FICA’s Special Timing Rule

 

I do not often read ERISA cases.

ERISA deals with employee retirement plans and refers to federal law: Employee Retirement and Security Act. It is old law (1974), and provides protection for individuals enrolled in private retirement and health plans. It can be as abstruse as the tax Code, and as difficult to follow. It is more in the purview of retirement specialists and not so much that of a general tax practitioner.

What made me think about it was a reference to the Henkel case from 2015.

Henkel involved a top hat plan for selected management and other highly compensated employees. The idea behind a top hat is to provide benefits in excess of those available to employees through regular plans (think 401(k), cafeteria plans and the like.) Top hats are mostly exempt from ERISA because of that select group of covered employees, You and I are unlikely to ever be enrolled in a top hat plan.

In Henkel, select employees were covered by a nonqualified deferred compensation plan. After benefits began, the company (Henkel Corporation) reduced the monthly benefits for federal tax withholding. ERISA has restrictions on reducing someone’s benefits – hence the litigation.

The federal withholding was FICA.

There is an odd rule in the tax Code for FICA taxation of deferred compensation. What sets it up is the income taxation of the deferred compensation itself.

Generally speaking, deferred compensation will include some kind of qualifying event. For example, say that an executive is entitled to 1% of his/her 2025 division profits as compensation, payable in 2028. To be entitled to the bonus, the executive must remain employed with the company through December 31, 2026.

It is that condition subsequent that makes the income taxation tick. It would be unfair to tax the executive in 2025, as he/she may never receive a dime if they are not employed through December 2026. Let’s say that they are employed through December 2026. It would still be unfair to subject the bonus to income taxation in 2026, as there is no cash until 2028. In general (and a big general at that) the tax Code will slow the income tax horses until 2028.

But this is compensation, meaning that there will also be FICA tax due.

When is that tax due?

A reasonable person would expect the FICA and income tax to lock arms and be due at the same time.

A reasonable person would be wrong.

FICA tax will be due at the later of:

The date the employee performs the services causing the deferred compensation (in our case, 2025), or

The date on which the employee is no longer subject to a substantial risk of forfeiting the deferred compensation (in our case, 2026).

Our executive would be subject to FICA tax in 2026.

What about concern for having cash to pay the tax?

It does not appear to apply to the FICA tax, only to income tax.

In practice, this is rarely as big an issue as it may first appear. FICA is divided into two parts: the old age (which is 6.2%) and Medicare (which is 1.45%). The old age (the acronym is OASDI) cuts off at a certain dollar amount. Medicare does not cut off. Odds are that someone in a top hat plan is well over the OASDI limit (meaning no old age tax), leaving only Medicare. 

It is unlikely that one is going to do a lot of tax planning for 1.45%.

This FICA trigger is called the “special timing rule.”

There is an upside to the special timing rule, and it depends on how the deferred compensation is determined.

If one can flat-out calculate the deferred compensation (in our case, 1% of division profits), the plan is referred to as an account balance plan. Granted, one can add interest or whatever to it to allow for the passage of intervening years, but one can calculate the beginning number.

If one pays FICA on an account balance plan under the special timing rule, there is no additional FICA when the plan finally pays out. This means that interest (for example) added to the beginning number is never subject to FICA.

Sweet.

Switch this over to a nonaccount balance plan and FICA can change. FICA is calculated on the actual distribution, but one is given credit for FICA previously paid under the special timing rule. In this case, one would pay FICA on the interest added to the beginning number.

There are also different ways to calculate the FICA under the special timing rule: the estimated method, the lag method, the administrative convenience method and so on.

Throw all the above in a bag, shake thoroughly, and that is how we got the Henkel case. How can the benefits go down? Take a nonaccount balance plan, with FICA being paid later rather earlier.

Is it a reduction in benefits?

Yes and no. It is technically a reduction if one was not thinking about the FICA.

It is not however a reduction for purposes of ERISA.

Our case this time was Davidson v Henkel, USDC, Eastern District of Michigan Southern Division, Case No. 12-cv-14103.

Another Runaway FBAR Case

 

Let’s talk about the FBAR (Report of Foreign Bank and Financial Accounts). It currently goes by the name “FinCen Form 114.”

This thing has been with us since 1970. It came to life as an effort to identify foreign financial transactions that might indicate money laundering or tax evasion. 

Sounds benign.

The filing requirement applies to a United States person, defined as

·      A citizen or resident of the U.S.

