Employers should consider reviewing their procedures for withholding and paying FICA tax in light of the recent district court decision in Davidson v. Henkel Corp. The court concluded that the employer was liable to participants in a nonqualified deferred compensation plan for failing to withhold FICA tax in a manner that would have decreased their overall tax liability. The additional FICA tax reduced the participants’ benefits under the plan, and the court concluded that this result was inconsistent with the plan’s design and purpose.
Compensation generally is subject to FICA tax when it is paid. However, a special timing rule requires an employer to include an amount deferred under a nonqualified deferred compensation plan in FICA wages when the employee has performed the related services and the employee’s right to the amount vests. If the plan is not an account balance plan, the employer may wait until the amount deferred becomes “reasonably ascertainable” before including it in FICA wages. In a nonqualified plan with a defined benefit formula, the present value of the employee’s entire benefit often is included in FICA wages under this special timing rule when the employee retires, even though the benefit is paid out in installments over many years after the employee’s retirement.
Once an amount deferred is subject to FICA tax under the special timing rule, neither the amount deferred nor any future earnings are subject to FICA tax again. If the employer fails to withhold and pay FICA tax when the tax is due under the special timing rule, however, the amount deferred and earnings are subject to FICA tax as they are paid.
An employee’s total FICA tax often is substantially less if the employer follows the special timing rule. Because the Social Security component of FICA tax is imposed on wages only up to the Social Security wage base each year, the total amount deferred under a nonqualified plan with a defined benefit formula generally is subject to the Social Security component of FICA tax only once, and only in an amount up to the Social Security wage base at the time of the employee’s retirement. In contrast, if the employer does not follow the special timing rule, payments to the employee are subject to the Social Security component of FICA tax each year to the extent of the Social Security wage base when each payment is made.
This was the situation at issue in Davidson v. Henkel Corp. Henkel Corporation failed to withhold and pay FICA tax under the special timing rule, resulting in increased FICA tax liability for some of its retirees receiving benefits under a nonqualified deferred compensation plan. Because Henkel’s nonqualified deferred compensation plan was a “top hat” plan subject to ERISA’s civil enforcement provisions, the retirees were able to bring a class action under ERISA to recover the benefits they lost due to their increased FICA tax liability. The court found that even though use of the special timing rule was not mandatory, the terms of Henkel’s nonqualified deferred compensation plan required Henkel to withhold FICA tax under the special timing rule. Based on this finding, the court granted summary judgment for the retirees.
To avoid incurring similar liability, employers should confirm that they properly withhold and pay FICA tax on amounts deferred under nonqualified deferred compensation plans using the special timing rule. Additionally, employers should review their nonqualified deferred compensation plan documents to make certain that they clearly state (1) that participants are responsible for ensuring that all taxes on their benefits are paid, even if the employer has a withholding obligation, and (2) that the employer has no obligation to secure the most favorable tax treatment for participants.