Back in 2013 I blogged about a class action lawsuit brought against Henkel Corporation for improper Social Security (FICA) tax withholding from nonqualified deferred compensation benefits. I am blogging now on an update to that case. To understand that case we need to review the taxation of nonqualified deferred compensation benefits. Nonqualified deferred compensation benefits are generally taxed for income tax purposes at the time the benefits are paid or made available to the participant. In contrast, those benefits are taxed for FICA tax purposes at the earlier of when the amounts are paid or when they vest. Thus, if benefits under the plan vest when a participant reaches retirement age, FICA taxation applies at that time to the present value of the entire benefit. If that taxation occurs in a year in which the participant has already been paid as wages an amount equal to the FICA wage base (e.g., $118,500 in 2015), then the employee is required to pay only the Medicare portion of the FICA tax (1.45% of the benefit), a relatively small amount.

The class action suit against Henkel Corporation was filed in 2012 by a former employee who claimed harm because his deferred compensation benefit vested on his retirement, but the employer failed to withhold and pay the FICA taxes at that time. Once the employer realized its error, the employer then withheld FICA taxes from each benefit payment as it was made and also paid the missed FICA taxes, reimbursing itself by reducing the deferred compensation payments to the employee. Withholding FICA taxes from each payment as it is made to the former employee will result in the former employee paying a higher amount of FICA taxes, but is required under the FICA rules for employers who fail to withhold the FICA taxes when the benefit vests. That additional FICA tax is the damage amount claimed by the former employee.

A year after the district court refused to dismiss the claims of the former employee, the court certified a class action, allowing the suit to proceed on a class basis. A few months later the court ruled that the employer was liable to the former employees for damages resulting from the withholding error. The court must still determine the amount of those damages – and attorneys’ fees incurred by the former employees in prosecuting the lawsuit.

As I mentioned in my earlier blog post, FICA tax withholding from a qualified deferred compensation plan can be tricky. Employers should take care to follow the rules. Failure to do so can result in liability to affected employees.