·      A domestic partnership

·      A domestic corporation

·      A domestic trust or estate

 We’ll come back that first one in a moment.

Next, one needs a financial interest or signature authority in a foreign financial account to trigger this thing.

A foreign financial account includes a bank account, which is easy enough to understand. It would also include a broker account (think Charles Schwab, but overseas). Some are not so intuitive, though.

·      A foreign insurance policy with cash value is reportable.

·      A foreign hedge fund is not.

·      A foreign annuity policy is reportable.

·      A foreign private equity fund is not.

·      A foreign cryptocurrency account is not reportable.

Some require a google search to understand what is being said.

·      A Canadian registered retirement savings plan is reportable.

·      A Mexican fondo para retiro is reportable.

Next, the foreign financial account has to exceed a certain dollar balance ($10,000) at some point during the year.

That $10,000 balance has been there for as long as I can remember. You will have a hard time persuading me that $10,000 in 1986 is the same as $10,000 now, but that number is apparently eternal and unchanging.

The $10,000 is tested across all foreign financial accounts. If it takes your fourth foreign account to put you over $10 grand, then you are over. Testing is done. All your accounts are reportable on a FBAR.

Like so many things, the FBAR started with reasonable intentions but has morphed into something near unrecognizable.

Fail to file an FBAR and the standard penalty is $10 grand. Fail to file for two years and the penalty is $20 grand. Have two foreign accounts and fail to file for two years and the penalty is $40 grand.

And that is assuming the error is unintentional. Do it on purpose and I presume they will execute you.

I exaggerate, of course. They will just bankrupt you.

It puts a lot of pressure on defining “on purpose.”

Let’s look at Osamu Kurotaki (OK).

OK was born in Japan and lives in Japan. He obtained a U.S. green card, making him a U.S. permanent resident. One of the pleasures of being a permanent resident is filing an annual tax return with the United States, irrespective of whether you live in the U.S. or not. One can talk about a foreign income exclusion or foreign tax credit – which is fine – but that annual filing makes sense only if someone intends to eventually return to the U.S. It does not make as much sense if someone does not intend to return, someone like OK.

OK paid someone to prepare his annual U.S. tax return. He found a CPA who was bilingual.

In 2021 the U.S. Treasury assessed civil penalties against OK for more than $10 million. His footfall? He failed to file FBARs. Treasury also upped the ante by saying that his failure was “willful.”

Huh?

Treasury is requesting summary judgement that OK willfully failed to file FBARs, prefers waffle over sugar cones and rooted for the Diamondbacks in the World Series. 

The Court wanted to know how Treasury climbed the ladder to get to that “willful” step.

So do I.

Here is what the Court saw:

·      OK is a Japanese speaker and does not speak English “at all.”

·      OK relied on his bilingual CPA to make sense of U.S. tax filing obligations.

·      His CPA provided annual tax questionnaires in both English and Japanese. The English was for theater, I suppose, as OK could not read English.

·      The CPA’s translation now becomes critical. Here are instructions to the FBAR in English:

U.S. taxpayers are required to report their worldwide income; that is, income from both U.S. and foreign sources.”

·      Here is the Japanese translation:

U.S. resident taxpayers are required to report their worldwide income, that is, income from both US. and foreign sources."

OK told the Court that he did not think he had a filing obligation because he was not a “U.S. resident.”

I get it. He lives in Japan. He works in Japan. His kids go to school in Japan. He is as much a “U.S. resident” as I am a Nepalese Sherpa.

Except …

OK was green card – that is, a “permanent” resident of the U.S.

Technically …

The Court cut OK some slack. Technically - and in a law school vacuum - he was a “resident.” Meanwhile - in the real world – no one would think that. Furthermore, OK hired a CPA who made a mistake. Even a trained professional erred interpreting the Treasury’s word salad. 

The Court said “no” to summary judgement.

Treasury will have to argue its $10 million-plus proposed penalty.

And I believe the Court just outlined reasonable cause.

Perhaps OK should consider turning in that green card. 

Our case this time was Osamu Kurotaki v United States, U.S. District Court, District of Hawaii.

 

IRS Wants Near $9 Million Penalty From A Holocaust Survivor

 

I’ll tell you what caught my eye:

This is a tax case in which the Government alleges that Defendant Walter Schik, a Holocaust survivor, failed to file a foreign bank account reporting form with the Internal Revenue Service …, which now seeks by this action to collect an almost nine-million-dollar civil penalty assessed against him for that failure.”

There are so many things wrong with that sentence.

