Insights from Human Resource Services Employers may be liable to employees for failing to collect FICA taxes on deferred compensation on a timely basis January 28, 2015 In brief A federal district court has ruled that an employer violated ERISA by failing to follow the terms of its nonqualified deferred compensation plan when it did not withhold Social Security and Medicare (FICA) taxes when the plan benefits became vested. The court concluded that the participants were harmed because they now had to pay FICA taxes on each payment that was made under the plan. In detail Background Generally, FICA taxes are withheld from wages at the time the payments are actually made. However, nonqualified deferred compensation (NQDC) is subject to a ‘special timing rule’ for FICA tax purposes. The special timing rule provides that NQDC be taken into account for FICA purposes at the later of: (1) the date on which the services creating the right to such amount are performed; or (2) the date on which the right to the deferred amount is no longer subject to a substantial risk of forfeiture (i.e., at the time of vesting). For account balance plans, such as salary and bonus deferral arrangements, this means that FICA taxes are withheld at the time the deferral is made, or upon vesting, if later. For supplemental executive retirement plans (SERPs) that are structured as defined benefit-type plans, the special timing rule generally applies at the resolution date when the benefit is reasonably ascertainable; this is often at retirement when the participant’s total years of service, final compensation and commencement date are known. Employers can also estimate the present value of the SERP each year as it accrues, withhold FICA on that estimated value, and true up at retirement. Under the special timing rule, once an amount deferred under a NQDC plan is taken into account (i.e., included in computing the amount of taxable wages) for FICA purposes, then neither the amount taken into account nor the income attributable to the amount taken into account is treated as wages for FICA tax purposes at any time thereafter. This is also known as the ‘nonduplication rule’ and it means that future payments of the benefit are not subject to FICA taxes again. For account balance plans that provide for earnings on deferrals, the nonduplication rule eliminates FICA taxes on earnings credited after vesting. If FICA taxes are not withheld under the special timing rule, they are due as each payment of deferred compensation is made. www.pwc.com Insights Davidson v. Henkel Corporation A recent federal district court has ruled that a company failed to follow the terms of its NQDC plan by failing to withhold FICA taxes on the deferred compensation, which resulted in a reduced benefit to a group of plan participants. In this case, Henkel Corporation (Henkel) sponsored a deferred compensation plan for a select group of management employees. Participants were allowed to defer a portion of their compensation and received a matching contribution from Henkel. Davidson was a participant in the plan. Henkel did not withhold FICA taxes on plan contributions at any time prior to Davidson’s retirement and initially did not withhold FICA taxes from the payments. Several years after Davidson had retired and begun receiving benefits, the company paid the FICA taxes due to date on behalf of the participants, and reduced future benefit payments to reflect this amount. The employer then began to withhold FICA taxes from each new payment. Davidson sued Henkel under ERISA charging that the employer failed to follow the plan terms that provided that for each year in which a deferral or match was credited to the participant’s account, the company would withhold all applicable Federal, state or local taxes. The court found that the company’s failure to withhold FICA taxes violated the plan’s terms. This violation caused the retirees to lose the advantage of the nonduplication rule, one of the key benefits of the plan, and had the effect of lowering their vested benefits in violation of ERISA. Observation Employees who voluntarily defer the receipt of salary and bonus amounts 2 under a nonqualified plan do so with the expectation that future taxes will be less than the taxes due if they were paid the compensation when it was earned. Many nonqualified plan participants have wages that exceed the Social Security wage base with normal salary and bonus payments. Thus, annual deferrals and matching contributions may only be subject to the Medicare portion of the FICA tax for that year. Failing to withhold FICA taxes on a timely basis subjects these amounts to Social Security taxes when the benefits are paid to the participant, when the participant may not have other wages up to the Social Security wage base and so must pay both Medicare and OASDI