Are employee contributions to a governmental plan that are picked up within the meaning of IRC Section 414(h)(2) by the employer subject to FICA withholding?
YES
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Actually, it varies. I.R.C. § 3121(v)(1)(B) provides that a 414(h)(2) pickup is subject to FICA only "where the pickup referred to in such section is pursuant to a salary reduction agreement (whether evidenced by a written agreement or otherwise)." Thus, in what I think of as the old-fashioned pickup situation, in which an employer simply decides as an extra benefit to pick up employee contributions without deducting the pickups from wages, the pickups would not be subject to FICA. However, if the pickups reduce the employees' wages, they are subject to FICA.
Obviously, the fact that pickups must be mandatory (Rev. Ruls. 81-35 and 81-36) makes it hard to determine in some instances whether there is a salary reduction "agreement." I've always thought that there might be some room for maneuvering here. (In a collective bargaining situation, for example, is there any real difference between saying that employees' salaries, as increased for COLAs and the like, shall be reduced by X% to cover the pickup, versus saying that employees' salaries shall be increased by a lesser amount, and that the employer will pay for the pickups without a salary reduction?) However, there are a number of limitations on the room for maneuver.
One is that if you treat pickups as not being pursuant to a salary reduction agreement for purposes of section 3121(v), and therefore has not being subject to FICA, they are also not part of wages for purposes of Social Security benefits. This can be a concern for some employees and unions.
Another is that a state statute will typically treat pickups, other than those made pursuant to a salary reduction agreement, as not included in wages for purposes of benefit calculations. Similarly, other plans (e.g., life insurance plans) may treat non-salary reduction pickups as not part of wages in calculating benefits.
Finally, public employers often have trouble competing for employees with the private sector, in those job positions in which wages are higher in the private sector. In theory, one should be able to argue that the $95x salary, plus the employer pickup of $5x, that one is offering is equivalent to another employer's offer of $100 in salary with a $5x salary reduction for the pickup. In the real world, though, the employee may see a $100x salary as better than a $95x salary, without going through the details enough to realize the equivalence.
Thus, as a practical matter, the modern trend has been to have more and more pickups involve salary reductions. But those who are dealing with the older type of pickup arrangement should be aware that FICA would not apply to it.
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Employee benefits legal resource site
Obviously, the fact that pickups must be mandatory (Rev. Ruls. 81-35 and 81-36) makes it hard to determine in some instances whether there is a salary reduction "agreement." I've always thought that there might be some room for maneuvering here. (In a collective bargaining situation, for example, is there any real difference between saying that employees' salaries, as increased for COLAs and the like, shall be reduced by X% to cover the pickup, versus saying that employees' salaries shall be increased by a lesser amount, and that the employer will pay for the pickups without a salary reduction?) However, there are a number of limitations on the room for maneuver.
One is that if you treat pickups as not being pursuant to a salary reduction agreement for purposes of section 3121(v), and therefore has not being subject to FICA, they are also not part of wages for purposes of Social Security benefits. This can be a concern for some employees and unions.
Another is that a state statute will typically treat pickups, other than those made pursuant to a salary reduction agreement, as not included in wages for purposes of benefit calculations. Similarly, other plans (e.g., life insurance plans) may treat non-salary reduction pickups as not part of wages in calculating benefits.
Finally, public employers often have trouble competing for employees with the private sector, in those job positions in which wages are higher in the private sector. In theory, one should be able to argue that the $95x salary, plus the employer pickup of $5x, that one is offering is equivalent to another employer's offer of $100 in salary with a $5x salary reduction for the pickup. In the real world, though, the employee may see a $100x salary as better than a $95x salary, without going through the details enough to realize the equivalence.
Thus, as a practical matter, the modern trend has been to have more and more pickups involve salary reductions. But those who are dealing with the older type of pickup arrangement should be aware that FICA would not apply to it.
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Employee benefits legal resource site
Thanks, Carol. I thought there were some differences in treatment depending on whether the pick-ups were by "salary reduction" or not. Have you seen PLR 9836005 on the mandatory contributions question you raised? I appreciate you outlining your thoughts on this issue.
Yep, that ruling confirms the availability of room to maneuver, subject to the constraints I mentioned.
In the ruling, some school district employees had previously had their mandatory contributions to the state retirement system paid by the school district on a salary reduction basis. The state was anxious to provide higher total compensation, so that school districts could retain valued employees.
The state could have accomplished its objective in one of two ways. The first would be to provide increases in cash compensation to the affected employees, in which case the mandatory contributions to the state retirement system picked up by the school districts would have continued to be subject to FICA. The second alternative, and the one the state adopted, was for the state instead to pick up a portion of the contributions, and to direct the school districts to provide additional cash compensation to employees exactly equal to the amount of contributions which the state (instead of the school district) now picked up.
