The time to collect FICA taxes on non-qualified deferred compensation may be sooner than expected for some employers. And failing to act soon enough could subject an employer to significant liability in the future.
In early 2015, a Michigan federal court ruled in Davidson v. Henkel that an employer is liable for the losses suffered by employees from the employer’s delayed approach to collecting FICA, even though the court also found that the law doesn’t require withholding at the first possible opportunity. The amount of damages to be awarded was not addressed in the court’s decision, yet it appears the employer will be liable for the additional FICA taxes owed by the employees as a result of the employer’s approach.
Background
The Federal Insurance Contributions Act (FICA) requires an employer and employee to each pay a share of the Social Security taxes (6.2 percent each) and Medicare taxes (1.45 percent each) applicable to the employee’s wages. In any one year, Social Security taxes are assessed only on wages up to a certain dollar limit (the wage base). The Social Security wage base is $118,500 for 2015.
The FICA rules addressing the time for taking deferred compensation into account are complex. It differs depending on the type of deferred compensation plan. For example, under an account balance plan, deferred compensation is included in FICA wages when: (1) services relating to the compensation are performed, or, if later, (2) the compensation is no longer subject to a “substantial risk of forfeiture.” In other words, FICA must be paid either when the wages are earned or when they are fully vested, whichever is later.
Under a non-account balance plan, deferred compensation generally is included in FICA wages when it becomes “reasonably ascertainable.” However, the FICA rules allow for inclusion in FICA wages at an earlier date.
Earlier inclusion may be desirable for a couple of reasons. Once deferred compensation is taken into account for FICA purposes, future payments of that compensation (and related earnings) generally are not subject to FICA. Further, any employee who earns more than the Social Security wage base can avoid paying any Social Security on the deferred compensation if it is taken into account in a year where the employee earns more than the wage base. For either or both of these reasons, an employee may be better off in retirement if the deferred compensation has been taken into account earlier for FICA purposes.
The Henkel Case
This case was brought by a group of employees whose employer set up a non-qualified supplemental executive retirement plan (SERP) for the deferral of compensation until retirement. The employees were upset that their employer did not collect FICA sooner and that FICA was instead being subtracted from their plan benefit payments. The lawsuit alleged that their tax liability would have been reduced if the employer collected FICA sooner. Because that did not occur, the employer subsequently reduced the employees’ benefit payments to pay their FICA tax liability. Not only did this lower the benefits payable to the employees from the plan, it also meant they had to pay FICA taxes they might otherwise have escaped had the deferred compensation been taken into account sooner.
While this may be an alarming result for employers, the court’s decision largely turned on the language in the plan document – not the FICA rules. The court held that employers are not required to take deferred compensation into account at the earliest point because the FICA rules contemplate that may not occur. Yet, the problem for the employer in Henkel was that its plan document suggested the employer would withhold FICA wages at the time of the compensation deferral. Moreover, the employer sent its employees a letter, admitting that it had not properly taken their benefits into account for FICA tax purposes and would subtract FICA now, even for retirees currently receiving benefits.
What It Means
Though the Henkel ruling recognizes the FICA rules do not require employers to take deferred compensation into account for FICA purposes at the first possible moment, it also signals that a court may find an employer liable if the employer’s approach to collecting FICA leads to a reduction in the employee’s deferred compensation. Whether a court would find similarly in a case with different plan language remains an open question, but the Henkel ruling seems to leave room for that argument.
This development highlights the importance of knowing what your plan document says about FICA and understanding how your approach to collecting FICA on deferred compensation may impact employees. If you are unsure about any of this or would like to discuss this development further, contact your Warner employee benefits attorney.
