Read the article below and Respond to the following:

State and Local governmental entities have special laws for FICA withholding under the Social Security Act. It may shock you to hear that not everyone pays Social Security &/or Medicare taxes.

After reading the article below, discuss the thoughts on this special provision and the reasons why it is important for a governmental accountant to know about this.

Explain why this could be a material amount for inclusion in financial statement audits.

COMMON ERRORS in State and Local Government FICA and Public RETIREMENT System Compliance

BY MARYANN MOTZA AND DEAN J. CONDER

Many state and local government employers and employees are confused by the Federal Insurance Contribution Act (FICA) tax and public retirement system obligations. This employment tax, which is the basis for Social Security and Medicare, is straightforward in the private sector. Applying FICA to state and local government employment, however, can be exceedingly difficult. In addition, the Governmental Accounting Standards Board (GASB) does not test for FICA compliance, which can lead to a false sense of security when a state or local government receives an audit compliance certificate based on GASB audit standards.

The laws and rules that affect public employers' federal FICA tax obligations regarding Social Security and Medicare coverage provisions include numerous exemptions and exceptions to the laws that apply to the private sector. Further exacerbating the situation are the semantics associated with the laws, which can create confusion that results in inadvertent noncompliance:

?"Voluntary" Social Security coverage through a Section 218 agreement was once the only way state and local governments could elect Social Security coverage for their employees. Since April 20, 1983, coverage under a Section 218 agreement cannot be terminated unless the governmental entity is legally dissolved.

?"Mandatory" Social Security coverage is not really mandatory for all state and local government employees. If a public employer has a qualifying FICA replacement retirement system for its employees, it is not required to pay the Old-Age, Survivor, Disability portion of Social Security.

?"Mandatory" Medicare coverage is also not really mandatory for all state and local government employees. It is actually illegal to pay Medicare tax for Medicare-exempt employees. The Medicare-only portion, however, is required for anyone hired by a public employer after March 31, 1986.

If you are not confused yet, you soon will be.

HOW WE GOT HERE

Congress enacted the Social Security Act in 1935 to establish an insurance program for "persons working in industry and commerce as a long-run safeguard against the occurrence of old-age dependency." Congress, however, faced constitutional questions as to whether it could force state and local governments to include their employees in the Social Security system, so state and local government entities were not compelled to take part. In fact, at that time, public employers were actually forbidden to do so.

Beginning in 1951, states were allowed to enter into voluntary agreements (authorized by Section 218 of the Social Security Act and thus called Section 218 agreements) with the federal government to provide Social Security coverage to their public employees. Each state enacted its own legislation to provide the authorization for the state and its political subdivisions to voluntarily enter into individual Section 218 agreements with the federal government that provided coverage to different classes and positions of employees. These original Section 218 agreements have a provision that allows an entity to withdraw from the agreement, but since 1983, that provision has been overridden by federal law.

With the enactment of the Medicare portion of FICA in 1965, all Section 218 agreements were automatically covered with Medicare. In 1985, Congress enacted what is popularly termed mandatory Medicare. Under this law, anyone hired on or after April 1, 1986, is subject to the Medicare portion of the FICA tax, regardless of whether or not the entity covers its employees by a public retirement system. Those employees covered only by Medicare (and not Social Security) are said to be Medicare Qualified Government Employment (MQGE). The employer is required to file W-2 and 941 forms for each MQGE employee.

In 1990, Congress amended the Internal Revenue Code (IRC) and the Social Security Act, making Social Security and Medicare coverage mandatory for most state and local government employees who were not covered by a qualifying FICA replacement public retirement system or a Section 218 agreement. This law became known as mandatory Social Security, which is different from mandatory Medicare. Medicare is mandatory regardless of the existence of a retirement system, but Social Security is mandatory only in the absence of a retirement system or Section 218 agreement.

STATE SOCIAL SECURITY ADMINISTRATOR

States are required by federal regulation to appoint an official as the state Social Security administrator. The state administrator is the person responsible for administering the Section 218 agreements for each state. Until 1987, the state administrator was also responsible for collecting the Social Security and Medicare contributions (now referred to as the FICA taxes) from state and local government employers and to deposit the funds with the United States Treasury. When the Internal Revenue Service (IRS) assumed this function in 1987, many states interpreted this change as eliminating any further responsibilities, but that is incorrect; the majority of functions and responsibilities of the state administrator remain. In fact, the responsibilities have become even more complicated since 1987, with the advent of the mandatory Social Security and Medicare provisions.

