Two recent cases illustrate one danger to employers in not drafting and administering retirement plans correctly: the danger that the employer might find itself on the hook to employees for the increased amount of taxes due based on the employer’s administration of the plan. First, in Cattau v. National Insurance Services of Wisconsin et. al. a Wisconsin state appellate court has revived a claim for damages based on “additional” taxes paid due to the negligent administration of a 403(b) retirement plan. The state circuit court had dismissed the complaint as involving a “tax situation” that required plaintiffs to file a claim for a tax refund with the IRS directly. The appellate court disagreed because it found that plaintiffs were not contesting that the tax was properly assessed in the facts of the situation; rather, their claim was that had defendants administered the plan properly, the taxes would not have been due in the first place.
In Cattau, the defendant school district offered a 403(b) plan to its teachers and administrators in connection with an early retirement program. The district represented to the plaintiffs that if they retired under the program they would receive 10 years of employer contributions under the plan, which would not be taxable for FICA purposes, and would be deferred for income tax purposes. The other defendants were parties administering the plan for the district, and they made similar representations. After plaintiffs retired, the IRS audited the 403(b) plan and found that the ten-year payment term exceeded the maximum payment term (which under 403(b) tax regulations is five tax years following the year in which the individual ceases to be an employee). The IRS and the school district settled this audit issue through an agreement by the district to pay $60,000 in federal taxes and penalties and the IRS to treat the first five and a half years of payments as compliant. This left the remaining four and a half years of payments as not compliant, and the IRS assessed income taxes and penalties against the retired plaintiffs for the payments made for those four and a half years.
The lawsuit claimed not that the taxes were not due under the actual administration of the plan, but instead that had the school district and the other parties structured and administered the plan as required for a 403(b) plan under federal law, those taxes would not have been due. In essence, the district’s negligence cost the plaintiffs taxes that would otherwise have been avoided. According to the court, “[a]t its core, the complaint alleges that the Retirees were erroneously promised that they could avoid FICA taxes and defer income taxes by use of a ten-year payment period in the 403(b) plan…We agree with the Retirees that this case is essentially no different than an action against an accountant who commits malpractice and whose client, as a result, incurs additional tax obligations and costs that the client would not have incurred had the accountant not been negligent in the performance of his or her duties.” The court sent the case back to the circuit court for further action.
The next case implicating employee tax obligations, Davidson v. Henkel, involved a “top hat” nonqualified deferred compensation plan. Eligible employees were allowed to defer compensation under the plan and FICA taxes were not due until retirement. The plaintiff retired in 2003 and began receiving payments. In 2011, the employer notified him that FICA was erroneously not taken at the time of his retirement and thus he would be subject to the “pay-as-you-go” application of FICA to all payments under the plan from 2008 and forward (all open tax years). Plaintiff then filed suit, which became a class action. Again, the issue in the case was not whether the FICA taxes were due, as the plaintiff did not dispute that once the issue was discovered, the FICA taxes were handled correctly based on the facts of the situation. Similar to Cattau, the essence of the claim in Davidson was that the failure to administer the plan correctly in the beginning caused the plaintiffs to pay more taxes than they otherwise would have.
Under federal tax law, FICA tax on wages deferred under nonqualified deferred compensation plans can be taken pursuant to a “Special Timing Rule,” upon the later of the performance of services to which the compensation relates or the vesting of the benefit under the plan. This rule generally results in less FICA tax than the “pay as you go” method, because once an amount is taken into income for FICA purposes, future interest or earnings are not subject to FICA. In addition, the Social Security portion of FICA is subject to an earnings cap, meaning that if deferred compensation is taken into account while the individual is still an employee, some of the earnings and/or deferred compensation could exceed the cap and thus not be subject to FICA. Because the employer did not apply the Special Timing Rule, payments made were subject to FICA when paid periodically during retirement. Thus all amounts in the plan were subject to FICA, moreover at a time after retirement when participants would be less likely to exceed the earnings cap.
The court in Davidson agreed that under plan terms it was the employer’s responsibility to withhold taxes when due. Because the employer did not withhold taxes at the earliest point it could have, the court agreed that the plaintiff’s tax liability was increased and granted summary judgment for the plaintiffs. Damages have yet to be decided.
The bottom line in both cases is that failure to properly operate retirement plans to ensure that employees receive the tax benefits either promised or expected under the terms of the plans can result in liability for employers.