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Improper Administration of FICA’s Special Timing Rule as Applied to Deferred Compensation Arrangements Could Lead to Employer Liability

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In a recent federal district court case, Davidson v. Henkel Corp., No. 12-cv-14103, 2015 WL 74257 (E.D. Mich. Jan. 6, 2015), the court granted plaintiffs’ motion for summary judgment finding defendants liable for damages as a result of the employer’s improper application of the FICA “special timing rule” as required by the employer’s deferred compensation plan documents. This case, and the oft-neglected special timing rule, could have broader implications for employers.

FICA and the Special Timing Rule

Compensation generally is subject to the FICA tax when the wages are actually or constructively paid by the employer to the employee. FICA taxes are comprised of Social Security taxes (also known as OASDI) and Medicare taxes (also known as HI). Under tax rates for 2015, employers and employees pay equal amounts of Social Security taxes (6.2% each) on wages up to the social security wage base of $118,500, and also pay equal amounts of Medicare taxes (1.45% each) on all wages, and the employee pays an additional 0.9% on earnings in excess of $200,000. Employers generally withhold and remit FICA taxes when the payment occurs; however, special rules apply for amounts deferred under nonqualified deferred compensation plans.

Section 3121(v) of the Internal Revenue Code imposes a special timing rule, which requires that employers include an amount deferred under a nonqualified deferred compensation plan in FICA wages upon the last to occur of (i) the date the services are performed, and (ii) the date when such amounts are no longer subject to a substantial risk of forfeiture. As applied to individual account plans, this would occur when amounts are allocated to an employee’s account and are no longer subject to a substantial risk of forfeiture (i.e., fully vested). For non-account plans, such as defined benefit type plans, this would occur when such fully vested amounts are “reasonably ascertainable.” An amount is considered “reasonably ascertainable” on the first date on which the amount, form, and commencement date of the benefit payments attributable to the amount deferred are known, and the only other assumptions needed to determine the amount deferred are interest and mortality.

Once an amount deferred under a nonqualified deferred compensation plan is taken into account as wages under the special timing rule, FICA’s non-duplication rule provides that neither that amount nor the income attributable to that amount is again treated as FICA wages. Failure to comply with this special timing rule will cause amounts of deferred compensation (and the earnings attributable to it) to be subject to FICA tax as the compensation is paid, potentially resulting in higher tax bills for employees. That is because employees benefitting from these types of plans often earn wages in excess of the social security wage base in the year the benefits vest. Thus, if amounts are taken into account as FICA wages by operation of the special timing rule (and at a time when employees have higher wages), such amounts may in effect be subject only to the Medicare tax (which does not have a wage base limit). On the other hand, if the employer does not comply with the special timing rule, not only will the amounts of deferred compensation be subject to an additional 6.2% tax (or the then applicable current Social Security tax rate) when paid, the earnings attributable to such amounts will also be subject to FICA tax (both Social Security and Medicare).

The Case

In Davidson, the employer maintained a nonqualified deferred compensation plan, but did not follow the special timing rule. As a result, plan participants experienced a reduction in net benefits due to the increased tax they incurred with respect to those benefits. The participants brought a class action suit under ERISA seeking to recover the benefits they lost as a result of the employer’s failure to withhold FICA tax pursuant to the special timing rule. While the court rejected the plaintiffs’ argument that the special timing rule is mandatory1, the court (basing its decision in large part on the general principles of contract law) did agree that the employer’s failure to apply the rule violated the terms of the plan document and the plan’s purpose and thus resulted in a reduced benefit to participants. Despite the rationale for the court’s decision in Davidson, as described below, the case could have larger implications for employers.

What This Means for Employers

Several important lessons can be learned from Davidson. First, the case highlights the importance of properly handling FICA payroll taxes in connection with the administration of nonqualified deferred compensation plans. The special timing rule alone, or coupled with plan provisions, could result in the imposition of liability on employers. Second, participants could try to expand the rationale of Davidson to other situations where there is a perceived improper application of tax rules to nonqualified deferred compensation plans, specifically in the context of 409A. In light of the potential for liability, employers should review and consider revising, as needed, any administrative language in plan documents that could be construed as creating participant rights in this regard. Additionally, employers may want to consider including disclaimers of tax warranties in any such documents. Finally, given the IRS’ recent uptick in 409A audits, periodic review of the general operational and documentary compliance of nonqualified deferred compensation plans would not be misplaced.

1 It is important to note that although the federal district court in Davidson held that the “special timing rule” was not mandatory, that does not mean that other courts or the IRS will agree with this conclusion. In fact, the preamble to the final FICA regulations states that “the special timing rule is not elective and, if an employer does not take an amount deferred into account (including payment of any resulting FICA tax) when required by section 3121(v)(2), interest and penalties may be imposed.”

This advisory was prepared by the Tax Department at Nutter McClennen & Fish LLP. For more information, please contact your Nutter attorney at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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