taxes on the payment. As a result, employees’ benefits are less than they would have been had the taxes been withheld under the special timing rule. Accurate administration of benefit plans This case highlights the need for employers to pay close attention to plan terms and administer plans according to such terms. Although nonqualified plans are generally excluded from many ERISA requirements, participants can still sue for damages under ERISA. Employers should also review processes for employment tax withholding for deferred compensation, and make sure these taxes are calculated properly and withheld on time, in accordance with the terms of the plan. Employers may be held responsible for excess taxes that must be paid on deferrals and earnings if FICA taxes were not properly withheld under the special timing rule. Observation For defined benefit-type plans, applying FICA taxes to the accruals each year and truing up the FICA due at the final resolution date may also reduce the amount of the SERP that is subject to Social Security tax, even if it does not reduce the amount of Medicare tax. If an employer chooses not apply FICA taxes prior to the resolution date, it should review the plan document to ensure that this conforms to the terms of the plan. Practical Considerations Most employers choose to withhold FICA tax due by means of an employee’s normal salary. However, there is a possibility the individual lacks sufficient salary to cover the tax due in the payroll period that it is due. There is also the added administrative complexity of coordination with payroll. Companies may collect the tax amounts due from an individual by requesting a personal check or cash wire, although this is not an ideal solution as it can become administratively burdensome when dealing with a large population. Retirement eligibility events under SERPs also pose a compliance challenge for many employers. Generally, individuals will not receive an actual cash payment at the time of retirement or retirement eligibility when FICA taxes are due. Employers may take advantage of the rule of administrative convenience to postpone the date that FICA taxes must be remitted during the year when they are due. This rule allows an employer to treat an amount deferred as required to be taken into account for FICA tax purposes on any date that is later than, but within the same calendar year as, the actual date on which the amount deferred is otherwise required to be taken into account. For example, if an individual’s right to the NQDC vested on July 1, 2014, the employer may choose to take the amount deferred into account on December 31, 2014 instead of on the actual vesting date pwc Insights (i.e., July 1, 2014). This rule may help with some of the cash flow issues identified above. Observation Generally, the burden falls on stakeholders in Payroll and/or Human Resources to ensure FICA taxes are paid on time. Early coordination with plan participants is essential. The takeaway Plan sponsors should review plan terms and to make sure their nonqualified plans are being administered in accordance with their terms. Liability under ERISA for failure to follow plan terms can represent significant cost to an employer. In addition, payment of FICA taxes on nonqualified deferred compensation plan benefits is complex, particularly for defined benefit SERPs; employers should review their employment tax policies and procedures to be certain they are following the legal requirements and taking advantage of the rules that minimize tax payments. Finally, it is important to confirm some type of tracking mechanism is in place to ensure FICA withholding is not duplicated when amounts are ultimately paid to participants. Let’s talk For more information, please contact our authors: Kerri McKenna, Philadelphia (267) 330-1723 [email protected] Susan Lennon, Washington, DC (202) 414-4625 [email protected] Anne Waidmann, Washington, DC (202) 414-1858 [email protected] or your regional Human Resource Services professional: US Practice Leader Scott Olsen, New York (646) 471-0651 [email protected] Charlie Yovino, Atlanta (678) 419-1330 [email protected] Craig O'Donnell, Boston (617) 530-5400 [email protected] Pat Meyer, Chicago (312) 298-6229 [email protected] Terry Richardson, Dallas (214) 999-2549 [email protected] Todd Hoffman, Houston (713) 356-8440 [email protected] Carrie Duarte, Los Angeles (213) 356-6396 [email protected] Ed Donovan, New York Metro (646) 471-8855 [email protected] Bruce Clouser, Philadelphia (267) 330-3194 [email protected] Jim Dell, San Francisco (415) 498-6090 [email protected],com Scott Pollak, San Jose (408) 817-7446 [email protected] Nik Shah, Washington Metro (703) 918-1208 [email protected] © 2015 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 3 pwc
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