Under federal tax law, non-qualified deferred compensation benefits are subject to a special timing rule that requires the employer to withhold Social Security and Medicare taxes (FICA taxes) when such benefits vest. While the use of this special timing rule is required, many employers fail to properly follow this withholding obligation thereby exposing the employer to potential tax penalties and, in the worst case scenario, claims from participants for the value of lost benefits.
From a practical perspective, the application of the special timing rule is generally advantageous to the participant and the employer for a number of reasons, including:
- The Participant and employer are shielded from future FICA tax rate increases.
- Once FICA taxes are imposed on a participant’s vested non-qualified deferred compensation benefits, no additional FICA taxes are imposed on such benefits or the future earnings credited thereon (commonly referred to as the non-duplication rule).
- Most participants earn non-qualified deferred compensation benefits in working-years in which their earnings exceed the Social Security taxable wage base. Accordingly, the special timing rule potentially allows such benefits to escape Social Security tax when earned, and the non-duplication rule allows such benefits (including the earnings thereon) to escape Social Security tax when paid.
Unfortunately, if an employer fails to apply the special timing rule when the benefits vest, all future benefit distributions (including the earnings thereon) will be subject to FICA taxes on a “pay as you go” basis at the tax rates in effect at the time of distribution. This type of withholding failure was the subject of the participants’ claims in Davidson v. Henkel Corp., 2015 WL 74257 (E.D. Mi. 1/06/15), in which a federal district court concluded that an employer who failed to timely withhold FICA taxes on non-qualified deferred compensation benefits was liable to plan participants for the reduced value of their future benefit distributions. Ultimately, the parties entered into settlement agreement whereby the employer was obligated to make an additional payment of $3,500,000.
The Davidson case serves as an important reminder to employers of the compliance risks associated with non-qualified deferred compensation plan benefits. Accordingly, as 2017 comes to an end, employers should consider taking the following action items to ensure compliance with federal tax withholding obligations and to mitigate against the risk of future benefit claims by participants:
Inventory Existing Arrangements - It is important to recognize that non-qualified deferred compensation benefits can take various forms, including elective and mandatory deferred bonus arrangements, supplemental executive retirement plans (SERPs), retirement restoration plans, phantom stock arrangements and certain types of equity awards.
- Depending on the terms of the award, restricted stock units (RSUs) and/or performance units with delayed payment dates (or deferral features) can give rise to non-qualified deferred compensation.
- Additionally, time-based RSUs awards that provide for accelerated vesting upon retirement can also give rise to non-qualified deferred compensation. For example, if a participant has satisfied the conditions to retire as of the grant date, the IRS will treat the award as vested and subject to FICA taxes on the grant date notwithstanding the fact that the award settles in a future year.
- Employers must also be vigilant in identifying any new arrangements that may have been implemented during the year, including arrangements buried in employment agreements.
Review Existing Tax Withholding and Reporting Procedures - Errors in the administration of non-qualified deferred compensation plans commonly affect more than one participant thereby exacerbating the employer’s potential liability exposure. In order to mitigate this risk, employers should annually review their tax withholding and reporting procedures for each identified non-qualified deferred compensation arrangement.
Utilize the Rule of Administrative Convenience - For purposes of satisfying the special timing rule, the tax regulations also contain a rule of administrative convenience. Under this rule, an employer may treat non-qualified deferred compensation benefits that have become vested during the year as taxable and subject to withholding on any later date within the same calendar year. For example, if a participant’s deferred compensation benefits became vested on April 1st (or any other date in the current calendar year), the employer may take this vested benefit into account in the final payroll in December.
Correct Prior Year’s Errors - To the extent a failure to apply the special timing rule relates to one or more prior tax years, employers should consider taking corrective action for open tax years (i.e., three years from April 15th following the year in which the benefit vested).