Recent Case Opens Door to Civil Enforcement Claims for Negligent FICA Tax Withholding

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By Paul J. Compernolle, Esq., Patrick D. Ryan, Esq.,
and Ruth Wimer , Esq., CPA
 

McDermott Will & Emery, Chicago and Washington, DC

A district court in Michigan recently rejected a motion to
dismiss a participant's benefit claim, holding that an employer
legally could be liable to a participant in a nonqualified deferred
compensation plan when the employer did not properly withhold FICA
tax in the manner most advantageous to the participant. As a best
practice, plan administrators should scrutinize any participant
communications or claim responses because they can open the door to
estoppel claims under ERISA.

The Federal District Court in Eastern Michigan recently rejected
a motion to dismiss a participant's benefit claim, holding that an
employer legally could be liable to a participant in a nonqualified
deferred compensation plan when the employer did not properly
withhold FICA tax in the manner most advantageous to the
participant. Plaintiff John Davidson participated in the Henkel
Corporation Deferred Compensation and Supplemental Retirement Plan
(the Plan), a top hat nonqualified deferred compensation plan
maintained by Henkel Corporation (the Company) that included
defined benefit payments. Beginning with his retirement in 2003,
the Company withheld FICA tax on each monthly defined benefit
payment under the Plan.  In 2011, the Company discovered and
informed Davidson that it had failed to withhold FICA taxes from
his Plan benefits in accordance with the favorable "special timing
rule" applicable to deferred compensation.

The Company remitted the full amount of the FICA taxes due to
that date on behalf of Davidson and reimbursed itself by reducing
his monthly benefit payments effective as of January 1, 2012.
Davidson brought suit against the Company and the Plan (the
Defendants) in the U.S. District Court for the Eastern District of
Michigan (Southern Division) under the Employee Retirement Income
Security Act of 1974 (ERISA), alleging that his benefits were
wrongfully reduced as a result of the Defendants' failure to follow
the special timing rule for withholding of FICA taxes on vested
deferred compensation. Davidson v. Henkel Corp., No.
4:12-cv-14103-GAD-DRG, 2013 BL 1965002013 EXC 10052,  (E.D.
Mich. 7/24/13).

FICA Taxes and Nonqualified Deferred Compensation
Plans
 

The "general timing rule" of Code §3102(a) requires that
employers deduct FICA taxes from an employee's wages when they are
actually or constructively paid. However, the Treasury Regulations
under Code §3121 provide a "special timing rule" applicable to FICA
taxes on payments from nonqualified deferred compensation plans. In
general, for an individual account type of nonqualified deferred
compensation plan, the special timing rule provides that FICA tax
is due on the date on which the right to the compensation is no
longer subject to a substantial risk of forfeiture (i.e., fully
vested and nonforfeitable).

On the other hand, for certain defined benefit type of deferred
compensation plans, FICA tax is due when amounts are "reasonably
ascertainable," which is usually at the time the participant
retires or terminates service and no longer earns benefits under
the plan. Treasury Regulations also include a "non-duplication
rule," which eliminates additional FICA withholding on payments
subject to the special timing rule. Thus, when the special timing
and non-duplication rules are properly applied to a defined benefit
type of nonqualified deferred compensation benefit, the
participant's entire benefit is subject to FICA taxes only at one
time and likewise is subject to the FICA dollar limit only at that
time. Conversely, if an employer fails to apply these rules, the
general FICA timing rule applies, and FICA taxes are assessed on a
payment-by-payment basis, which can result in overall higher FICA
dollar limits and thus greater taxation.

Claims for Recovery of Benefits under ERISA and
Equitable Estoppel
 

The court held that the Defendants may be liable under ERISA
because the Plan gave Defendants discretionary control over the tax
treatment of the participant's benefits and obligated the
Defendants to properly manage FICA tax withholding. Importantly,
the court noted that the Defendants appeared to admit their failure
to properly manage FICA withholding when the Company replied in
response to Davidson's claim letter "… at the time [you] commenced
receipt of this benefit, [the Company] should have applied FICA tax
to the present value of your nonqualified plan benefit."

In addition, the court held that Davidson properly asserted his
ERISA equitable estoppel claim. The U.S. Court of Appeals for the
Sixth Circuit recognizes equitable estoppel as a viable theory for
recovery in ERISA cases and recently extended the doctrine's
application to ERISA-governed pension plans in Bloemker v.
Laborers' Local 265 Pension Fund
, 605 F.3d 436 (6th Cir.
2010).  Post-Bloemker, plaintiffs can invoke
equitable estoppel when (1) plan terms are unambiguous, (2) he or
she can demonstrate the traditional elements of estoppel and (3)
certain extraordinary circumstances exist that shift the balance of
the equities strongly in favor of the plaintiff. The court
concluded that Davidson properly asserted an equitable estoppel
claim under ERISA by showing that the Defendants were grossly
negligent in determining FICA taxes and also in negotiating with
the IRS on such taxes, and later reducing benefit payments, without
Davidson's input.

Future Impact on Sponsors of Nonqualified Deferred
Compensation Arrangements
 

Sponsors of nonqualified deferred compensation arrangements
should review their participant communications and FICA computation
withholding procedures. Those plan sponsors with discretionary
authority over the determination and distribution of benefits from
top hat plans must recognize that any mistake made in determining
FICA withholding could provide a basis for participants to assert
claims under ERISA. Further, as a matter of prudent practice, plan
administrators should carefully scrutinize any participant
communications or claim responses because such materials can open
the door to estoppel claims under ERISA.

For more information, in the Tax Management Portfolios, see
Allman, 392 T.M.
, Withholding, Social Security and
Unemployment Taxes on Compensation, Marmoll, 391 T.M.,
Employment Status - Employee v. Independent Contractor,
 and in Tax Practice Series, see ¶5440, Obtaining IRS
Approval for Qualified Plans.

© 2013 McDermott Will & Emery