United States: View From McDermott: Conduct Regular Reviews To Ensure Compliance With FICA Tax Withholding Rules

I. Introduction

Sponsors of nonqualified deferred compensation plans should pay close attention to the special tax withholding rules under the Federal Insurance Contributions Act (FICA) to avoid paying interest and penalties, and potentially being sued by plan participants. FICA tax on nonqualified deferred compensation must be withheld when compensation vests, not later when actually paid out. Failure to withhold FICA tax at the time of vesting will cause the compensation plus any earnings to be subject to FICA tax later as it is distributed to the participant, potentially resulting in higher overall FICA taxes for both the employer and the participant. As shown by the case of Davidson v. Henkel, employees may even successfully sue the employer for causing them to receive lower benefits due to the higher tax burden created by a failure to follow the correct withholding rules.

This article explores the common FICA and Additional Medicare Tax withholding errors and the potential remedies that may be available to employers who fail to timely withhold FICA and/or Additional Medicare Tax on nonqualified deferred compensation.

II. FICA Tax Withholding Rules As Applied to Nonqualified Deferred Compensation

Employers and employees are both subject to the FICA tax. The FICA tax consists of two parts: a 6.2% Old-Age, Survivors and Disability Insurance (Social Security) tax and a 1.45% Hospital Insurance (Medicare) tax. Importantly, the higher Social Security tax rate only applies to the taxable wage base, which for 2016 is $118,500. The Medicare Tax is not subject to a wage cap. Higher earning individuals are also subject to payment of a 0.9% Additional Medicare Tax on wages above a certain threshold. Although this threshold is set at $250,000 for married individuals filing a joint return; $125,000 for married individuals filing a separate return; and $200,000 for all other cases, the employer is strictly required to withhold on wages above $200,000 in all cases. Employers are not subject to the Additional Medicare Tax.

In general, FICA tax must be withheld when wages are actually or constructively paid, referred to as the ''general timing rule.'' However, on amounts deferred under a nonqualified deferred compensation plan (i.e., generally, amounts paid after the year in which they are earned and vested), FICA tax must be withheld no later than (i) when the services creating a right to those amounts are performed, or (ii) when the amounts are no longer subject to a substantial risk of forfeiture (i.e., when they become vested). This is called the ''special timing rule.'' The special timing rule applies slightly differently depending on whether the plan at issue is an account balance plan (a defined contribution type plan where deferrals and income are credited to, and benefits are paid, based solely on the balance of, an individual account) or a nonaccount balance plan (generally a defined benefit type plan where amounts are equal to the present value of future payments). In an account balance plan, deferred amounts must be treated as wages for FICA tax purposes when they vest. However, in a nonaccount balance plan, deferred amounts must be included in wages for FICA purposes no later than when they are both vested and ''readily ascertainable.'' A deferred amount is considered to be ''readily ascertainable'' when the amount, form, and benefit start date attributable to the deferred amount are known, and the only other assumptions needed to determine the amount deferred are interest and mortality.

Amounts deferred during a calendar year are combined with an employee's other wages to determine the employee's FICA taxes for that year. If the employee has other wages that exceed the Social Security wage base limit in the year in which the deferred amounts vest, then the deferred amounts will not be subject to the Social Security tax. However, the amounts will be subject to the Medicare tax and, if wages are high enough, to the Additional Medicare Tax. Once the deferred amounts are taken into account for FICA purposes, the Internal Revenue Code's nonduplication rule provides that the amounts and any earnings will never be subject to the FICA tax again.

Whether account balance or nonaccount balance, the major problem with failing to follow the special timing rule occurs when the benefits under the plan are paid out over several years, as in the Henkel case, rather than as a lump sum.

Example: John and Mary, both earning over the Social Security wage base, participate in nonqualified deferred compensation plans, with John electing annual distributions and Mary electing a lump-sum. John and Mary's employer ''forgot'' to use the special timing rule wherein all FICA tax liability would have been satisfied prior to John and Mary's retirement in 2016 and the amount paid on such vested accruals would have only been taxed at the lower 1.45% Medicare rate because they had other wages at that time in excess of the Social Security wage base. If Mary receives her lump-sum in 2017, she will be subject to Social Security tax, as well as Medicare tax under the general timing rule, compared to ''0'' liability under the special timing rule. John will have an even worse result as he will be liable for the higher Social Security taxes and the Medicare tax for each and every year during his retirement that he receives a distribution, compared to ''0'' had the special timing rule been used. Both John and Mary will also be paying the FICA tax on any earnings which occurred after the date that the deferred compensation would have been subject to FICA tax under the special timing rule, which could result in substantially higher FICA.

