Deferred accumulated leave payments are subject to FICA when the employee commits to the program

Plain-English summary

Chief Counsel advice addressed an early-retirement program that deferred accumulated vacation-leave payments over five years. The advice concluded that the deferral is not a window benefit because employees were entitled to the lump-sum leave payment at retirement regardless of whether they joined the early-retirement program, and the benefit was offered continuously. It further concluded that section 3121(v)(2) applies to the deferred leave component, so FICA tax applies in the first year when the employee commits to the program. The advice also discussed an alternative view that the full accumulated leave amount could be treated as the first-year balance of a nonqualified deferred-compensation plan.

Ruling snapshot

• Question: When are FICA taxes imposed on accumulated vacation-leave payments deferred under an early-retirement program?
• Outcome: Advice given
• Key authorities: IRC §§ 3121 and 3121(v)(2); Treas. Reg. §§ 31.3121(v)(2)-1(b)(4)(iv)(A), 31.3121(v)(2)-1(b)(4)(iv)(B), and 31.3121(v)(2)-1(b)(5)

Full text (IRS public release)

ID: CCA_2012101813255232 Number: 201302031
Release Date: 1/11/2013
Office: --------------
UILC: 3121.00-00

From: --------------------
Sent: Thursday, October 18, 2012 1:25:58 PM
To: -------------------------
Cc:
Subject: RE: Window benefits ---------

We didn't think of this aspect of the question, but it looks like you are making a good point.

Section 31.3121(v)(2)-1(b)(4)(iv)(A) provides that vacation benefits, sick leave, compensatory time,
disability pay, severance pay and death benefits do not result from the deferral of compensation for
purposes of section 3121(v)(2), even if those benefits constitute wages within the meaning of section
3121(a).

I do not think that this regulation applies with respect to the employee's entitlement to a lump sum
payment of annual leave that is then deferred, because at that point vacation benefits are not being
deferred in the usual sense because the employee is not retaining any right to vacation.

I also do not think the annual leave payments are window benefits. A window benefit is defined by the
regulations as an early retirement benefit, retirement-type subsidy, social security supplement, or other
form of benefit made available by an employer for a limited period of time (no greater than one year) to
employees who terminate employment during that period or to employees who terminate employment
during that period under specified conditions. The regulations also provide that a window benefit will not
be considered a window benefit if an employer establishes a pattern of repeatedly providing for similar
benefits in similar situations for substantially consecutive limited periods of time.

As the write-up you provided noted, the deferral of the accumulated vacation leave is not a
window benefit because the employees were entitled to a lump sum payment of this benefit at retirement
regardless of their election to participate in the early retirement program. The deferral of the payment of
amount of the accumulated vacation leave also is not window pay because the accumulated vacation
leave is not offered for a limited period of time but provide on a continuous basis to employees who
retire. It is questionable whether the payout of the accumulated vacation leave over the five years versus
immediate payout of the vacation leave is even a benefit. Receipt of the accumulated vacation leave
payment over 5 years would generally be considered to be worth less than immediate receipt of the leave
payment upon retirement. The deferral of the leave payment will also generally make the program less
costly to the employer. Whether it is beneficial to the employee would depend on the tax rates of the
employee over the 5-year period, which cannot be determined at the outset of the payments. Also, the
regulations about a pattern of repeatedly providing the benefits would mean the accumulated vacation
leave is not a window benefit because the lump sum annual leave is offered continuously.

Therefore, we agree that section 3121(v)(2) should apply to the portion of the early retirement program
that is the deferral of the accumulated vacation leave, and FICA tax would apply in the first year to
the accumulated vacation leave payments to be received when the employee committed to the early
retirement program.
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You could also argue that a portion of the $-------- payments essentially relates to the fact
that accumulated vacation leave is being deferred from the lump sum the employee would otherwise be
entitled to at retirement, and thus that portion would be part of a nonqualified deferred compensation plan
relating to the accumulated vacation leave. Essentially I would view the accumulated annual leave
payment plan as being NQDC account balance plan beginning with the full amount of the accumulated
annual leave in year 1 and a certain amount (representing reasonable interest) from the discounted flow
of $---------payments being allocated to the accumulated annual leave deferral plan to bring it up to the full
amount of the accumulated annual leave, that would be taxable in year one. Thus, the full amount of the
accumulated vacation leave should be included in FICA wages in year one not the discounted stream of
five payments. How is the employee otherwise being paid for the fact that he or she is not receiving the
annual leave upon retirement but over five years, which means it is worth considerably less than the lump
sum? Although the amount of the vacation leave pay outs were only, in total, about one fourth of the total
years of service payout, you could argue that part of the years of service payout was to get the employee
to agree to the five year payout of vacation leave.