February 5, 2014
Introduction. Most employers routinely and properly calculate, withhold and pay the federal employment taxes that are due on the current compensation for their employees. However, employers are often less familiar with the rules for calculating and paying FICA taxes on nonqualified deferred compensation (NQDC), which is compensation to which an employee earns a legally binding right in one year, but which is not payable until a later year. This is particularly problematic because the rules for when NQDC is recognized or taken into account (subject to tax) for income tax differ from those for FICA .
When is NQDC Recognized for FICA? Compensation that is considered to be “wages” is generally subject to FICA tax when it is “paid or otherwise made available” to the employee. However, amounts deferred under an NQDC plan are subject to both a “special timing” rule and a “non-duplication” rule. For purposes of FICA taxes, the “special timing” rule treats as “wages” amounts deferred under a nonqualified plan as of the later of (i) the date on which the services are performed; or (ii) the date on which the employee’s right to the deferred compensation is no longer subject to a “substantial risk of forfeiture” (vests).
Consequently, amounts deferred under a nonqualified plan usually are considered “wages” for FICA purposes well before they are actually “paid or made available” to the employee. If the nonqualified plan is a defined contribution type of plan, the compensation may be treated as wages as early as the year in which it is credited to the participant’s hypothetical “account” or in which his right to benefits “vests” (becomes non-forfeitable). If the plan promises a defined benefit (a specific benefit determined by a formula, payable at a later date), it may be treated as wages as soon as the amount is “reasonably ascertainable.”
Under the “non-duplication” rule, once an amount is taken into account as wages for FICA purposes, neither that amount nor any subsequent earnings or income attributable to that amount is treated as “wages” for purposes of FICA tax in any future year.
How Much Income is Recognized for FICA? The Social Security (or OASDI) portion of the FICA tax (but not the Medicare portion of the tax) is limited to or capped at the “taxable wage base” (which is $117,000 for 2014). If amounts deferred under a nonqualified plan are taken into account as “wages” in a year in which the employee has other income subject to FICA tax, some or all of the NQDC will not be subject to the 6.2% OASDI portion of the FICA tax. Similarly, if amounts deferred under a nonqualified plan over several years all become “vested” in a single year, only the first $117,000 of the employee’s total FICA wages (including both current and deferred compensation) will be subject to the OASDI portion of the
tax in the year of vesting.
Once the amount deferred (and any earnings accrued before vesting occurs) is properly taken into account as FICA wages, neither the amount taken into account nor any subsequent earnings will be subject to FICA tax in the future. However, if the amounts deferred (including any pre-vesting earnings) are not properly “taken into account” under the special timing rule, then the non-duplication rule does not apply, and the entire amount paid to the employee will be subject to FICA tax at the time of payment.
Consequences of Error. A recent federal court decision ( Davidson v. Henkel ) in Michigan underscores the problems of failing to follow the rules. An executive was a participant in a “top-hat” NQDC plan (for a select group of management or highly compensated employees) and became entitled to a monthly supplemental pension payment for life upon retirement in 2003.
Under the special timing rule, the present value of his future supplemental pension payments should have been taken into account as “wages” for FICA purposes in 2003 (when the value of his benefit was “reasonably ascertainable”), and he should have paid Social Security tax only on the amount that (when combined with his regular pay for 2003) did not exceed the taxable wage base for that year. However, the company failed to pay or withhold any FICA tax in 2003with respect to the deferred compensation. In addition, the company failed later to withhold FICA tax from annual supplemental pension payments.
When in 2011 the company discovered that FICA taxes had never been paid on this deferred compensation, it informed the executive that each pension payment thereafter was subject to FICA withholding. Adding insult to injury, the company also noted that additional amounts would be withheld to “catch-up” on the FICA taxes that were not properly paid for the “open” tax years between 2008 and 2011. Unsurprisingly, the executive objected to this un-welcome news and sued his former employer.
In procedural rulings prior to an actual trial, the court tossed out some of the executive’s state law claims for negligence as being preempted by ERISA, but found that he had stated a valid claim under ERISA “to recover benefits due to him under the terms of his plan, to enforce his rights under the terms of the plan, or to clarify his rights to future benefits under the terms of the plan.” Consequently, the court found that the company could be liable (subject to proof at trial) under ERISA because the plan gave the company discretionary control over a participant’s funds and authorized and obligated the company to manage properly the tax withholding from a participant’s benefits. Thus, the court refused to dismiss that claim.
Conclusion. It is not over (no trial has been completed), but I suspect that the company is considering a settlement that makes the executive whole.