A federal district court in Michigan recently upheld ERISA benefit claims by participants in a deferred compensation plan arising from the employer’s failure to timely calculate and withhold FICA tax on plan benefits. Davidson v. Henkel Corp.,No. 12-cv-14103, 2015 U.S. Dist. LEXIS 722 (E.D. Mich. Jan. 6, 2015). This decision may have implications for other types of failures in administering the tax rules applicable to such plans.

FICA Tax Rules for Deferred Compensation

Section 3121(v) of the Internal Revenue Code (Code) imposes a “special timing rule” for when FICA tax must be paid on nonqualified deferred compensation plan benefits. Under the rule, such benefits are treated as “wages” subject to FICA tax withholding as of the later of:

  • when the services giving rise to the deferred compensation benefit were performed; or
  • when the deferred compensation benefit is no longer subject to a substantial risk of forfeiture (i.e., when the employee’s right to the deferred compensation is vested).

For supplemental executive retirement plans and other defined benefit-type nonqualified deferred compensation plans, the special timing rule generally requires that FICA taxes be computed based on the present value of the benefit payable under the plan, determined as of the date on which the benefit is “reasonably ascertainable.” This typically occurs when the amount, form and commencement date of benefit payments are known, and the only actuarial factors or other assumptions needed to determine the amount of the participant’s benefit are interest and mortality.

If the special timing rule is properly applied, a participant’s nonqualified deferred compensation plan benefit will not be subject to FICA tax when it is later paid to him or her. The rule frequently results in a participant paying lower overall FICA taxes than if his or her benefits were subject to FICA tax on an “as-paid” basis, because the Social Security portion of the FICA tax (6.2 percent for the employee) applies to amounts up to a specified wage base ($118,500 for 2015), while the Medicare portion of FICA (1.45 percent for the employee) is not subject to a wage base and the Medicare surtax (0.9% paid only by the employee) applies to wages over $200,000 for single taxpayers and $250,000 for married taxpayers filing jointly. When the special timing rule is applied to a plan participant who is still working, he or she will often have earned other amounts during the year that are wages subject to FICA, so that none or only a portion of the present value of his deferred compensation plan benefit may be subject to the 6.2 percent rate.

Facts in Davidson

John Davidson’s employer maintained a nonqualified supplemental retirement plan for certain of its executives. Davidson retired in 2003 and began receiving monthly retirement payments from the plan.

In 2011, the employer sent a letter to Davidson and other participants informing them that FICA tax had not been properly withheld from their plan benefits in accordance with the special timing rule, nor had any FICA tax been withheld from the payments they had received from the plan. The letter indicated that this error would be corrected by withholding FICA tax for benefit payments they had received since 2008 (the earliest tax year for which the statute of limitations had not yet expired at that time). Such FICA tax, according to the letter, would be collected by reducing future benefit payments for a 12-to-18-month period and payments thereafter would be subject to FICA tax withholding as those payments were made.

Davidson brought a class-action suit against the employer, the plan and its administrator under ERISA Section 502(a) seeking to recover the benefits they lost as a result of the employer’s failure to properly withhold FICA tax on the present value of their benefits under the special timing rule. The district court granted the plaintiffs’ motion for partial summary judgment but did not decide what damages were appropriate.

The Davidson Court’s Reasoning

The court rejected the employer’s defense that Davidson was requesting a “tax refund in disguise.” It held instead that his lawsuit was for recovery of a reduction in plan benefits that occurred as a result of the employer’s failure to properly apply FICA tax rules, and that Davidson was not challenging whether such benefits were subject to FICA tax or the manner in which FICA taxes should have been collected following the employer’s failure to properly apply the special timing rule.

The court rejected Davidson’s argument that the employer was required by law to apply the special timing rule. However, it agreed with Davidson that the employer’s failure to apply the rule violated the terms of the plan. Focusing on a plan provision that required the employer to “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,” the court concluded that the plan was specifically designed to apply the special timing rule. The employer’s admitted failure to do so violated the design and purpose of the plan, therefore resulting in Davidson and the other class members receiving less benefits than they were entitled under the plan.

Lessons

The Davidson case raises the specter that any failure to properly apply tax rules to a nonqualified deferred compensation plan that then results in additional tax liability to a participant may expose the employer to an ERISA benefit claim. For example, similar to the manner in which Davidson argued that the plan’s terms required the FICA special timing rule to be applied, a participant might argue that other types of tax liabilities he or she incurred as a result of the employer’s failure to operate the plan in accordance with applicable tax laws impermissibly reduced the benefits he or she was entitled to receive under the plan. Of particular concern are the complex requirements imposed under Code Section 409A which, if violated, can result in significant penalties to affected employees, such as immediate taxation of their plan benefits, a 20-percent additional tax and a “premium interest tax.”

Under the district court’s reasoning in Davidson, the success of such a claim will depend upon the presence of plan provisions that impose (or could be read to impose) requirements as to how the plan will be administered. While the tax-withholding provision of the plan at issue in Davidson is not customary, many nonqualified deferred compensation plans include provisions explicitly addressing compliance with Section 409A.

The Davidson case is a reminder that employers should review their FICA tax-withholding procedures to confirm that those procedures comply with applicable requirements. If FICA withholding is handled by a third-party administrator, the employer should review the administrator’s processes and consider what contractual protections the employer may have in place if the administrator fails to follow those procedures. Employers may also want to review the terms of their plan documents to assess potential risk for Davidson-like claims and consider whether modifications may be appropriate.