The state administrator is often thought of as a bridge between the federal agencies and local entities. Many small local entities do not have the expertise to effectively communicate and respond to the relevant issues, as this area of taxation is extremely complex and changing a single fact can alter a particular outcome. See Exhibit 1 for examples of typical fact patterns that result in vastly different conclusions about an entity's probable tax compliance when seemingly minor additional factors are added to the scenario.

DETERMINING COMPLIANCE

Employee or Contractor? In determining FICA compliance, the first question to ask is if the worker is an employee or an independent contractor. No FICA taxes are withheld for independent contractors; instead, the payment is recorded and filed on IRS Form 1099-MISC.

Is There a Section 218 Agreement In Place? This question can most readily be answered by the state Social Security administrator, whose office is responsible for administering the particular state's master agreement and each individual entity's agreement. Each entity's Section 218 agreement can differ, even within the same jurisdiction.

Coverage under Section 218 agreements can be extended only to groups of employees known as coverage groups. Once a position is covered under a Section 218 agreement, any employee filling that position is permanently covered for Social Security and Medicare. Each entity decides, within federal and state laws, which groups to include under its Section 218 agreement. Federal law excludes certain services or positions from coverage and requires coverage of others. For example, individuals whose compensation is solely fee based are excluded from mandatory coverage under federal law but can be included as optional coverage under an entity's Section 218 agreement.

Does the Entity Have a Qualifying Public Retirement System? State and local government employees must be covered by either a qualifying public retirement system or Social Security, by either a Section 218 agreement or the mandatory provisions of the federal law. (There is, however, new legislation regarding contracts involving goods and services.) Regardless of whether or not employees are covered by a retirement system, the employer is subject to the Medicare portion of the FICA tax for employees hired on or after April 1, 1986. Similarly, it is equally improper to withhold and pay Medicare on an employee who is covered by a retirement system and was hired before April 1, 1986, if that employee is not covered under a Section 218 agreement ? unless the referendum procedures are followed.

Finally, not all retirement systems qualify under the Omnibus Budget Reconciliation Act (OBRA) of 1990. If the position is not covered under a Section 218 agreement, an employer can provide an alternative retirement system, so long as it meets IRC requirements. According to Treasury Regulation 26 C.F.R. 31.3121(b)(7)-2, a pension, annuity, retirement, or similar fund or system "is not a retirement system with respect to an employee unless it provides a retirement benefit to the employee that is comparable to the benefit provided under the Old-Age portion of the Old-Age, Survivor, and Disability Insurance (OASDI) program of Social Security." A defined contribution retirement system meets the test provided by this regulation if allocations to the employee's account are 7.5 percent of compensation and do not include any credited interest in the calculation. Matching contributions by the employer may be taken into account for this purpose. Thus, a defined contribution plan that has a contribution rate from the employer, employee, or both that is 7.5 percent of compensation can take the place of the OASDI portion of Social Security under OBRA 1990 (unless of course, the position is covered under a Section 218 agreement). Mandatory Medicare still must be paid.

Exhibit I: Complexity Chart - Representative Examples of State and Local Government FICA Issues* Primary Fact Situation Additional Relevant Facts Probably Probably (Nuance/Possible Issue) Non-Compliant Compliant Employer is not withholding If all employees are covered under Medicare on all employees. a Section 218 agreement. If all employees are covered under a public retirement system and Medicare is being withheld only from employees hired on or after April 1, 1986 Political entity has stopped paying If political entity is covered Social Security and is paying into for Social Security under a qualifying public retirement plan. a Section 218 agreement If political entity is covered for Social Security by mandatory Social Security provisions. Political entity has a Section 218 If entity did not opt out of the agreement and is not paying FCA. agreement before April 20, 1983, it is permanently locked into the agreement and must pay FICA on all covered employees. If entity opted out of its Section 218 agreement before April 20, 1983, and its employees are covered by a public retirement system and are paying Medicare, as applicable. Political entity has continuously Officials erroneously think the entity been paying Social Security and must pay into a public pension system also into a public retirement system and into Social Security, believing the for all employees. requirement is "mandatory" for all public employers since July 1991. No Section 218 agreement exists. Public entity voluntarily elected to be double covered by entering into a Section 218 agreement while continuing to pay into a public pension plan. *At least 500 compliance scenarios exist related to state and local government FCA, Social Security and Medicare coverage, and public pension system issues