Employers May Be Liable for Mishandling FICA Taxes Under Nonqualified Plans

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John E. Schembari and William C. McCartney

Kutak Rock LLP, Omaha, NE

A recent case out of a federal court in Michigan (Davidson v. Henkel Corp., No. 12-cv-14103, 2015 BL 1384 (E.D. Mich. Jan. 6, 2015) highlights the need for employers to properly withhold FICA taxes on nonqualified deferred compensation benefits. In the Michigan case, the employer failed to properly withhold FICA taxes and an executive successfully sued the employer for the delinquent FICA taxes. This case is a good reminder for employers to review their nonqualified plan documents and procedures to ensure the proper handling of FICA and income tax withholding.

Legal Background

Normally, wages are subject to FICA tax when they are actually paid to the employee. Under a special rule for nonqualified plans, deferred compensation is taken into account when the amount is no longer subject to a substantial risk of forfeiture. If FICA taxes are withheld under this special rule, there is no FICA tax withholding when the deferred compensation is later paid to the employee. Most employers and employees avail themselves of this rule, as many executives hit the maximum taxable wage base for FICA purposes sooner while they are working and deferring compensation as opposed to when they are retired and generally drawing down on their deferred compensation benefit. Note that if an employer does not follow this special rule, the deferred compensation will be subject to FICA taxes when the amount is paid.

Facts of the Case

Henkel Corporation maintained a nonqualified deferred compensation plan to provide supplemental retirement benefits to a select group of management and highly compensated employees. The plan permitted certain Henkel employees to defer compensation (and taxation thereon) until they retired.

One highly compensated employee, John Davidson, participated in the plan for several years before retiring in 2003, at which point he began receiving his monthly benefit under the plan.  In 2011, Henkel sent a letter to Davidson informing Davidson that FICA taxes associated with his plan benefits had not been withheld.  The letter further provided that FICA taxes were payable on the present value of all future plan payments as well as individually on each previous payment dating back to 2008 (the earliest tax year still considered open for retroactive payment purposes). Finally, the letter provided that Henkel had paid the FICA tax owed to the IRS and would reduce future plan benefits to reimburse itself.

Davidson sued Henkel, arguing he and other similarly situated participants suffered a reduction in their benefits under the plan due to Henkel's failure to withhold FICA taxes as required under the special rule for nonqualified plans.

The Court's Decision

The court held that Henkel did not have a mandatory obligation to withhold FICA taxes under the special rule since the regulations provide that if the special timing rule is not followed, FICA should be withheld as the benefits are paid. However, the court did find that the plan itself required Henkel to properly withhold taxes when assessable or due. Further, Henkel had previously conceded that FICA taxes had not been properly withheld.

As a result, the court found that Henkel was liable for failing to withhold FICA taxes under the special rule and Henkel was required to cover the costs of its failure.

Next Steps

If your company maintains a nonqualified deferred compensation plan or arrangement, you should review the terms of the plan and your procedures for withholding FICA taxes. If you are not taking advantage of the special FICA tax rule, you should determine whether this creates any risk for the organization and whether utilizing the special rule may make more sense for your executives and the company.

For more information, in the Tax Management Portfolios, see Brisendine, Drigotas and Pevarnik, 385 T.M., Deferred Compensation Arrangements,  and in Tax Practice Series, see ¶5440, Employment Tax Withholding Requirements, ¶5710, Deferred Compensation Tax Concepts and Structures.

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