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How the Social Security Tax Is Altered by Employee Benefits

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As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

Is the cost of employer-provided group term life insurance subject to Social Security tax?

Yes. The cost of group term life insurance that is includable in the gross income of the employee is considered wages subject to Social Security tax.

The general rule is that an employee may exclude the cost of the first $50,000 of employer-provided group term life insurance from income. Therefore, only the cost of coverage in excess of $50,000 generally will be subject to the Social Security tax.

An employer is required to report amounts includable in the wages of current employees for purposes of the Social Security tax on employees’ W-2 forms. An employer generally may treat wages as though paid on any basis so long as they are treated as paid at least once each year.

Social Security tax must be paid by an employee if a payment for group term life insurance is considered wages and is for periods during which there is no longer an employment relationship between the employer and the employee. An employer is required to separately state the portion of an employee’s wages that consist of payments for group term life insurance and the amount of Social Security tax.

Is employer-provided sick pay subject to Social Security and federal unemployment tax?

Preretirement wage continuation payments by an employer or an insurance company to an employee because of his or her sickness or disability are subject to Social Security tax (FICA) and federal unemployment tax (FUTA) for the first six calendar months after the last month in which the employee worked for the employer.

After six months, they are exempt from Social Security and federal unemployment tax.

Payments or parts of payments attributable to employee contributions made to a sick pay plan with after tax dollars are not subject to Social Security or FUTA taxes.

Are amounts received under a cafeteria plan subject to Social Security and federal unemployment taxes?

Amounts received by participants, or their beneficiaries, under a cafeteria plan are not treated as wages. Thus, these amounts are not subject to tax under the Federal Insurance Contributions Act (FICA) or under the Federal Unemployment Tax Act (FUTA) if such payments would not be treated as wages without regard to the plan, and if it is reasonable to believe that IRC Section 125 would not treat any wages as constructively received.

Are amounts contributed to a Health Savings Account (HSA) subject to Social Security or federal unemployment taxes and federal income tax withholding?

The definition of wages for purposes of the federal unemployment tax (FUTA) does not include any payment made to or for the benefit of an employee if it is reasonable to believe that the employee will be able to exclude the payment from income under IRC Section 106(d), which deals with contributions to HSAs.

Unfortunately, a similar change was not made to IRC Section 3121(a) with respect to FICA. The IRS has stated, however, that employer contributions to an HSA are not subject to withholding from wages for income tax or subject to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), or the Railroad Retirement Tax Act. A similar statement has been made by the Joint Committee on Taxation.

How is a reduction in salary for a tax sheltered annuity treated for Social Security tax and income tax withholding purposes?

Excludable amounts paid into a tax sheltered annuity are not wages subject to income tax withholding, even if the amounts are derived from a salary reduction agreement.

The amount of salary reduction contributions to the plan is subject to Social Security taxes even though it is excludable from the employee’s gross income. Employer non-salary reduction contributions are not includable in wages for Social Security purposes.

Under the final regulations, salary reduction agreement means a plan or arrangement under which payment will be made by an employer on behalf of an employee or his or her beneficiary under or to an annuity contract if the employee:

(1) elects to reduce his or her compensation under a cash or deferred election;

(2) elects to reduce his or her compensation pursuant to a one time irrevocable election made at or before the time of initial eligibility to participate in such plan or arrangement; or

(3) if the employee agrees as a condition of employment to make a contribution that reduces his or her compensation.

The Seventh Circuit Court of Appeals concluded that Congress intended IRC Section 3121(a)(5)(D) to include salary reduction agreements, whether voluntary or mandatory, in the FICA wage base. Accordingly, the Seventh Circuit held that payments made under a salary reduction agreement include salary reductions made under voluntary andmandatory agreements.

Amounts contributed by salary reduction by a minister or by church employees whose organizations have chosen to be exempt from FICA are not treated as wages subject to Social Security taxes to the extent the contributions are not more than the employer contribution limit.

Amounts of salary reduction treated as wages for Social Security tax are creditable to the individual’s Social Security account for benefit purposes.

Are self-employed individuals and corporate directors subject to FICA and FUTA taxes for deferred compensation arrangements?

Self-employed individuals pay Social Security taxes through self-employment (“SECA”) taxes rather than FICA taxes. Deferred compensation of self-employed individuals is usually counted for SECA tax purposes when it is includable in income for income tax purposes. Deferred compensation of self-employed individuals generally is counted for SECA purposes when paid, or when it is constructively received, if earlier.

Likewise, corporate directors who defer their fees generally count those fees for SECA purposes when paid or constructively received.

What are domestic partner benefits and how are they taxed?

Domestic partner benefits are benefits that an employer voluntarily offers to an employee’s unmarried partner. An employee’s domestic partner may be of the same sex or the opposite sex. An employer determines the scope of its plan’s definition of domestic partner.

After July 13, 2013, same-sex couples who were married in a state in which sex marriage is recognized (the state of “celebration”) are considered spouses, regardless of where they live.

Employers may offer a range of domestic partnership benefits, such as family, bereavement, sick leave, and relocation benefits. In general, most people mean employer-provided health insurance coverage when they speak of domestic partnership benefits.

An employee is taxed on the value of employer-provided health benefits for his or her domestic partner unless the domestic partner qualifies as the employee’s dependent under IRC Section 151. The tax is determined by assessing the fair market value of the coverage provided to the domestic partner. This amount then is reported on the employee’s W-2 form and is subjected to Social Security (FICA) and federal income tax withholding taxes.

Any amount received by a domestic partner as payment or reimbursement of plan benefits will not be included in the income of the employee or the domestic partner to the extent that the coverage provided to the domestic partner was paid for by the employee’s plan contributions or the fair market value of the coverage was included in the employee’s income under IRC Section 104(a)(3).

Coverage of domestic partners, whether or not they qualify as dependents, under an employer-provided health plan will not otherwise affect the ability of employees to exclude amounts paid, directly or indirectly, by a plan to reimburse employees for expenses incurred for medical care of the employees, their spouses, and dependents.

Cafeteria Plans and Flexible Spending Accounts- Contributions used to provide coverage for a non-dependent domestic partner are treated as taxable income. Benefits under flexible spending accounts may not be provided to a domestic partner because these accounts can include only nontaxable income.

For more tax stories and Tax Facts Q&A’s, check out ThinkAdvisor’s 21 Days of Tax Planning Advice for 2014 Special Report.