Under a special timing rule contained in the federal tax regulations, benefits earned under a non-qualified deferred compensation plan are generally subject to Social Security and Medicare employment taxes (FICA taxes) as of the date the services are performed or, if later, the date the benefits vest. While the use of the special timing rule is required, many employers fail to properly apply this rule. This failure can expose employers to various tax penalties and, as one recent case illustrates, subject employers to claims from participants for the value of lost benefits.
The application of the special timing rule is generally advantageous to the participant and the employer for a number of reasons, including:
- The Participant and employer are shielded from future FICA tax rate increases.
- Once FICA taxes are imposed on a participant’s vested non-qualified deferred compensation benefits, no additional FICA taxes are imposed on such benefits or the future earnings credited thereon (commonly referred to as the non-duplication rule).
- Most participants earn non-qualified deferred compensation benefits in working-years in which their earnings exceed the Social Security taxable wage base. Accordingly, the special timing rule potentially allows such benefits to escape Social Security tax when earned, and the non-duplication rule allows such benefits (including the earnings thereon) to escape Social Security tax when paid.
It is important to recognize, however, that if an employer fails to properly apply the special timing rule, the non-duplication rule will not apply and all future benefit distributions (including the earnings thereon) will be subject to FICA taxes at the rates in effect at such time. This failure was the subject of participants' claims in Davidson v. Henkel Corp., 2015 WL 74257 (E.D. Mi. 1/06/15), in which a federal district court ruled that an employer who failed to timely withhold FICA taxes on non-qualified deferred compensation benefits was liable to plan participants for the reduced value of their future benefit distributions. The employer’s failure resulted in the participant's benefits being subjected to FICA taxes on a "pay as you go" basis (i.e., all future benefit distributions, including the earnings thereon, were subject to FICA taxes). Accordingly, the participants brought suit against the employer and the plan asserting that their plan benefits were wrongfully reduced due to the fact that they were required to pay FICA taxes on the full value of each benefit payment.
Employer Action Items to Enhance Compliance and Reduce Risk for Benefit Claims
The Davidson case serves as an important reminder for employers to review their existing tax reporting and withholding obligations for non-qualified deferred compensation plan benefits. Accordingly, as 2015 comes to an end, employers should consider the following action items:
Inventory Existing Arrangements - In applying the special timing rule, it is important to recognize that non-qualified deferred compensation benefits can be provided in many forms, including, among others, account balance plans (e.g., elective and mandatory deferred bonus arrangements), non-account balance plans (e.g., Supplemental Executive Retirement Plans (SERPs)) and phantom stock arrangements.
- Certain types of equity awards can also fall within the definition of non-qualified deferred compensation depending on their terms. For example, restricted stock units (RSUs) with delayed payment dates (or deferral features) and time-based RSUs awards that provide for accelerated vesting upon retirement can give rise to non-qualified deferred compensation. With respect to the latter situation, the IRS will treat the award as vested and subject to FICA taxes on the grant date if the participant has satisfied the conditions to retire as of such date or, alternatively, on the date the participant becomes retirement-eligible during the vesting period.
- Employers must also be vigilant to address any new arrangement that may be implemented in the future.
Review Existing Tax Withholding and Reporting Procedures - Errors in the administration of non-qualified deferred compensation plans commonly affect more than one participant, and therefore, the employer’s liability exposure can increase materially depending on the number of participants affected and the level of benefits provided. In order to mitigate this exposure, employers should annually review their tax withholding and reporting procedures for each identified non-qualified deferred compensation arrangement.
It’s Not Too Late - For purposes of satisfying the employer's FICA withholding obligations under the special timing rule, the tax regulations also contain a rule of administrative convenience. Under this rule, an employer may treat non-qualified deferred compensation benefits that have become vested during the year as taxable and subject to withholding on any later date within the same calendar year. For example, if a participant’s deferred compensation benefits became vested on April 1st (or any other date in the current calendar year), the employer may take this vested benefit into account in the final payroll in December. Additionally, to the extent a failure to apply the special timing rule relates to one or more prior tax years, employers should consider taking corrective action for open tax years (i.e., three years from April 15th following the year the benefit vested).