As the end of 2012 approaches, various compensation- and benefit-related issues may need to be addressed and corrective action taken before Dec. 31.
The 2 percent payroll tax cut enjoyed in 2011 and 2012, which reduced the employee’s share of Social Security payroll taxes, will expire as of Jan. 1, 2013, unless Congress passes an extension. Specifically, this tax cut reduced the employee’s share of Social Security taxes from 6.2 percent to 4.2 percent on the first $110,100 of wages in 2012. A similar reduction from 12.4 percent to 10.4 percent applied to the income of self-employed individuals. Although the increase is on employee contributions, the increase also affects an employer’s withholding obligations. Furthermore, if an employer provides a gross-up of any type to an employee, such gross-up will be commensurately more expensive beginning in 2013.
At the same time that the temporary 2 percent decrease in employee payroll taxes expires, a new 0.9 percent Medicare payroll tax increase applies (from 1.45 percent to 2.35 percent) under the Patient Protection and Affordable Care Act on wages over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. Self-employed individuals will have a similar increase in self-employment tax liability. Although this increased rate of tax is not an employer liability, employers must be prepared to withhold the additional 0.9 percent from wages for any employee with wages over $200,000.
Because this withholding is required on an employee’s wages over $200,000, which does not particularly correlate with an employee’s ultimate tax liability, many employees, particularly those who are married, may find that they are over- or under-withheld, depending upon the earnings of their spouse. For example, if a husband and wife each earn $200,000, with joint wages totaling $400,000, this couple will be under-withheld because their respective employers will withhold nothing. However, the additional 0.9 percent tax for them is owed on combined wages over $250,000, resulting in an under-withholding of $1,350 ($150,000 times 0.9 percent).
Acceleration of Compensation
In anticipation of widely expected increases in income, FICA and long-term capital gains tax rates starting in 2013, many companies are exploring ways to accelerate into 2012 income that would otherwise be recognized in 2013 or later, particularly for executives and other highly compensated employees.
• Compensation subject to Section 409A. It is crucial that companies exploring acceleration of compensation keep the restrictions of Section 409A of the tax code in mind. That section generally prohibits acceleration of payments of nonqualified deferred compensation. Therefore, it will generally not be permissible to accelerate the payment of supplemental retirement income that would otherwise be payable after 2012. Moreover, Section 409A may also impact a company’s ability to accelerate the payment of restricted stock units, performance shares, multi-year bonuses or other types of deferred compensation.
Even if it is not possible to accelerate distributions from nonqualified retirement plans, it may be possible to accelerate into 2012 the FICA taxation of benefits under such plans.
• Compensation not subject to Section 409A. Annual bonuses, restricted stock and stock options are among the types of compensation that are generally outside the scope of Section 409A and therefore it may be possible to accelerate the payment, vesting or exercise of such bonuses, stock and options. However, publicly traded companies that are considering accelerating annual bonus payments or other performance-based compensation first need to examine the effect of any such acceleration under tax code Section 162(m) of the tax code, which limits the deduction of non-performance-based compensation to $1 million annually for certain executive officers. Other relevant considerations include shareholder disclosure and, for stock options and the sale of vested stock, insider-trading laws and related company policies.
• Qualified retirement plans. Tax-qualified retirement plan benefits are also exempt from Section 409A and in some cases it may be possible for participants and beneficiaries to take or commence distributions from such plans in 2012 rather than in 2013 or later.
Section 409A “Release-Timing” Issues
The IRS’s special transition relief for correcting “release-timing” issues under Section 409A in certain employment, severance and other similar agreements expires on Dec. 31, 2012.
Employment agreements commonly condition severance payments upon an employee’s execution of a release of claims. The IRS has indicated that the typical way these release provisions are drafted does not comply with Section 409A and that covered agreements affected by this problem that have been in existence since Dec. 31, 2010, must be amended before the end of 2012 in order to avoid significant tax problems for employees and employers.
Agreements that are not corrected by this deadline could result in significant additional taxes being imposed on employees or other “service providers” who are parties to the agreements. Employers and other “service recipients” should review agreements that condition payments on an employee’s or other service provider’s execution of a release of claims or other similar condition, and, where possible, take any necessary steps before year-end to amend these agreements to comply.
In light of the attention that the IRS has given to the release-timing issue, we anticipate that this might be the focus of examination activity in coming years.
• Qualified adoption assistance. The income tax exclusion for amounts paid by an employer under a qualified adoption assistance program is also set to expire on Dec. 31, 2012. A qualified adoption assistance program allows an employer to reimburse an employee on a tax-free basis for as much as $12,650 in 2012 for expenses related to the adoption or attempted adoption of a child. Qualified adoption expenses include reasonable and necessary adoption fees, including court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging while away from home) and other expenses directly related to the legal adoption of an eligible child.
• Educational assistance. Certain reimbursements for employer-provided educational assistance will expire at the end of 2012. Section 127 of the Internal Revenue Code allows an employer to reimburse an employee on a tax-free basis up to $5,250 for certain educational expenses provided through a non-discriminatory educational assistance program, including reimbursements for graduate school and programs that allow the employee to qualify for a new position. Even if employer-provided educational assistance programs no longer have tax subsidies in 2013, employers can still provide some type of educational reimbursements in a more limited manner if the educational reimbursements qualify as a business expense and meet certain requirements, such as enhancing the employee's performance but not qualifying the employee for a new position or career.
• Flexible Spending Account (FSA) contributions. Employee contributions to health care FSAs will be reduced to $2,500 per year for plan years beginning in 2013. Prior to 2013, the tax code did not limit health care FSA contributions. This new limit must be documented in a flexible benefits plan by Dec. 31, 2014, regardless of the fiscal year of the flexible benefits plan, and this change must be retroactive to the beginning of the 2013 plan year.
With the uncertainty of the approaching fiscal cliff, employers should consider advising employees of the ambiguity surrounding educational assistance and adoption assistance benefits for 2013 and the possibility of a 2 percent payroll tax increase. However, even if tax extensions for education assistance, adoption assistance and the 2 percent payroll tax increase are adopted in a new tax bill, employers should note that it is highly unlikely that either the new limits on health care FSAs or the new 0.9 percent payroll tax increase for high-income employees will be altered or eliminated.
The above compensation acceleration and Section 409A analysis is by G. William Tysse, Steven D. Kittrell, and Jeffrey R. Capwell of McGuireWoods.
The payroll tax and benefits impact anaysis is by Jacob Mattinson, Diane M. Morgenthaler and Ruth Wimer of McGuireWoods.
With approximately 900 lawyers and 18 offices worldwide, McGuireWoods serves public, private, government and nonprofit clients. Republished with permission. © 2012 McGuireWoods LLP. All rights reserved.
Editor’s Note: This article should not be construed as legal advice.
Year-End Brings Changes to Employee Tax Provisions, SHRM Online Benefits, December 2012
Proposed Rules on Additional Medicare Tax, SHRM Online Compensation, December 2012
Pay, Benefits Face 'Fiscal Cliff,' SHRM Online Legal Issues, November 2012
Tax-Free Education Benefits at Risk, SHRM Online Benefits, October 2012
Wages Subject to Social Security Tax to Increase, SHRM Online Compensation, October 2012
SHRM Online Compensation Page
SHRM Salary Survey Directory
SHRM Compensation Data Center
SHRM Metro Economic Outlook reports