The final chapter of an unusual FICA tax saga recently was ordered in the form of a settlement between Henkel Corporation and a group of its retirees. Although framed as a case involving retiree benefits, the case’s application is not that narrow.
Henkel sponsored a nonqualified deferred compensation (“NQDC”) plan that provided monthly benefits after retirement. The case involved the timing of the payment of FICA taxes due on the benefit. Background on that issue is in order: Employee wages usually are FICA taxable when they’re actually paid (under the “general timing rule”). Under the “special timing rule” for NQDC, an amount deferred under a NQDC plan is taxable for FICA on the later of: (a) the date on which the services creating the right to that amount are performed; or (b) the date on which the right to the deferred amount is no longer subject to a substantial risk of forfeiture, i.e., the vesting date. Under the special timing rule, the full present value of a benefit is taxable, regardless of whether the benefit is paid later. This rule actually can be beneficial to an employee because the date of vesting - which triggers the FICA tax - often occurs when the employee still is working and has regular wages that exceed the FICA wage base. Including the amount vested under the special timing rule for FICA usually results only in payment of the “hospital insurance” portion of FICA - 1.45% – and not the “social security” portion of FICA - 6.2%. Once the present value of the benefit is taxed under the special timing rule, then FICA tax never is due on the future payment of the benefit - by the employee or the employer.
If FICA tax isn’t paid on the present value of the NQDC benefit when the benefit is vested under the special timing rule, then each benefit payment every year is subject to FICA tax - the full 7.65% (up to the wage base) – as wages under the general timing rule. Think of it as a penalty because the special timing rule wasn’t followed. It’s a much more expensive “do over.”
In the Henkel case, the company had a NQDC plan but it made a mistake with the FICA tax and did not tax the present value of the benefit under the special timing rule. Henkel then notified retirees that each future payment would be reduced for FICA taxes, i.e., under the general timing rule. It also paid back FICA taxes due by employees and deducted that amount over several monthly payments. A retiree who had been receiving payments for eight years before he was notified of the tax reductions objected and sued Henkel, claiming that Henkel wasn’t paying his full benefit.
Earlier in 2015, the judge reviewed the NQDC Plan and concluded that the Plan required Henkel to withhold FICA taxes when they first were due - under the special timing rule - and couldn’t merely collect (more) FICA tax as each payment was made over time. The way Henkel botched the FICA tax rules meant that retirees were ending up with less money in their pockets. After summary judgment in favor of the retirees (the case expanded to include all retirees), the parties ultimately settled in the waning days of 2015 for close to $3.5 million. That’s quite a sting over a FICA tax issue.
Henkel lessons learned and applied: Although the IRS allows the FICA “do over” if the special timing rule isn’t followed with a NQDC plan, this usually isn’t the proper way to administer the plan because plan terms almost always require proper tax withholding. Employers should review their procedures and make sure they are properly handling the FICA tax. They also may want to revise their NQDC plan documents if possible to have more flexibility on the tax issue.
But the Henkel lesson doesn’t apply only to a NQDC plan. Many employers annual incentive (bonus) plans with a specific payment formula permit payment of the bonus if the employee is employed at year end and do not require the employee to be employed on the date of payment (usually 2-3 months later). The FICA special timing rule applies to the bonus payment because it is “vested” at the end of the year (assuming that the employer cannot unilaterally eliminate the bonus). If the employee’s pay was above the FICA wage base for the bonus year at issue, and he or she terminates employment before the date of payment, that employee has had to pay the full 7.65% FICA tax, when if it had been taxed for FICA in the prior year only 1.45% tax would be due. The former employee will have the same claim as the retiree in the Henkel case - improper reduction of the bonus.
Keep in mind that FICA savings to the employee also is FICA savings to the employer. Over time, the savings to the employer can add up from applying the special FICA timing rule.