Obviously, the financial results of the two alternatives would have been identical. However, the IRS held that under the second alternative, the contributions picked up by the state would not be subject to FICA. The ruling emphasizes that the exact same arrangement may have different FICA consequences, depending on how the applicable documentation characterizes it.
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Employee benefits legal resource site
In the ruling, some school district employees had previously had their mandatory contributions to the state retirement system paid by the school district on a salary reduction basis. The state was anxious to provide higher total compensation, so that school districts could retain valued employees.
The state could have accomplished its objective in one of two ways. The first would be to provide increases in cash compensation to the affected employees, in which case the mandatory contributions to the state retirement system picked up by the school districts would have continued to be subject to FICA. The second alternative, and the one the state adopted, was for the state instead to pick up a portion of the contributions, and to direct the school districts to provide additional cash compensation to employees exactly equal to the amount of contributions which the state (instead of the school district) now picked up.
Obviously, the financial results of the two alternatives would have been identical. However, the IRS held that under the second alternative, the contributions picked up by the state would not be subject to FICA. The ruling emphasizes that the exact same arrangement may have different FICA consequences, depending on how the applicable documentation characterizes it.
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Employee benefits legal resource site
Postscript to the above notes: it has come to our attention that in at least a couple of audits, the IRS has basically asserted that all contributions picked up by the employer are pursuant to a salary reduction agreement, and therefore subject to FICA taxes, regardless of other circumstances. Has anyone else faced this?
Carol-
Doesn't that New Mexico court case more or less hold that the "salary reduction" language is meaningless and that all 414(h) contributions are subject to FICA?
Prior to the 1984 legislation all 414(h) pick-up contributions were subject to FICA taxes. Congress changed the law, but the legislative history of 3121(v)(1)(B) indicates that the amendment meant nothing (and that is why we have this confusion).
Doesn't that New Mexico court case more or less hold that the "salary reduction" language is meaningless and that all 414(h) contributions are subject to FICA?
Prior to the 1984 legislation all 414(h) pick-up contributions were subject to FICA taxes. Congress changed the law, but the legislative history of 3121(v)(1)(B) indicates that the amendment meant nothing (and that is why we have this confusion).
I'm assuming the New Mexico case to which you are referring is Public Employees' Retirement Board v. Shalala, 153 F.3d 1160 (10th Cir. 1998). And no, I would not agree that that case holds that the "salary reduction" language is meaningless. Actually, it's the "agreement" language that I think was held to be meaningless, 
in the sense that the court clearly held that a salary reduction "agreement" could exist even in the absence of any individually negotiated contract. However, the court still said that "a salary reduction agreement necessarily includes any arrangement in which there is a reduction in an employee's salary in exchange for the employer's contribution of the amount of the reduction to a pension plan on the employee's behalf." Thus, a situation in which there is absolutely no reduction of an employee's salary (the employer makes the contribution in addition to the stated amount of the employee's salary) should not be a salary reduction agreement. But we understand that in some audits, even contributions made with no reduction in salary are being treated as subject to FICA.
in the sense that the court clearly held that a salary reduction "agreement" could exist even in the absence of any individually negotiated contract. However, the court still said that "a salary reduction agreement necessarily includes any arrangement in which there is a reduction in an employee's salary in exchange for the employer's contribution of the amount of the reduction to a pension plan on the employee's behalf." Thus, a situation in which there is absolutely no reduction of an employee's salary (the employer makes the contribution in addition to the stated amount of the employee's salary) should not be a salary reduction agreement. But we understand that in some audits, even contributions made with no reduction in salary are being treated as subject to FICA.
KFGO radio station in Fargo, ND, just reported that the IRS would not bring up the FICA/pick-up issue in its closing letter regarding the audit of one of the Fargo school districts. The audit had originally sought to impose FICA taxes with respect to non-salary-reduction pick-ups.
This is good news. Also, it appears that the National Office of IRS has now dropped the idea of a field directive concerning the circumstances in which pick-ups are FICA-taxable. Instead, it will merely be concentrating on "informal guidance" reminding people that FICA is due on contributions picked up pursuant to a salary reduction agreement.
This is good news. Also, it appears that the National Office of IRS has now dropped the idea of a field directive concerning the circumstances in which pick-ups are FICA-taxable. Instead, it will merely be concentrating on "informal guidance" reminding people that FICA is due on contributions picked up pursuant to a salary reduction agreement.
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