A federal district court ruled earlier this year that an employer is liable to pay damages to employees participating in its nonqualified deferred compensation because it withheld Social Security and Medicare taxes at the time distributions were made, rather than earlier when the amounts vested. (John B. Davidson et al. v. Henkel Corp. et al.)
The case highlights the growing risk of costly employee litigation when employers make payroll tax errors that increase employees’ tax liability.
The significance of the FICA special timing rule. Under the special timing rule, nonqualified deferred compensation must be included in Social Security and Medicare wages at the time there is no longer a risk of forfeiture (at vesting). (IRC §3121(v)(2)(A); T.D. 8814.)
Under the non-duplication rule, when the special timing rule is used, future investment changes on nonqualified deferred compensation balances are not taken into account for FICA purposes. (IRC §3121(v)(2)(B).)
Conversely, in Treas. Reg. §31.3121(v)(2)-1(d)(1)(ii), it states that if an amount deferred for a period is not taken into account for FICA purposes at the time of vesting, the non-duplication rule of IRC §3121(v)(2)(B) and Treas. Reg. §31.3121(v)(2)-1(a)(2)(iii) will not apply and, instead, the benefits attributable to the amount deferred are included as wages subject to FICA taxes in accordance with the “general timing” rule (i.e., when the amounts are distributed to the employee).
Failure to use the special timing rule could result in significantly higher FICA taxes for the employee and the employer, depending on the facts.
Assume that at the time of vesting on March 1, 2015, an individual’s benefits in the nonqualified deferred compensation plan are $100,000 in a year when the employee earns a regular salary (in addition to the vesting) of $150,000. Further assume that on April 1, 2019, interest and dividends have increased the balance in the plan to $120,000.
If the employer applies the special timing rule within the statute of limitations (before April 15, 2019), the $20,000 increase in the account balance is exempt from Social Security and Medicare tax under the non-duplication rule. Additionally, because the employee’s annual earnings exceeded the Social Security wage base of $118,500 in 2015, the $100,000 vested benefit in the nonqualified deferred compensation plan is subject only to Medicare tax of 1.45% (and $50,000 is subject to the Additional Medicare Tax of 0.9%).
If the employer fails to apply the special timing rule before the statute expires, the general timing rule applies. Accordingly, if the benefits are distributed after April 15, 2019, the full $120,000 is subject to Medicare tax and Social Security tax up to the 2016 Social Security wage base.
In this example, the account balance increased over time. It can also be the case that the account balance loses value over time, and in that case, employees may actually reap a FICA tax benefit from the employer’s failure to use the special timing rule. For this reason, the extent of an employee’s damages can vary significantly depending on multiple facts, including the extent of investment gain in the employees’ account and their year-to-date earnings at the time of vesting compared with their earnings in the year of distribution.
The facts of the case. To supplement the company’s qualified retirement plan, it makes available to select highly compensated employees a “top hat” (nonqualified deferred compensation) plan into which qualified employees can elect to defer amounts from their base salaries or bonuses. Supplemental retirement benefits from this top hat plan are paid to participants at the time of retirement.
On September 15, 2011, the company sent top hat plan participants a letter informing them that “during recent compliance reviews performed by an independent consulting firm, it was determined that Social Security FICA payroll taxes associated with your nonqualified retirement benefits have not been properly withheld.” To remedy the error, the company informed participants that FICA tax would be owed on prior plan distributions retroactive to 2008 and on a pay-as-you-go basis for all future payments.
In 2011, the company deposited with the IRS the employee and employer FICA taxes owed for open years (2008–2011) with the intention of recovering the employee portion from future benefits paid to affected plan participants.
In 2012, a class action was brought against the company by 49 retirees alleging in part that they were subject to excessive FICA taxes because of the company’s negligence in failing to withhold FICA taxes in accordance with the special timing rule and that this failure resulted in reducing promised benefits.1
In 2013, the case was allowed to move forward on the premise that the nonqualified retirement plan was governed by IRC §502(a)(1)(B) of the Employee Retirement Income Security Act (ERISA).
The court’s ruling. In 2015, the court ruled that the company violated provisions of the plan and the plan’s purposes to reduce the tax burden of the compensation. Furthermore, the court stated that the plan agreement required the company to properly withhold the participants’ taxes when they were assessable or due. Rather than properly withholding the plaintiffs’ taxes as required by the plan, the company paid the taxes at the time of each benefit payment and acknowledged in a letter to plan participants that they had not properly withheld taxes. The court noted that this approach resulted in the participants’ losing the benefit of the non-duplication rule and owing more in FICA taxes than they would have owed had the company properly and timely paid taxes when they were due.
The court awarded summary judgment to the participants because the company failed to adhere to the purpose and terms of the plan, resulting in a reduced benefit to the plaintiffs.
Damages are still to be determined.
Ernst & Young LLP insights
Employers should carefully review when they are collecting and remitting FICA taxes for all of their nonqualified deferred compensation plans. If it is discovered that FICA taxes were not taken into account at the time of vesting, and the statute of limitations has not expired, the FICA wages and taxes should be reported and paid under the special timing rule using Form 941-X. Keep in mind that adjustments timely reported on Form 941-X carry no interest or penalty.
It is also important to carefully review the terms of nonqualified deferred compensation plans to ensure they are properly administered. Employees can bring costly suits against the employer for plan administration failures, including those that result in the erroneous timing or calculation of withholding taxes and reporting of wages on Form W-2.
“Businesses should carefully review their compliance with nonqualified qualified deferred compensation tax and reporting rules, taking into consideration employee litigation for FICA timing errors.”
— Deborah Spyker,
Executive Director, Employment Tax Services
1 The company argued that it correctly withheld FICA tax in accordance with the general timing rule and is not required to use the special timing rule. Although TD 8814 states that the special timing rule must be used, the court agreed with the company that use of the special timing rule was not mandatory and that the participants have not shown that the company failed to withhold taxes in accordance with federal law. Nonetheless, the court ruled that damages were owed participants because of the excess FICA taxes that were the result of losing the benefit of the non-duplication rule.