A recent decision by a Michigan federal trial court serves as a warning to employers that their failure to shield participants in nonqualified deferred compensation plans from adverse tax consequences may subject the employers to unanticipated liability. Although this decision (in Davidson v. Henkel Corporation) involved FICA taxation, the court’s reasoning would seem to apply equally to the 20% penalty tax and interest assessments triggered by a violation of Code Section 409A.
We summarized the facts underlying the Henkel dispute in our January 2014 article, where we addressed the same court’s denial of an employer’s motion to dismiss a class-action lawsuit filed on behalf of 49 participants in the employer’s nonqualified deferred compensation plan. In administering that plan, the employer had failed to apply a “special timing rule” found in IRS regulations. Under that rule, nonqualified deferred compensation becomes subject to FICA taxation (both Social Security and Medicare) as of the later of the date the compensation vests or when the related services are performed – even if this is well before the designated distribution date. A “non-duplication rule” then insulates that deferred compensation – and all subsequent earnings – from FICA taxation when it is later paid to the participant. And because active participants in nonqualified plans typically receive salaries that exceed the Social Security taxable wage base, the interaction of these two rules often allows their nonqualified deferrals (and earnings) to entirely escape the 6.2% Social Security portion of FICA.
In this case, however, the employer had failed to subject participants’ deferrals and matching contributions to FICA taxation as they were earned and vested (under the special timing rule). As a result, the IRS required the employer to withhold FICA taxes from each of the monthly benefits as they were paid to retired participants. But because those participants were no longer receiving any salary, their deferred compensation benefits were all below the Social Security wage base. As a result, they were required to pay Social Security taxes on amounts that otherwise would have escaped such taxation. The affected participants filed suit against their former employer, alleging that – by needlessly subjecting their benefits to Social Security taxation – the employer’s actions had the effect of reducing their benefits under the plan.
Rejecting various legal defenses asserted by the employer, the court granted the participants’ motion for summary judgment. Although much of the court’s decision simply tracks its earlier decision denying the employer’s motion to dismiss the participants’ lawsuit (as outlined in our January 2014 article), the reasoning in this latest decision could have even broader implications for sponsors of nonqualified deferred compensation plans.
The court actually agreed with the employer that the IRS regulations did not require it to take advantage of the special timing rule. Those regulations merely provide that, absent compliance with that rule, the general timing rule applies. Under that general rule, nonqualified deferrals are subject to FICA taxation as they are paid or made available. And the employer complied with that general rule by deducting FICA taxes from each monthly benefit payment.
However, in ruling in favor of the participants, the court pointed to two other factors: (1) language in the employer’s own plan document, and (2) the “purpose” of a nonqualified plan.
- The plan provided that, “[f]or 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.” (Emphasis added.) According to the court, this language obligated the employer to take advantage of the special timing rule.
- The court also noted that the purpose of a nonqualified deferred compensation plan is to provide a tax benefit to its participants. Although, in this context, one normally thinks of deferred income taxes, the court also referenced an expectation “that the Participants will reap the benefit of the non-duplication rule.”
This second point is particularly interesting. It suggests that, even if the quoted plan provision had read that the company “may” withhold taxes from a participant’s non-deferred compensation, the court would have reached the same conclusion – based on the overall “purpose” of a nonqualified plan.
And that’s where Section 409A enters the picture. Nonqualified deferred compensation plans commonly include language to the effect that they are intended to comply with Section 409A (or to be exempt from its requirements). Although not a panacea, IRS guidance suggests that these statements of intent may prove helpful in demonstrating compliance. But could those same statements – which are generally intended to shield executives from Section 409A penalties – come back to haunt employers? For instance, under the Henkel court’s reasoning, even an inadvertent failure to comply with Section 409A would be inconsistent with the “purpose” of the arrangement – thereby conceivably supporting a claim for damages by an affected participant.
Of course, an employer and its executives may be perfectly happy with that result. In many cases, employers already indemnify their executives against Section 409A penalties (although doing so can get rather expensive, particularly if an employer also “grosses up” a payment to cover the executive’s tax liability resulting from the indemnification). But if an employer does not intend to cover an executive’s Section 409A penalties, it would be well-advised to draft its nonqualified deferred compensation plans in such a way as to disclaim that intent.
Nor should sponsors of nonqualified deferred compensation plans lose sight of the Henkel decision’s more obvious lesson. It is in everyone’s interest for an employer to take advantage of the special timing rule when applying FICA taxes to nonqualified deferred compensation. Not only will this minimize participants’ liability for Social Security taxes, but the same is true for employers. After all, employers are generally required to pay the same Social Security and Medicare taxes as their employees. So every dollar saved for an employee should be a dollar saved for the employer, as well.