Let’s talk about Form TD F 90-22.1, also known as the FBAR (“Eff- Bar”). The form existed before I took my first course in accounting years ago, but it has gathered steam and interest when Treasury started to chase overseas bank accounts during the aughts. If one has a foreign account, or has authority over a foreign account, which exceeds $10,000 during the taxable year, one is required to disclose on one’s individual income tax return (on Schedule B) and file Form TD F 9-22.1 with the Treasury.

Up to this point, it is just another form to file. We are drowning in forms, so what is the big deal?

The deal is the penalties for not filing the form. Let’s separate not filing the form because you did not know you had to file from knowing you had to file but deciding not to. That second one is considered “willful” (which makes sense) and can cost you a penalty from $100,000 to 50% of the account balance at the time of violation.

This is VERY expensive money.

The IRS assessed a penalty of almost $9 million against Schik for failure to file an FBAR.

Some background:

·      Mr Schik is a Holocaust survivor.

·      His education was cut short by, how shall we say this …, being in a concentration camp.

·      After the war, he immigrated to the U.S. and became a citizen.

·      After becoming a citizen, he opened a Swiss bank account where he deposited monies recovered from relatives who were slaughtered during the Holocaust.

·      He left the monies in Switzerland as he was fearful that another Holocaust-like event could occur.

·      Schik did not touch or manage the money. That was done by his son and a Swiss money manager.

·      Schik did talk with the money manager occasionally, though.

·      By 2017 one of those Swiss accounts had over $15 million.

·      His accountant never asked Schik if he had overseas bank accounts or explained the recently heightened IRS interest in the area.

I am sympathetic with the accountant. What are the odds of having a client who is a Holocaust survivor and having over $15 million in a Swiss bank account? One could go a career. I have.

The year at issue is 2007. There is a question on the individual tax return whether one has an interest or signature authority over a foreign bank account. Schik’s accountant answered it “No.” Schik did not correct his accountant. More fairly, Schik did not even notice the question.

Wouldn’t you know that Schik’s Swiss money manager got pulled into the UBS investigation?

UBS entered into a deferred prosecution arrangement with the United States. It however had to provide identities of U.S. citizens and residents who were customers of the bank.

At which point Schik submitted a voluntary disclosure to the IRS.

Which the IRS denied.

Without an alternative, Schik submitted a late FBAR.

The IRS then slapped the 50% penalty we are talking about.

Which brings us up to speed.

The penalty requires one’s behavior to be “willful.” Not surprisingly, the word has specific meaning under the law, and the Court evaluated whether Schik’s behavior was willful.

Treasury argued that “willful” means “objectively reckless.”

Got it. Ignoring an issue to an extreme degree is the same as knowing and not caring.

Schik argued that willful means “intentional disregard.”

The difference?

Schik argued that the underlying law was opaque, long-ignored and now quickly – if somewhat capriciously – conscripted into action. He no more intentionally disregarded his tax reporting obligations than he intentionally disregarded the newest developments in cosmological galaxy formation. There was no conspiracy by hundred-year-old Holocaust survivors: he just didn’t know.

And such is tax law. Nine million dollars hangs on the meaning of a word.

The Court noted that other courts – relying on records similar to those available to it - have found willfulness.

Not good for Schik. 

However, the Court was concerned about the many countervailing factors:

·      Schik was nearly 100 years old.

·      Schik had minimal formal education.

·      Schik did not manage the money.

·      Schik did not prepare his own tax returns.

·      Schik had no idea about a disclosure requirement.

·      Schik’s accountant did not explain the disclosure requirement.

·      The question answered “No” was pre-filled by the accountant’s software and did not represent any assertion made by Schik.

The Court denied the IRS summary judgement, noting there was a substantial question of fact.

I agree.

Who will review and clarify the facts?

“The Court believes that the Parties in this case would benefit from mediation. By separate order the Court will refer the Parties to the Southern District of New York’s Mediation Program. … the assigned District Judge … may determine that a case is appropriate for mediation and may order that case to mediation, with or without the consent of the parties.”

Methinks the IRS should just have allowed the voluntary disclosure.  

Was the IRS encouraging compliance, promoting education and providing a ramp to enter/reenter the tax system? Or is this something else, something with the purpose of terrifying the next person?

Our case this time was United States of America v Walter Schik, 20-cv-02211 (MKV)

No Required Minimum Distributions For 2020

There is a tax deadline coming up. It may matter to those who are taking required minimum distributions (MRDs) from your IRAs and certain employer-based plans.

