Executive Compensation

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1 Executive Compensation Bulletin IRS Issues Two Final Rules With Implications for High-Income Taxpayers Russ Hall and Steve Seelig, Towers Watson January 13, 2014 Recently, the Internal Revenue Service (IRS) issued final regulations to guide employers and individuals in complying with two new tax provisions affecting high-income taxpayers that were adopted as part of the Patient Protection and Affordable Care Act (PPACA): The additional 0.9% Medicare tax that must be paid by taxpayers whose income exceeds certain thresholds The new 3.8% tax on the net investment income of certain high-income taxpayers The Medicare tax affects individuals whose Federal Insurance Contributions Act (FICA) wages exceed $250,000 for marrieds filing jointly, $125,000 for marrieds filing separately and $200,000 for singles and heads of household, and the net investment income tax affects taxpayers with modified adjusted gross income exceeding those levels. Both provisions took effect at the beginning of Here s an overview of these new provisions. Additional Medicare Tax Employers pay FICA taxes on the amount of wages paid to employees during the year. FICA taxes also apply to nonqualified deferred compensation, with taxes often being due well before actual distributions are made. FICA taxes are composed of two parts: The Old Age, Survivors and Disability Income (OASDI) tax, which is 6.2% on earnings up to the annual Social Security wage base ($117,000 for 2014) The hospital insurance (HI) tax for Medicare, which is 1.45% on all earnings (i.e., there is no cap) The Medicare tax affects individuals whose FICA wages exceed $250,000 for marrieds filing jointly, $125,000 for marrieds filing separately and $200,000 for singles and heads of household, and the net investment income tax affects taxpayers with modified adjusted gross income exceeding those levels. Employees must pay FICA taxes on wages at the same rates that employers pay, and the employee portion of the FICA tax generally must be withheld and remitted to the government by the employer. The employer generally is liable for the amount of this tax whether or not the employer withholds the amount from the employee s wages.

2 The PPACA augmented the HI portion of the tax to help finance health care reform. Effective in 2013, the law increases the HI employee portion (but not the employer portion) of the Medicare tax by 0.9% on FICA wages in excess of the income thresholds noted above. These dollar thresholds are not indexed for inflation. Unlike the general 1.45% HI tax on wages, which applies only to the wages earned by a particular employee, this new Medicare tax and its dollar threshold are applied to the combined wages of the employee and the employee s spouse if the employee files a joint return. However, the law requires the employer to withhold the new Medicare tax only for employees who receive more than $200,000 in wages from that employer for the year, without regard to any wages received by the employee s spouse. This means the employee will be liable to the IRS for the additional 0.9% HI tax to the extent the tax is not withheld by the employer. The final IRS regulations provide rules to guide employers in computing, withholding, reporting and paying the new Medicare tax on wages. Following are some of the key issues that employers should be aware of regarding the new rules: Employer s obligation to withhold. The additional withholding must commence for the pay period in which wages in excess of $200,000 are paid, but the obligation to withhold applies only to pay in excess of the dollar threshold. The regulations reiterate that employers cannot take into account the employee s filing status, or other wages or compensation (e.g., wages received by the employee s spouse or from another employer). If an employee expects to owe more tax than is being withheld by the employer (e.g., due to spousal income), the individual may request that the employer withhold additional income tax by completing IRS Form W-4 (or, alternatively, can make estimated tax payments). Calculating the tax. The timing of the tax calculation is no different from that for any FICA taxes, which is generally when wages are paid. For amounts set aside under a nonqualified deferred compensation plan, FICA tax timing will depend on the approach taken by the employer under the IRS s 3121(v)(2) regulations: Where FICA wages are taken into account under the special timing rule when earned and vested, the additional Medicare tax is taken into account at the same time. If, instead, the entire value of a nonqualified deferred compensation benefit, such as a defined benefit supplemental executive retirement plan (SERP), is taken into account when an employee retires, that value will be used to determine whether the total FICA wages for the year of inclusion exceed the applicable dollar threshold so that all or part of the value of the nonqualified benefit will be subject to the additional Medicare tax. This second approach is available only for certain non-account-balance-type plans such as defined benefit SERPs. Executives whose employers take the second approach will have new tax-planning considerations. On the one hand, they may consider retiring early in the year to avoid owing the additional 0.9% Medicare tax on all the deferred compensation paid to them, since they will be under the income threshold for the year. On the other hand, taking that distribution earlier could expose the nonqualified benefit value to the larger 6.2% OASDI tax if total FICA wages are under the taxable wage base for the year, which might encourage retirement later in the year. The best tax scenario necessarily will depend on particular facts and circumstances. Other strategies for minimizing the IRS Issues Two Final Rules With Implications for High-Income Taxpayers I 2 Practices I 2