As illustrated, failure by the employer to withhold the FICA tax on deferred amounts at the time of vesting will cause those amounts to be subject to FICA tax as the compensation is paid. This could result in higher taxes for employees whose other FICA wages may have decreased, such as in cases where the employee retired, as the deferred compensation payments may then be subject to both Social Security and Medicare taxes. An employer who fails to withhold FICA tax when nonqualified deferred compensation vests may end up fighting a lawsuit filed by employees who may have had to pay higher taxes and as a result receive lower benefits. The recent case of Davidson v. Henkel illustrates these facts, as described below.

III. Davidson v. Henkel

The 2015 federal district court decision in the case of Davidson v. Henkel, No. 12-cv-14103, 2015 BL 1384, 59 EBC 2917 (E.D. Mich. Jan. 06, 2015), shows the potential consequences for employers of not withholding FICA tax when nonqualified deferred compensation vests (05 PBD, 1/8/15). Davidson, a former employee of Henkel Corporation, was a participant in a nonqualified nonaccount balance plan designed to provide a supplemental benefit for a group of management employees. Eight years into his retirement, Davidson received a letter from his former employer stating that the FICA tax had not been properly withheld on the present value of his future benefits and that Davidson would be subject to FICA tax on a ''pay as you go'' basis under the general timing rule. In the same letter, Henkel also stated that it had (i) consulted with the IRS; (ii) paid the full amount of the FICA tax owed to the IRS on behalf of the participants; (iii) reimbursed itself by reducing the participants' monthly benefits for a 12 to 18 month period; and (iv) planned to adjust the participants' benefits going forward. Davidson filed a class action suit against Henkel, arguing that Henkel's administration of the plan and failure to comply with the special timing rule had created a tax liability for the participants and reduced their benefits.

The Court found that the special timing rule was not mandatory for employers because alternative procedures exist if an employer fails to follow the rule. The Court nonetheless granted judgment for Davidson on the ground that Henkel had violated the plan's purpose and plan provisions that gave Henkel control over the participants' funds and required it to properly handle tax withholding. Because of Henkel's failure to withhold taxes as required by the plan, the Court concluded that the participants wound up paying more in FICA taxes than they would have paid had Henkel withheld taxes when they were originally due. Henkel underscores three points of relevance for sponsors of nonqualified deferred compensation plans:

  • First, plan sponsors should pay attention to the Internal Revenue Code's special timing rule. Compliance with this rule would potentially insulate employers from Henkel-type participant-lawsuits.
  • Plan sponsors should pay careful attention to how their plans are drafted. In Henkel, the Court interpreted certain plan sections as giving the plan sponsor discretion over the participants' funds, requiring them to properly handle tax withholding. To avoid similar litigation outcomes, plan sponsors should make sure that their plan documents do not guarantee any particular tax treatment to the participants. Nevertheless, where the FICA error affects a large enough number of participants, as it did in Henkel, litigation may be difficult to avoid.
  • To minimize litigation risk, plan sponsors should conduct regular compliance reviews and, as explained below, promptly correct errors when they are ascertained.

IV. Remedies for FICA and Additional Medicare Tax Withholding Errors

A. General Correction for FICA Tax. Between the time that the nonqualified deferred compensation vests and is subject to the special timing rule and the time it is actually paid, employers may be able to correct any FICA tax withholding errors and avoid the negative tax consequences to their employees by filing an adjusted quarterly federal tax return. Corrections are permitted only for errors occurring during the ''open period,'' that is, three years following the April 15th of the year in which the error occurred. This is done by filing Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund. Timing-wise, Form 941-X must be filed (i) within the three-year statute of limitations on assessment, and (ii) by the due date for filing a return for the calendar year quarter in which the error was discovered. If the adjustment is filed late, interest will accrue from the payment due date. If the employer files Form 941-X by the applicable due date, then the adjustment to the FICA withholding will be interest and penalty-free. If not, the FICA withholding will not be interest- and penalty-free. However, employers may not use this form if the IRS has already audited their prior years' tax returns and discovered the underreporting or if the employer knowingly underreported its FICA tax liability.

To be able to use Form 941-X, the employer must have ascertained the FICA tax withholding error after filing its federal tax return for the quarter in which the error occurred. Treasury regulations state that an error is considered to be ascertained ''when the employer has sufficient knowledge of the error to be able to correct it.'' The remedy provided by Form 941-X—an interest-free adjustment—is not available if the employer learned of the error before filing the quarterly return on which the FICA tax must be reported and failed to report and pay the correct amount of tax at that time. Employers should pay special attention to the deadline for filing Form 941-X. The form must be submitted by the deadline for filing a tax return for the calendar year quarter in which the employer discovered the FICA error. As an example, if an employer learns of a prior year FICA withholding error on February 29, 2016, it must then file Form 941-X by April 30, 2016, which is the due date to file a return for the January-March calendar year quarter. The employer must also remit the FICA tax underpayment by the date it files Form 941-X or interest will begin to accrue on that date.

