I first blogged on Davidson v. Henkel Corporation back in 2013, under the title: Is This the Template for Future Lawsuits Against Employers by Executives Hit with a 409A Penalty? Now the federal district court in the Eastern District of Michigan has ruled against the company in a published decision that may set a bad precedent for employers. In Henkel, current and former employees who were participants in the employer’s non-qualified deferred compensation plan filed a class action lawsuit against the employer and the plan when the employer began withholding required FICA tax payments from their plan distributions.
As most readers know, contributions (employer and employee) to, and benefits accrued under, a non-qualified plan are subject to FICA taxes (both capped social security taxes and uncapped Medicare taxes) when vested (the “special timing rule”). The employer and the employee each pay a portion of the FICA taxes due.* This can result in a mismatch, as taxes are due but the employee receives no compensation to pay them. However, as a practical matter, this rule benefits employees, as all non-qualified (or “Top Hat”) plan participants earn in excess of the FICA wage base ($118,500 in 2015) and, thus, technically pay no social security taxes on non-qualified plan benefits or contributions. If FICA tax is withheld when non-qualified plan benefits or contributions become vested, then no FICA tax is due when the benefits are eventual paid (the “non-duplication rule”).
That is what went wrong in Henkel. The employer maintained a non-qualified plan that allowed employees to make pre-tax contributions and provided for employer matching contributions. Employer contributions vested over time during the employees’ service. However, when contributions were made and became vested during employment, Henkel did not withhold FICA taxes according to the special timing rule. Consequently, when the plan began making benefit payments, FICA taxes were due. Since many of the benefit recipients had no other source of significant income at the time, their taxable earnings were below the FICA wage base, and part or all of their plan benefit was subject to FICA.
Importantly, Henkel violated no law or regulation by waiting until distribution to withhold FICA taxes. FICA tax regulations provide the special timing rule and the non-duplication rule, but do not require that employers use them, which the court acknowledged. What lost the case for Henkel was the following language in the plan:
"Taxes. For each Plan Year in which a Deferral is being withheld or a Match is credited to a Participant’s Account, the company shall 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. If necessary, the Committee may reduce a Participant’s Deferral in order to comply with this Section.”
The court concluded that the plan required the employer to withhold FICA tax at the time an employee deferral contribution was withheld or an employer matching was credited to an employee’s account. If Henkel had done so - following the special timing rule - no FICA taxes would have been due on payments from the plan because of the non-duplication rule and employees/participants would have enjoyed more favorable tax consequences. The court granted summary judgment to plaintiffs on their claim that the employer "committed a FICA error in violation of the Plan."
As I observed back in 2013, future plaintiffs could argue that Henkel creates an obligation on employers to cause the best possible tax consequences to plan participants and, thus, could be template for future lawsuits against employers by executives hit with 409A penalties. However, most non-qualified plans and other compensation agreements (none that I have ever drafted) contain the language that doomed Henkel and its plan. The lessons for employers from Henkel are (1) to have plans and agreements drafted by experts and (2) follow best practices in plan administration (e.g., advantageous withhold).