3 Medicare tax may also be considered (e.g., use of the 3121(v) early-inclusion rules so that the tax may be applied in years when the employee is under the threshold). Under- and overpayments. The procedures to correct under- and overpayments of the additional 0.9% Medicare tax are more limiting than those that generally apply to the under- or overpayment of FICA taxes because the new Medicare tax does not include an employer portion, and the ultimate liability is reconciled with the amounts withheld on the individual employee s income tax return. Unfortunately, subject to some limited exceptions, this means that if an error is not caught in the same year wages are paid, the employer will need to inform the employee of the error (via a corrected W-2c), and the employee will need to file an amended return on Form 1040X to pay any additional tax owed or obtain a refund for an overpayment. Especially for complex FICA tax determinations, such as those involving SERPs and certain other deferred compensation programs, employers should evaluate whether their current payroll processes could be improved upon to minimize such errors and the administrative complexities of needing to make corrections. Net Investment Income Tax The net investment income tax (NIIT) applies at a rate of 3.8% to certain individuals, estates and certain trusts that have income above the statutory threshold amounts. Individuals are subject to this tax if they have net investment income and their modified adjusted gross income (MAGI) exceeds the threshold outlined above. If an individual s MAGI is above the threshold level, the 3.8% NIIT applies, but only to the lesser of the following: The amount by which MAGI exceeds the applicable threshold The amount of net investment income The definition of net investment income is complex, but generally, for an individual, it s the sum of the following types of income, reduced by certain expenses properly allocable to the income: Gross income from interest, dividends, nonqualified annuities, royalties and rents, except to the extent excluded under the ordinary course of a trade or business exception in the regulations Passive income from some trades or businesses, including those that trade financial instruments or commodities Net gain attributable to the disposition of property that generates passive income The final regulations follow the statute and exclude from net investment income distributions from the following retirement plans: 401(a) qualified plans, 403(b) plans, individual retirement accounts (IRAs), Roth IRAs, 457(b) plans and foreign pension plans. The final regulations also clarify that qualified plan distributions not subject to the NIIT include: Dividends on employer stock distributed to participants in accordance with Internal Revenue Code (IRC) Section 404(k) Amounts treated as distributed for tax purposes (e.g., Roth IRA conversion or a deemed distribution under IRC 72(p)) IRS Issues Two Final Rules With Implications for High-Income Taxpayers I 3 Practices I 3

4 Rollovers to an IRA or another qualified plan Corrective distributions from a qualified plan or arrangement to maintain its tax-favored status Net unrealized appreciation attributable to employer securities that is realized on the later sale of the securities Qualified plan distributions (other than Roth IRA or Roth 401(k) distributions) will, however, increase MAGI, as such distributions are includable in income. Amounts taxed as wages, including nonqualified deferred compensation, are also excluded from net investment income. This is clear from the definition of excluded income in the final regulations. Using the same logic that applies to nonqualified deferred compensation, we read the final regulations to also consider any equity-based compensation as wages not treated as net investment income. For example, the following amounts should not be subject to NIIT: The in-the-money value of stock options and stock appreciation rights at exercise The value of restricted stock at vesting The value of restricted stock units (RSUs) at payment The value of performance shares at payment The fact that these kinds of income are excluded from NIIT may pose tax-planning opportunities for some executives. For example, by deferring compensation, employees may be able to avoid the 3.8% tax on interest and earnings during the period of deferral that would otherwise apply to most investments held outside the employer/employee relationship. This would include nonqualified deferred compensation that either earns interest or pays dividends on shares held as nonqualified deferred compensation (like deferred RSUs). As with all income-deferral decisions, nonfinancial factors, such as the loss of flexible access to the money under the 409A rules and the credit status of the employer, would need to be balanced against the potential for increased investment earnings on pretax deferrals. Similarly, because stock value increases that take place before taxation are not considered net investment income, it may appeal to executives to receive more compensation in the form of pretax, equity-based compensation that builds up free of tax, including the added 3.8% tax, rather than paying cash values currently. Of course, this also must be balanced against other factors, such as the potential for changes in ordinary income and capital gains tax rates. For more on these issues, see Executive Deferral and Equity Compensation Plans May Be More Attractive With the New Medicare Tax on Investment Income Looming, Executive Pay Matters, December 13, IRS Issues Two Final Rules With Implications for High-Income Taxpayers I 4 Practices I 4

5 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Information in this publication should not be used as a substitute for legal, accounting or other professional advice. IRS Issues Two Final Rules With Implications for High-Income Taxpayers I 5 Practices I 5