The term "top hat plan" generally refers to an unfunded plan maintained by an employer for the primary purpose of providing deferred compensation for a select group of management or highly compensated employees. If a top hat plan is properly structured, and the employer is a taxable entity, employees covered by the plan are not taxed for income tax purposes until plan benefits are distributed. The rules for FICA taxation under a top hat plan differ from those for income taxation. A recent case from the Eastern District of Michigan demonstrates that employers ignore this difference at their peril.
Top hat plans are exempt from most requirements under the Employee Retirement Income Security Act ("ERISA"). To avoid filing requirements under ERISA, a top hat plan must file a one-time notice with the Department of Labor. As discussed below, the Department has issued proposed regulations under which this notice can be filed electronically.
Employer Liable for Failure to Use Special Timing Rule for FICA Taxes Under its Deferred Compensation Plan
In general, FICA taxes on nonqualified deferred compensation must be reported and withheld by the employer at the time the employee's right to such compensation becomes vested, even though the employee may not receive the compensation until many years later. Although this rule accelerates the time at which FICA wages must be recognized, it generally results in employees paying lower FICA taxes than if the compensation were subject to FICA taxation at the time the compensation is paid. This is because most or all of the deferred compensation, when added to the employee's other wages for the year of FICA inclusion, typically exceeds the Social Security wage base. If the employer fails to recognize and withhold FICA wages on deferred compensation at the appropriate time, the compensation is generally subject to FICA at the time paid, which often results in substantially higher FICA taxes.
In Davidson v. Henkel, which was decided in January of this year, a federal district court in Michigan found Henkel Corporation liable for damages caused to plan participants due to its failure to withhold and pay FICA taxes at the appropriate time (i.e., at the time of vesting rather than the time of payment) under its top hat plan. Henkel's failure resulted in affected participants paying more in FICA taxes than they would have had to pay if Henkel had reported the FICA wages and withheld and paid applicable taxes at the correct time. The court found that the plan document imposed a duty on Henkel to report and withhold FICA taxes correctly and that Henkel was liable to the affected participants for its failure to fulfill this duty.
The decision in Davidson raises a number of interesting issues. For example, it would appear that a participant who is subject to additional taxes under Code Section 409A due to an employer's error could make a claim very similar to that asserted in Davidson. Because the court's decision in Davidson is based on its interpretation of the plan document, an employer might avoid a similar result by including plan language that expressly denies any employer responsibility for the tax consequences of the plan. Of course, the best result for both the employer and the employee is to administer the plan so that it has the most favorable tax consequences for the employee.
E-Filing of Top Hat Statements
Last fall, the Department of Labor proposed regulations that would require electronic submission of the one-page filing by which the sponsors of top hat plans can avoid annual filing requirements under ERISA. Until the regulations are approved, both electronic and paper filing are acceptable. The proposed regulations do not change the required content of the statements. The new filing system is available at http://www.dol.gov/ebsa/efiletophatplanfilinginstructions.html.