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Insurance Agent Tax Resolution

Retired insurance agents’ renewal commissions didn’t qualify for FICA special timing rule

Mike Habib, EA

Chief Counsel Advice 200813042

In a Chief Counsel Advice (CCA), IRS has ruled that because renewal commissions paid to its retired employees were subject to a substantial risk of forfeiture as of the insurance agents’ retirement dates, an insurance company couldn’t take those amounts into account on the employees’ retirement dates under the special FICA timing rule for nonqualified deferred compensation under Code Sec. 3121(v)(2) . As a result, IRS denied the refund claimed by the insurance company, which had been withholding and paying FICA taxes on the renewal commissions at the time that they were actually paid.

Background. Any amount deferred under a nonqualified deferred compensation plan is taken into account for purposes of the Federal Insurance Contribution Act (FICA) tax as of the later of:

    • when the services are performed; or
    • when there is no substantial risk of forfeiture of the rights to the amount. (Code Sec. 3121(v)(2)(A))

    Observation: This is so-called “special timing rule” in contrast to the general timing rule (which provides that wages are taken into account for FICA purposes when they are actually or constructively paid).

    Observation: In many cases, the application of the special timing rule will reduce FICA taxes from what they would have been under the actual or constructive payment rule. The Old Age, Survivors and Disability Insurance (OASDI) portion of FICA tax is assessed against a limited amount of compensation, called the taxable wage base. Consequently, deferred compensation will effectively escape the OASDI portion of FICA taxation to the extent it is taken into account in early years (e.g., when the service is rendered) in which an individual’s compensation subject to FICA exceeds the taxable wage base. If the nonqualified deferred compensation is taken into account for FICA purposes when paid, and this occurs after the individual has retired, it’s more likely to be subject to the OASDI portion of FICA taxation, especially since income from a qualified retirement plan isn’t subject to FICA taxation.

    Under Reg. § 31.3121(v)(2)-1(e)(4)(ii)(A), for FICA purposes, a taxpayer can take into account an amount deferred under a nonaccount balance plan (i.e., generally plans other than ones in which employees receive amounts based solely on balances in their individual accounts) that isn’t reasonably ascertainable, if that amount is no longer subject to a substantial risk of forfeiture.

    Facts. Under Insurance Company’s compensation plan, an employee received a renewal commission only if: (1) the agent was either an active sales agent or his services had been terminated because of retirement, disability, or death; and (2) the insurance policy was in force on the anniversary date of the policy and the customer paid the renewal premiums. Insurance Company represented that renewal commission rates couldn’t be reduced after the sale of the policy, i.e., they weren’t subject to unilateral reduction or elimination by Insurance Company.

    Insurance Company filed refund claims, asserting that it shouldn’t have withheld and paid FICA tax on the renewal commissions at the time it paid the renewal commissions to its retired agents. It argued that its compensation plan gave the agents the right to future renewal commissions because all required services had been performed as of the date of retirement. Accordingly, it argued, under Code Sec. 3121(v)(2), it could treat the renewal commissions that it may eventually pay a retired agent as subject to FICA tax on the retirement date of the agent.

    Based on Reg. § 31.3121(v)(2)-1(e)(4)(ii)(A), Insurance Company contended that it could retroactively aggregate the renewal commissions from all insurance policies sold by a retired agent and assign a fair market value at the date of retirement based on the discounted value of the entire stream of renewal commission payments the agent was expected to receive, subject to true up at the resolution date. (In fact, for the years at issue, Insurance Company used the actual renewal commission payment data to retroactively determine the value of renewal commissions as of the date of the agent’s retirement, rather than applying a methodology in order to estimate the fair market value on the date of retirement.)

    No refund allowed. In the CCA, as an initial matter, IRS concluded that the insurance agents’ rights to renewal commissions were paid under a nonqualified deferred compensation plan for purposes of Code Sec. 3121(v)(2). However, IRS further ruled that the renewal commissions were subject to a substantial risk of forfeiture on the dates the agents retired. Insurance Company only paid renewal commissions if the customer renewed the underlying insurance policy and paid the renewal premiums. As a result, the commission was subject to a substantial risk of forfeiture until the policy was renewed, and the customer paid the related renewal premiums on the policy. The renewal and premium payment was a condition related to the compensatory purpose of the transfer of the right to the renewal commission, and an agent forfeited the right to any renewal commission if the customer didn’t renew the policy or pay the premium. Accordingly, the CCA advised denying the refund that Insurance Company claimed based on the erroneous assumption that it could use the Code Sec. 3121(v)(2) special timing rule.

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