A federal district court recently ruled that an employer who failed to timely withhold Social Security and Medicare taxes (FICA taxes) on nonqualified deferred compensation (NQDC) in accordance with the special timing rule was liable to plan participants for the reduced value of their future benefit distributions. Davidson v. Henkel Corp., 2015 WL 74257 (E.D. Mi. 1/06/15).
Under federal tax law, NQDC is subject to a special timing rule, which generally requires that Social Security and Medicare taxes (FICA taxes) be withheld when the NQDC vests. If FICA taxes are withheld at that time, no additional FICA taxes are imposed on such benefits or the future earnings credited thereon (commonly referred to as the non-duplication rule). If, however, an employer fails to properly apply the special timing rule to vested NQDC, the entire amount of all future benefit distributions will be subject to FICA taxes at the FICA rates in effect in the year of distribution. For a more complete discussion on the special timing rule, see “Year-End Employment Tax Update – Complying With the Special Timing Rule for Nonqualified Deferred Compensation (12/5/2014).”1
In Davidson, a class action, the named plaintiff was a former employee and participant (Participant) in the employer’s NQDC supplemental restoration retirement plan, a top-hat plan under ERISA (Plan). In 2003, the Participant retired and commenced receiving monthly benefit distributions from the Plan. Subsequently, in 2011, the employer informed the Participant that it had not followed the special timing rule with respect to benefits earned under the Plan and that all future benefit distributions to the Participant would be subject to FICA taxes.
Had the employer timely applied the special timing rule when the participant retired in 2003, the Participant would have owed Medicare taxes (1.45%) on the present value of all future benefit distributions from the Plan. The Participant, however, would not have owed any additional Social Security taxes (6.2%), as his wages for 2003 had already exceeded the Social Security wage limit. Additionally, under the non-duplication rule, the Participant would not be liable for FICA taxes on future benefit distributions from the Plan in any subsequent year.
Based on these facts, the Court agreed that the employer’s failure to timely apply the special timing rule reduced the Participant’s NQDC benefits under the Plan. Interestingly, the court’s decision was not based on a finding that the employer was legally obligated to apply the special timing rule.2 Rather, the court determined that the following Plan provision required the employer to properly withhold the Participant’s FICA taxes as and when they were due under the special timing rule:
Taxes. For each Plan Year in which a Deferral is being withheld or a Match is credited to a Participant’s Account, the company shall ratably withhold from that portion of the Participant’s compensation that is not being deferred the Participant's share of all applicable Federal, state or local taxes. If necessary, the Committee may reduce a Participant’s Deferral in order to comply with this Section.
Based on this provision, the court reasoned that the employer was contractually obligated to timely withhold FICA taxes under the special timing rule when they became due in 2003. Accordingly, the court found that the employer’s actions caused the Participant to lose the benefit of the nonduplication rule and thereby owe more FICA taxes than the Participant would have otherwise owed had the employer timely withheld FICA taxes when they were due.
Employer Action Items to Enhance Compliance and Reduce Risk for Benefit Claims
Similar to Davidson, errors in the administration of NQDC plans commonly affect more than one participant. Therefore, the employer’s liability exposure can increase materially depending on the number of participants affected and the level of benefits provided. Nonetheless, by pro-actively exercising a reasonable amount of due diligence, employers can mitigate their exposure by undertaking a few prudent actions:
Review Existing Tax Withholding and Reporting Procedures - Without a doubt, the most important action item an employer can undertake is to annually review its compliance with the tax withholding and reporting obligations for NQDC benefits, including the special timing rule.
Review Plan’s Terms to Determine if Revisions are Advisable - In light of the Davidson decision, employers who sponsor NQDC plans should review the provisions of existing arrangements to determine whether any revisions are necessary or advisable.
Tax Withholding Provisions - While most NQDC plans commonly grant the employer the right to withhold any applicable taxes, it may be advisable to modify overly broad language that contractually obligates the employer to withhold taxes at the earliest permissible date.
Section 409A Administrative Provisions – Recognizing that significant additional taxes can be imposed on participants in connection with a violation of Section 409A, participants may attempt to apply the logic of the Davidson case to recover for reduced benefits in connection with a violation of Section 409A. Accordingly, employers should consider adding a provision to their NQDC plans (or modify existing provisions) that expressly relieves the employer and its affiliates from any and all tax liability and/or reduction in benefits that could arise or occur in connection with a violation of Section 409A.
On a final note, it is important to remember that a right to NQDC can be created under a variety of different arrangements (e.g., employment agreements, restricted share unit awards (RSUs), performance share unit awards (PSUs), phantom stock arrangements, change of control severance agreements, etc.). Accordingly, employers must be vigilant and address not only each current NQDC arrangement, but also any new NQDC arrangement that may be implemented in the future.
2While Treas. Reg. § 31.3121(v)(2)-1(a)(2)(ii)(A) provides that an employer is required to take into account wages under the special timing rule, the regulations also provide alternative reporting and withholding procedures to be followed when an employer fails to follow the special timing rule. Accordingly, in light of the fact that the regulations provide alternative procedures, the Court determined that the application of the special timing rule is not mandatory.