim a refund or credit. If the employer has paid in too little, then the shortfall may be treated as FICA wages in the first quarter of this following year, or as wages back to the original year (using a W-2c to correct any misreporting on the original W-2, as necessary). The shortfall is not subject to late deposit penalties if deposited by the employer's first regular deposit date following the first quarter. The right to treat any shortfall as wages in the first quarter of the following year, without late deposit penalties, provides a reasonable opportunity to determine more accurately the amount of FICA due.50

      Under the lag method, a deferral taken into account for a year may be calculated as of any date in the first quarter of the following year. The deferral is treated as wages on that date, and the amount that would have been taken into account as of the end of the first year is increased by income through the date it is treated as wages. Income is taken into account under this method because (in contrast to the estimated method) there has been no substantial deposit in the first year.51

      While the Proposed Regulations only allowed use of the estimated and lag methods when the amount deferred could not be "readily calculated" by December 31 of a year (that is, the last date applicable under the rule of administrative convenience), the Final Regulations eliminate this requirement.52 Employers are free to use either method, regardless of whether the deferred amount can be readily calculated. Use of the lag method may be attractive because it permits the employer to withhold out of annual bonuses, which typically are paid in the first quarter of the following year. In addition, under the Final Regulations, income is calculated under the lag method using a rate that is not less than the AFR rate.53 Consequently, using the lag method is simpler than having to track actual earnings, for example, under an account balance plan.


      Although long and detailed, the Final Regulations provide relatively flexible guidance for the FICA taxation of NQDC that should make it possible for most employers to develop a workable strategy for compliance with Section 3121(v)(2). In addition, this flexibility also presents some opportunities for tax minimization. This will interest some, but for most employers administrative considerations are paramount. Because of this practical reality, the drafters are to be commended for their sound priorities, that is, for not subordinating flexibility to the goal of preserving relatively modest amounts of revenue.


      1. Regs. §§31.3121(v)(2)-1 and 31.3121(v)(2)-2, 64 Fed. Reg. 4,452 (Jan. 29, 1999).

      2. 61 Fed. Reg. 2,194 (Jan. 25, 1996).

      3. Reg. §31.3121(v)(2)-1(g)(1).

      4. Reg. §31.3121(v)(2)-1(a)(2)(ii).

      5. Id.

      6. Reg. §31.3121(v)(2)-1(e)(2).

      7. Reg. §31.3121(v)(2)-1(b)(3)(i).

      8. Reg. §31.3121(v)(2)-1(e)(3).

      9. 64 Fed. Reg. 4,454 (Jan. 29, 1999).

      10. Reg. §31.3121(v)(2)-1(e).

      11. Reg. §31.3121(v)(2)-1(a)(2)(iii).

      12. Reg. §31.3121(v)(2)-1(d).

      13. Reg. §31.3121(v)(2)-1(d)(1)(i).

      14. Reg. §31.3121(v)(2)-1(d)(3), Example 2.

      15. Id. The example provides that if FICA is paid (along with any applicable interest and penalties) before the statute is closed then "neither the amount deferred nor the income attributable to the amount taken into account will be treated as wages for FICA tax purposes at any time thereafter." (Emphasis added.) This language leaves the door open for the IRS to argue that it can assess FICA under the general rule at any time therebefore. However, while that could increase revenues, it would fail to apply the terms of Section 3121(v)(2), which contemplate taxing NQDC in accordance with the special timing rule. Only when that is not possible should the general timing rule apply.

      16. Reg. §31.3121(v)(2)-1(d)(1)(ii)(B).

      17. Reg. §31.3121(v)(2)-1(d)(1)(i) and (d)(3), Example 1.

      18. Reg. §31.3121(v)(2)-1(c)(1)(ii)(A).

      19. Reg. §31.3121(v)(2)-1(c)(1)(iii)(C).

      20. Reg. §31.3121(v)(2)-1(d)(2)(i).

      21. Reg. §31.3121(v)(2)-1(d)(2)(iii)(A).

      22. Id.

      23. Reg. §31.3121(v)(2)-1(d)(2)(i)(B)(1) and (d)(3), Example 7.

      24. Reg. §31.3121(v)(2)-1(d)(2)(i)(B)(2).

      25. Reg. §31.3121(v)(2)-1(d)(3), Example 8.

      26. Reg. §1.411(d)-4, Q&A-1(c)(1); see also Rev. Rul 92-66, 1992-2 C.B. 92.

      27. Reg. §31.3121(v)(2)-1(d)(2)(i)(C)(2).

      28. Reg. §31.3121(v)(2)-1(c)(2)(i).

      29. Reg. §31.3121(v)(2)-1(d)(2)(ii).

      30. Reg. §31.3121(v)(2)-1(d)(2)(iii)(B).

      31. Reg. §31.3121(v)(2)-1(c)(1)(i).

      32. Reg. §31.3121(v)(2)-1(c)(2)(i).

      33. Reg. §31.3121(v)(2)-1(c)(2)(ii).

      34. Id.

      35. Reg. §31.3121(v)(2)-1(c)(2)(iii).

      36. Reg. §31.3121(v)(2)-1(c)(2)(iii)(C).

      37. Reg. §31.3121(v)(2)-1(c)(2)(iii)(E).

      38. Reg. §31.3121(v)(2)-1(c)(1)(iii)(C).

      39. Reg. §31.3121(v)(2)-1(b)(2).

      40. Reg. §31.3121(v)(2)-1(e)(1).

      41. Reg. §31.3121(v)(2)-1(b)(2)(iii).

      42. Reg. §31.3121(v)(2)-1(e)(4)(i)(A).

      43. Reg. §31.3121(v)(2)-1(e)(4)(i)(B). The Final Regulations state that "the amount of a benefit is treated as known even if the exact amount of the benefit payable cannot be determined until future changes in the cost of living are reflected in the section 415 limitation on benefits payable under a qualified retirement plan."

      44. Reg. §31.3121(v)(2)-1(e)(4)(i)(B).

      45. Reg. §31.3121(v)(2)-1(e)(4)(ii)(B).

      46. Id.

      47. Reg. §31.3121(v)(2)-1(e)(4)(i)(B).

      48. Reg. §31.3121(v)(2)-1(e)(5).

      49. Reg. §31.3121(v)(2)-1(f)(1).

      50. Reg. §31.3121(v)(2)-1(f)(2).

      51. Reg. §31.3121(v)(2)-1(f)(3).

      52. Reg. §31.3121(v)(2)-1(f)(1).

      53. Reg. §31.3121(v)(2)-1(f)(3).

      Mark D. Wincek is a partner in the Washington, D.C. office of Kilpatrick Stockton LLP. His practice concentrates on tax aspects of employee benefits. Mr. Wincek gratefully acknowledges the assistance of Scott Kirmil, an employee benefits associate with Kilpatrick Stockton.

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