Most employers (or their payroll systems) properly calculate, withhold and pay the federal employment taxes that are due on the current compensation that they pay their employees each year. However, employers are often less familiar with the rules for calculating and paying FICA taxes on “nonqualified” deferred compensation (i.e., amounts that an employee attains a legally binding right to in one year, but which are not payable to the employee until a future year).
Compensation that is considered “wages” under Code Section 3121 is generally subject to FICA tax when the compensation is “paid or otherwise made available” to the employee. Under Code Section 3121(v), however, amounts deferred under a nonqualified plan are subject to both a “special timing” rule and a “non-duplication” rule. In the recent case of Davidson v. Henkel, an employer that failed to heed these special rules for nonqualified deferred compensation found itself facing the prospect of bearing substantial additional tax liability.
Under the “special timing” rule, amounts deferred under a nonqualified plan are treated as “wages” for purposes of FICA taxes as of the later of:
(i) the date on which the services creating the right to that amount are performed; or
(ii) the date on which the employee’s right to the deferred compensation is no longer subject to a “substantial risk of forfeiture.”
Therefore, in many cases, amounts deferred under a nonqualified plan are considered “wages” for FICA purposes long before they are actually “paid or made available” to the employee. If the nonqualified plan is an account-type plan (similar to a qualified deferred contribution plan), the compensation may be treated as wages as early as the year in which the amount is credited to the participant’s hypothetical “account.” If the arrangement is more like a defined benefit plan (promising a specific benefit payable at a later date), the amounts may be treated as wages as soon as the amount is reasonably ascertainable.
Under the “non-duplication” rule, once an amount is taken into account as wages for FICA purposes, neither that amount, nor any subsequent earnings or income attributable to that amount, is treated as “wages” for purposes of FICA tax in any future year.
The other rule that comes into play (which is not specific to nonqualified deferred compensation) is one that limits the Social Security (or OASDI) portion of the FICA tax (but not the Medicare portion of the tax) to the “taxable wage base” (which is $117,000 for 2014). If amounts deferred under a nonqualified plan are taken into account as “wages” for FICA tax purposes in a year that the employee has other income subject to FICA tax, some or all of the amounts deferred under the nonqualified plan will not be subject to the 6.2% OASDI portion of the 7.65% FICA tax. Similarly, if amounts deferred under a nonqualified plan over several years all become “vested” (i.e., no longer subject to forfeiture) in a single year, only the first $117,000 of the individual’s total FICA wages (counting both regular compensation and deferred compensation) will be subject to the OASDI portion of the tax in the year of vesting.
For example, if in 2014 an employee agrees to defer $10,000 of his compensation until January 1, 2020, and if his right to such compensation is not subject to a vesting schedule or any other risk of forfeiture, the amount deferred (i.e., the $10,000) is treated as “wages” for FICA tax purposes in 2014 (the year he performed the services for which the compensation is paid). If that amount is credited with earnings each year, and grows to $16,000 by the time it is paid, under the non-duplication rule, the employee pays no FICA tax when the $16,000 is distributed in 2020 (meaning the employee never pays FICA on the $6,000 of earnings).
By contrast, if in 2014 the employee and employer agree that $10,000 of his wages will be “deferred” until January 1, 2020, but the employee’s right to such compensation is subject to forfeiture if the employee terminates employment before January 30, 2017, the employee will not have any “wages” for FICA purposes until 2017, the first year that his right to the deferred compensation is no longer subject to a substantial risk of forfeiture. In 2017, if the $10,000 has grown to $14,000, he will have FICA “wages” equal to $14,000 (i.e., the $10,000 deferred, plus any earnings on that amount prior to 2017).
In either case, once the amount deferred (and any earnings that accrue before the deferred amount is no longer subject to forfeiture) is properly taken into account as FICA wages, neither the amount taken into account nor any subsequent earnings will be subject to FICA tax in any future year. However, if the amounts deferred (including any pre-vesting earnings) are not properly “taken into account” under the special timing rule, then the employee loses the benefit of the non-duplication rule, and the entire amount paid to the employee (i.e., both the amounts deferred and the earnings on those amounts) will be subject to FICA tax at the time of payment.
In Davidson v. Henkel (Case No. 12-cv-14102, filed on July 24, 2013, in the U.S. District Court for the Eastern District of Michigan, Southern Division), the plaintiff (John Davidson) was a participant in a “top-hat” nonqualified deferred compensation plan (a plan designed to supplement the benefits payable under the defendant company’s tax-qualified pension plan for a select group of management or highly compensated employees). When he retired in 2003, he was entitled to a monthly supplemental pension payment for life.
Under the special timing rule, the present value of his future supplemental pension payments should have been taken into account as “wages” for FICA purposes in 2003 (when the value of his benefit was “reasonably ascertainable”), and he should only have paid Social Security tax on the amount that (when combined with his regular pay for 2003) did not exceed the taxable wage base for that year. However, the company failed to pay or withhold any FICA tax in 2003. The company also failed to withhold FICA tax from each year’s supplemental pension payments.
In 2011, after an internal compliance review, the company discovered that FICA taxes had never been paid on this deferred compensation. In September of that year, the company informed Mr. Davidson that, because FICA taxes were not properly paid in 2003, each pension payment thereafter was subject to FICA. Thus, Mr. Davidson was told that, not only would all future supplemental pension payments be subject to FICA taxes, but that additional amounts would be withheld from his pension payments (for approximately 12 to 18 months) to “catch-up” on the FICA taxes that were not properly paid for the last three years (the “open” tax years between 2008 and 2011). Mr. Davidson objected to this approach and filed a lawsuit against the company.
The District Court, in response to the company’s motion to dismiss, held that some of Mr. Davidson’s “state-law” claims for negligence were preempted by ERISA, and those claims were dismissed. However, the court found that Mr. Davidson had in fact stated a valid claim under Section 502(a) of ERISA “to recover benefits due to him under the terms of his plan, to enforce his rights under the terms of the plan, or to clarify his rights to future benefits under the terms of the plan.” Even though top-hat plans are exempt from much of ERISA’s regulatory scheme (including the vesting and funding rules and the fiduciary rules), they are not exempt from the reporting and disclosure provisions or the administration and enforcement provisions of ERISA. Therefore, the court found that the defendant company could be liable under ERISA because the Plan gave the company discretionary control over a participant’s funds and their tax treatment, and the Plan authorized and obligated the company to properly manage the tax withholding from a participant’s benefits. Thus, the court refused to dismiss that claim (or a related claim for equitable estoppel, which was based on certain representations made by the Company regarding the amount of Mr. Davidson’s supplemental pension benefit).
This case serves as an important reminder that FICA taxes on nonqualified deferred compensation are subject to special rules, and that failure to follow those rules may have significant adverse consequences for both the employer paying, and the employee receiving, such deferred compensation. If you have any questions about the FICA tax treatment of amounts deferred under a nonqualified deferred compensation plan, please contact any of the attorneys in the Employee Benefits Practice Group at Spencer Fane.