Withholding and paying FICA tax on nonqualified deferred compensation can be a tricky business.  Because special timing rules apply to FICA tax, employers can’t simply withhold and pay FICA tax when they pay deferred compensation to the employee.  Instead, FICA tax is due when the deferred compensation vests (or, in some cases, when the amount of the deferred compensation can be determined).

It is not always easy to tell when these triggering events occur.  In fact, it is sometimes hard to tell whether compensation is “deferred compensation” that is subject to the special timing rules.  Employers faced with these complications often discover long after the fact that they have failed to withhold and pay FICA tax on deferred compensation when the tax was due.  The additional 0.9% Medicare tax introduced in 2013 makes these errors much more difficult to correct.

Interest and Penalties Apply to Underpayments

An employer that fails to pay FICA tax when the tax is due ordinarily owes interest (at 3 percentage points above the federal short-term rate) from the date the FICA tax was due until it is paid.  The employer might owe penalties as well.  The most significant penalty—for failing to deposit the tax on time—is 10% of the employer’s share of the FICA tax.

When an employer fails to withhold the employee’s share of FICA tax, the employer becomes liable for the tax the employer should have withheld (though the employer’s liability is reduced to the extent that the employee actually pays the tax).  The employer’s liability for failing to withhold seldom comes into play for deferred compensation, because the employer is able to recover the employee’s share of FICA tax from the unpaid deferred compensation or from other amounts owed to the employee.

An employee who relies on an erroneous Form W-2 provided by the employer is unlikely to owe a penalty for failing to pay his own share of FICA tax when it was due.  The employee will owe interest on his share of the unpaid FICA tax, however, at the same high interest rate that applies to the employer’s share.

Interest-Free and Penalty-Free Corrections

In the past, an employer could correct an underpayment of FICA tax relatively easily, even if the employer discovered the error in a later tax year.   IRS regulations allow the employer to make an interest-free and penalty-free correction until the end of the three-year limitations period for collecting the FICA tax.

In order to use the correction procedure, the employer reports the underpayment by the due date for Form 941 (the employer’s quarterly federal payroll tax return) for the quarter in which the employer discovers the error.  The employer pays both its own share and the employee’s share of the FICA tax owed, although the employer can recover the employee’s share of the tax from the employee’s deferred compensation or other wages.

The correction procedure is an attractive way to deal with FICA tax errors involving an executive’s deferred compensation.  By correcting the error voluntarily, the employer avoids interest and penalties for its own underpayment, and the employer also protects the employee from owing interest on the employee’s underpayment.

In addition, once the employer has included an amount of deferred compensation in the employee’s FICA wages and paid the correct amount of tax, any income or other reasonable investment gain credited to the deferred compensation after that date is exempt from FICA tax.  Accordingly, when an employer voluntarily corrects an underpayment of FICA tax by recognizing that the deferred compensation was includable in FICA wages as of an earlier date, the employer shields income credited after the inclusion date from FICA tax.

The Additional Medicare Tax Complicates the Correction Procedure

Previously, an employer could correct FICA tax errors without affecting the employee’s income tax liability or causing the employee to file an amended income tax return, since the FICA system and income tax system operate independently of one another.  The additional Medicare tax has made FICA tax corrections more complicated, however.

Starting in 2013, employees owe an additional Medicare tax of 0.9% on wages above a threshold amount.  The employer must withhold the additional 0.9% tax from all FICA wages (including deferred compensation) above $200,000.  We described the additional Medicare tax in an earlier post.

If an employer fails to withhold the additional Medicare tax from an employee’s deferred compensation, the employer can correct this error using the interest-free, penalty-free correction procedure only if the employer discovers and corrects the error in the same calendar year in which the employer should have withheld the additional Medicare tax.

Correction in a Later Year Involves the Executive

If the employer discovers a FICA tax error in a later calendar year, the employer can still use the interest-free, penalty-free correction procedure to correct the failure to withhold and pay regular FICA tax; but the employee must file an amended tax return to pay the additional Medicare tax.

For example, assume that an executive has $1 million of deferred compensation that vests in 2014.  The employer discovers in the fall of 2015 that the deferred compensation was not included in the executive’s FICA wages in the preceding year.  The employer can use the interest-free, penalty-free correction procedure to pay its own share and the executive’s share of the regular FICA tax on the deferred compensation.

The executive owes $9,000 of additional Medicare tax on the deferred compensation, however, and the employer cannot correct the underpayment of additional Medicare tax after the end of 2014.   As part of the correction procedure for the regular FICA tax, the employer must report the $1 million increase in the executive’s 2014 FICA wages on a corrected Form W-2.  The executive must file an amended income tax return to report and pay the additional Medicare tax on the increased wages.

Most employers are understandably reluctant to commence a voluntary correction procedure that will require their executives to file amended returns.  If the employer does not correct the FICA error, however, both the employer and the executive will owe FICA tax when the deferred compensation is ultimately distributed; and the tax will apply not only to the original $1 million, but also to any investment gain credited between the vesting date and the distribution date.  As a result, even if the IRS does not discover the error and assess interest and penalties, the employer’s decision not to use the voluntary correction procedure is likely to increase the tax liability of both parties.

It is better to avoid this dilemma by discovering errors in computing FICA tax on deferred compensation in the same calendar year in which the error occurs.  For many employers, however, it will be difficult to put this principle into practice.  The difficulty of discovering FICA errors before year-end is compounded by the fact that many payroll departments take FICA wages into account at the end of the calendar year rather than on the deferred compensation’s actual vesting date.

In view of the new complications introduced by the additional Medicare tax, employers might wish to consider whether an ongoing internal review process or other administrative safeguards will help them discover FICA errors in time to correct them more easily.