B. Additional Medicare Tax. If an employer fails to withhold the Additional Medicare Tax from employees' wages, the employer can correct that error as well by making an adjustment. As noted earlier, employees (but not employers) are subject to the Additional Medicare Tax. The timing for making the correction is stricter in case of the Additional Medicare Tax as opposed to the Social Security and Medicare portions of the FICA tax. To correct errors in Additional Medicare Tax withholding, the errors must have been ascertained within the same calendar year that the wages or compensation was paid to the employee, unless the underpayment occurred because of an administrative error (i.e., an error involving the inaccurate reporting of an amount that actually was withheld) or a few other reasons. For example, if an employer learns on February 29, 2016 that it made an underwithholding error in a prior year, the employer can make an interest-free adjustment by April 30, 2016 with respect to its underwithholding of the Social Security and Medicare taxes, but not with respect to its underwithholding of the Additional Medicare Tax. The employer can, however, correct any Additional Medicare Tax underwithholding in the current calendar year.

Correcting FICA withholding errors need not be administratively burdensome. Under the ''rule of administrative convenience,'' all deferred amounts that become vested and ascertainable during a given year can be included in income for FICA and Additional Medicare Tax purposes in the last quarter of such year. It is therefore possible that only the last quarterly tax return for each year in which an error occurred will need to be corrected.

C. Employers' Reimbursement Methods. An employer who files Form 941-X will end up paying both the employer and the employee share of tax. However, employers can be reimbursed by the employee for paying the employee's portion of the FICA tax. The method set forth in the Treasury regulations provides that the employer must deduct the amount of the underwithheld tax from the employee's other compensation, if any, that is paid after the employer discovers the error. An employer can also deduct the amount of the underwithheld FICA tax even if an employee's compensation, ''for any reason, does not constitute wages or compensation.'' If the employer for some reason fails to deduct that amount, then ''the obligation of the employee to the employer with respect to the undercollection is a matter for settlement between the employee and the employer.'' This may mean that if the employer does not recover the taxes paid by withholding from wages, then the employer may request a check from the employee. If the employer is not reimbursed for the payment by the employer of the employee's share of FICA taxes under the special timing rule, then the employee will have additional income equal to such amount in the year in which the employer made the payment.

The timing rules are again stricter in regard to the Additional Medicare Tax. If an employer collects less than the correct amount of Additional Medicare Tax that must be withheld, the employer must then recover the undercollection ''on or before the last day of the calendar year by deducting the amount from the remuneration of the employee, if any, paid after the employer ascertains the error.'' Employers should therefore be especially vigilant about any potential errors in the Additional Medicare Tax withholding. If an employer pays the amount of the underpayment but does not deduct it from the employee's compensation, recovery is again a matter of settlement between them.

D. Failure-to-Deposit Penalty. Both the employee and employer portions of the FICA tax must be deposited on time (employers can be monthly or semi-weekly depositors). A consequence of failing to deposit the FICA tax within the statutorily prescribed times is that employers could be subject to failure-to-deposit penalties under the Internal Revenue Code. However, there is an exception to these rules for employers who are making interest-free adjustments. The deposit rules state that an employer who files an interest-free adjustment (i.e. Form 941-X) must pay the amount of the adjustment (i.e. the amount of the FICA tax) by the time it submits the adjusted tax return. If this requirement is met, the amount of the adjustment will be deemed to have been timely deposited by the employer. In other words, the failure-to-deposit penalty will not apply in that case. Employers who are correcting FICA withholding errors should for that reason ensure that all adjustments are paid on time.

V. Conclusion

Plan sponsors of nonqualified deferred compensation plans should conduct regular compliance reviews to ensure that they are complying with the Internal Revenue Code's rules for FICA tax withholding on deferred amounts which are subject to the special timing rule. Failure to withhold FICA tax on a timely basis may result in liabilities, including those attributable to lawsuits brought against the plan sponsor by employees on the ground that the sponsor's faulty plan administration and failure to adhere to the special timing rule resulted in higher taxes and lower benefits for the employees. One remedy that may be available to certain employers who fail to timely withhold FICA taxes is to file an adjusted quarterly tax return on Form 941-X to correct the FICA (and any Additional Medicare Tax) underwithholding. These remedies are only available during specific tax years, however. In the event that a withholding error falls outside the period when an amended employment tax return can be filed, the deferred amounts will still remain subject to FICA tax as the compensation is paid. As evidenced by Henkel, to lessen the risk of litigation brought about as a result of the employees facing negative FICA tax consequences, plan sponsors should pay attention to when deferred amounts vest and are required to be included in income for FICA purposes.

Originally published by Pension & Benefits Daily, Bloomberg BNA.

View From McDermott: Conduct Regular Reviews To Ensure Compliance With FICA Tax Withholding Rules

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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