Does Medicare Tax Apply to Deferrals That Are Not to Be Paid?

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By Howard Perlman

“Because of my company's bankruptcy, I will not receive all the retirement benefits I am owed,” said Phillip, a retiree. “I deserve a refund of Medicare tax I paid on deferred benefits I will not receive.”

“Laws and regulations regarding the type of deferred compensation you had been eligible to receive do not require a refund in this situation,” said Sandra, a representative of the Internal Revenue Service.

FACTS:An airline decided to include the full present value of a pilot's retirement benefits under a nonqualified deferred compensation plan in the year of his retirement.

The pilot's previous compensation that year already exceeded the Social Security taxable wage base for the year. About $4,200 from the pilot's wages was withheld that year to satisfy the Medicare tax liability of 1.45 percent on the value of the nonqualified deferred retirement benefits, which was about $290,000.

Medicare tax had to be paid in the year the compensation was deferred because of the special timing rule under Internal Revenue Code Section 3121(v)(2). Under the rule, nonqualified deferred compensation is not subject to Social Security and Medicare taxes when the compensation is paid, but instead is subject on the later of the date when services that caused an employee to be eligible for the compensation were performed or the date when the compensation no longer is subject to a substantial risk of forfeiture.

Six years after the pilot retired, the airline's responsibility to pay retirement benefits to him was discharged under the terms of its bankruptcy reorganization plan, with about 20 percent paid at the time of discharge.

The retiree sued the federal government for a refund of the Medicare tax that he had paid on the amount that had been deferred under the nonqualified plan but that he no longer was to receive because of the bankruptcy agreement. The retiree claimed that he was entitled to a refund because it is “arbitrary and irrational” for the Treasury regulations (Section 31.3121(v)(2)-1) that implemented Section 3121(v)(2) to not have a provision permitting refunds of FICA taxes on deferred compensation that cannot be received because of developments that occurred after the compensation was deferred.

The federal government claimed that no refund was due precisely because Section 3121(v)(2) and the regulations that implemented it do not contain a refund clause.

A retiree sought a refund of Medicare tax on payments he could not receive because of his former employer's bankruptcy.

ISSUE: Is the retiree eligible for a refund of Medicare tax?

DECISION:The special timing rule of Section 3121(v)(2) was properly applied and the retiree is not entitled to a refund for Medicare tax he paid on amounts of nonqualified deferred compensation he no longer can receive because of his former employer's bankruptcy, the U.S. Court of Federal Claims said.

The language of Section 3121(v)(2) does not explicitly permit a refund of FICA tax on amounts that will not be disbursed from a plan, which indicates that Congress did not intend such relief to be available, the court said. Congress has explicitly identified similar relief in other tax provisions. For example, the language of I.R.C. Section 166 identifies that deductions are available for business income that was taxed but never received, the court said.

Treasury regulations regarding the statute did not need to allow a refund option for FICA taxes on deferrals that cannot be received not just because I.R.C. Section 3121(v)(2) did not require it, but because regulations issued by the IRS “must be upheld if they are within the zone of reasonableness,” the court said.

Not offering a refund option for FICA taxes on deferrals that cannot be received was reasonable because the IRS, when considering aspects of Section 3121(v)(2), determined that adjusting the taxable value of nonqualified deferred compensation that has not been received would be administratively impractical, the court said. The regulations were reasonable also because the IRS designed them “to be workable, to minimize complexity, and to provide appropriate flexibility for taxpayers,” the court said, quoting an IRS comment about the regulations in the Jan. 25, 1996, issue of the Federal Register.

Even though the retiree could not acquire a refund of FICA tax on amounts he did not receive, the law needed to be upheld, the court said.

“These are matters for law makers, not judges—suboptimal tax laws are still valid tax laws,” the court said (Balestra v. United States,2014 BL 151613, Fed. Cl., No. 09-283T, 5/31/14).

POINTERS:Social Security and Medicare taxes do not apply when retirement benefits are disbursed under a nonqualified deferred compensation plan because they are required to be assessed when contributions are made to the plan.

Federal income tax generally is assessed on disbursements from nonqualified deferred compensation plans but not contributions to them. Disbursements from these plans subject to federal income tax withhlolding are reported in boxes 1 and 11 of Form W-2, Wage and Tax Statement.

For more information, see Payroll Administration Guide's “Deferred Compensation: Section 401(k) and Other Plans” chapter.

This analysis illustrates how courts resolve pay-related disputes. The names and dialogue are fictitious.