You may recall that there is a trigger concerning retirement plans when one reaches age 72.

COMMENT: The trigger used to be age 70 ½ for tax years before 2020.

The trigger is – with some exception for employer-based plans – that one has to start withdrawing from his/her retirement account. There are even IRS-provided tables, into which one can insert one’s age and obtain a factor to calculate a required minimum distribution.

COMMENT: There are severe penalties for not withdrawing a minimum distribution. Fortunately, the IRS is fairly lenient in allowing one to “catch-up” and avoid those penalties. At 50% of the required distribution, the MRD penalty rate is one of the most severe in the tax Code.

Let’s say that you are in the age range for MRDs. You have, in fact, been taking monthly MRDs this far into 2020.

There has been a law change: you can take 2020 distributions if you wish, but distributions are not mandatory or otherwise required. That is, there are no MRDs for 2020. This means that you can take less than the otherwise-table-calculated amount (including none, if you wish) and not taunt that 50% penalty.

Why the change in tax law?

The change is related to the severe economic contractions emanating from COVID and its associated lockdowns and stay-at-home restrictions. Congress realized that there was little financial sense in forcing one to sell stocks and securities into a bear market to raise the cash necessary to pay oneself MRDs.

Hot on the heels of the change is the fact that different people take MRDs at different times. Some people take the distribution early in the year, others late, and yet others take distributions monthly or quarterly. There is no wrong answer; it just depends on one’s cash flow needs.

Let’s take the example we started with: monthly distributions.

Well, it’s fine and dandy that I do not have to take any more distributions, but what about the amount I took in January -before the law change? And February – before …., well, you get the point.

You can put the money back into the IRA or retirement account.

Think of it as a mulligan.

But you have to do this by a certain date: August 31, 2020.

You have approximately another month to get it done.

Here are some questions you may have:

(1)  Does this change apply to 401(k)s, 403(b)s, 457(b)s?

Answer: Yes.

(2)  How about inherited accounts?

Answer: Yes. You have to put it back in the same (that is, the inherited) account, of course.

(3)  What if I was having taxes withheld?

Answer: You are going to have reach into your pocketbook temporarily. Say that you took a $25,000 distribution with 20% federal withholding. You never spent any of it, so you have $20,000 sitting in your bank account. If you want to unwind the entire transaction, you are going to have to take $5,000 from somewhere, add it to the $20,000 you already have and put $25,000 back into your IRA or retirement account.

You may wonder what happened to the $5 grand that was withheld. It will be refunded to you – when you file your 2020 tax return.

(4)  Continuing with Example (3): what if I don’t have the $5 grand?

Answer: Then put back the $20,000 you do have. It’s not 100%, but you put back most of it. You will have that gigantic withholding when you finally file your 2020 taxes.

(5)  What if I turned 70 ½ last year (2019) and HAVE TO take a MRD in 2020?

Answer: The answer may surprise you. The downside to waiting is that you would (normally) have to take a distribution for 2019 (you turned 70 ½, after all) and another for 2020 itself. This means that you are taking two MRDs in one tax year. Under the new 2020 tax law, you do not have to take EITHER (2019 or 2020) distribution. Your first distribution would be in 2021, and you would have had no distributions for 2019 or 2020.

(6)  Does this change apply to pensions?

Answer: No. Pensions are “defined benefit” plans, whereas IRAs, 401(k)s and so on are “defined contribution” plans. The change is only for defined contribution plans.

(7)  Does this change apply to Roths?

Answer: Roths do not have minimum required distributions, so this law change means bupkis to them.

(8)  What if I went the other way: I withdrew from my traditional IRA and would like to put it back as a Roth?

Answer: Normally one cannot do this, as MRDs do not qualify for a Roth conversion. With no MRDs for 2020, however, you have a one-time opportunity to flip some of your traditional IRA into a Roth. Remember that you will have to pay tax on this, though.  

(9)  How does this law change interact with the qualified charitable distribution rules?

Answer: A qualified charitable distribution (QCD) is when you have your IRA custodian issue a check directly to a charity. You do not get a deduction for the contribution, but the upside is that you do not have to report the distribution as income. If you do not itemize deductions, this technique is – by far – the most tax-efficient way to go. The QCD rules are independent of the MRD 2020 rule change. If you want to donate via charitable distributions in 2020, then go for it!

If you are already into your MRD for 2020 and do not need the money – some or all of it – remember that you have approximately another month to put it back.