Benjamin Franklin famously wrote in a letter dated November 13, 1789, “nothing can be said to be certain except death and taxes.” Even so, most of us would like to delay both for as long as possible! Congress specifically encourages retirement savings by delaying taxation on certain funds designated to provide retirement income: that’s a key element of the private retirement system in the U.S.
While tax-qualified retirement plans (defined benefit and defined contribution) are subject to certain limits on benefits and deferral amounts, nonqualified retirement plans are intended to go above and beyond those limits, albeit with their own set of complex tax laws and regulations. One of those complexities concerns limits on corporate federal income tax deductions.
Changes to corporate tax deductibility rules under IRC Section 162(m)
IRC section 162(m) prevents a publicly traded corporation from taking a tax deduction for compensation paid in excess of $1 million per year to a covered employee which includes the CEO and the three highest-paid executives. The Tax Cuts and Jobs Act of 2017 expanded the scope of the section 162(m) limitation in three primary ways: To cover the CFO in addition to the other four, to expand what type of compensation is included, and to add a lifetime clause. Specific to nonqualified retirement plans, this means that amounts paid to these executives (termed “covered employees”) after retirement are still subject to the corporate tax– deductibility limits. Once an executive is covered, it’s forever – even after death (which according to Franklin, will eventually happen!) – and nonqualified plan benefits paid to a beneficiary remain subject to the compensation tax deductibility limit.
While the broader scope of section 162(m) may appear to diminish the value of nonqualified plans, in fact it does not. Were an executive to instead receive the income deferred in the year earned, when the section 162(m) limit has already been reached, the corporation would not be able to claim the tax deduction. However, if is instead paid after retirement, any amount under the $1 million annual limit can be deducted each year paid. This would add support for paying out retirement benefits as an annuity or as installments to maximize deductions (up to $1 million per year).
The newly enacted American Rescue Plan Act of 2021 even further expands covered employees for purposes under section 162(m), but with a delayed effective date. Beginning in 2027, an additional five highly compensated employees will be covered and subject to the deductibility limit. However, these five additional employees are re-determined each year and do not have the lifetime clause of the top five executives. This lends itself to using a nonqualified plan to defer amounts in excess of $1 million to a year in which they are not considered covered employees (for example, after retirement) and where the corporation can deduct the entire amount.
Of course, deductibility is only one factor in a nonqualified plan design and does not automatically justify design changes – there are many other factors to consider. But certainly, it is something to consider seriously.
Will FICA tax rates go up?
Nonqualified plans are subject to federal employment taxes, including Federal Insurance Contributions Act (FICA) tax. Generally, wages are subject to FICA tax (Social Security and Medicare tax) when they are actually paid. However, a special rule applicable to nonqualified plans (known as the “special timing rule”) requires an employer to withhold the employee share of FICA tax and pay the employer share of FICA tax earlier than when paid. For certain nonqualified defined benefit plans this tax is due at separation from service when the retirement benefit can be determined (even if it is not yet paid).
There is some speculation that FICA tax rates will rise under the current administration. To avoid the anticipated FICA tax rate increase, some companies are considering paying this tax now. This is possible under the “early inclusion rule” that permits payment of a portion of FICA tax earlier than otherwise due. FICA paid under early inclusion would be “locked in” based on current FICA rates.
Challenges ahead
The American Rescue Plan Act of 2021 is just one of the responses to the COVID-19 pandemic that touches on retirement plans, tax-qualified and nonqualified, and corporate pension risk. Employers who sponsor these programs may face potential disruption to the processes, administration, governance, investment strategy, and funding aspects of their plans.