Case highlights employer responsibility for proper FICA tax treatment
Davidson, et al., v. Henkel Corporation, et al.
INSIGHT ARTICLE |
In Davidson, et al., v. Henkel Corporation, et al., No. 4:12-cv-14103, a district court held that Henkel Corporation is liable to former employees for its treatment of FICA tax on their nonqualified deferred compensation plan payments. The employees who filed the lawsuit against their former employer were participants in a nonqualified deferred compensation plan that allowed them to defer a portion of their compensation until the time they retired, at which time payments were to be paid to them monthly during their retirement.
Under a special timing rule provided in Reg. section 31.3121(v)(2)-1(a)(2), nonqualified deferred compensation is required to be included in FICA wages on the later of:
- The date on which the services creating the right to that amount are performed, or
- The date on which the right to that amount is no longer subject to a substantial risk of forfeiture.
According to this rule, the monthly payments should have been included in FICA wages at the time an employee retired, since retirement is the condition that must be met in order to have full rights to the payments. Under Reg. section 31.3121(v)(2)-1(d)(1)(ii)(A), if this special timing rule is not followed, the amount is included in FICA wages according to the general timing rule, which is at the time of payment rather than the time the substantial risk of forfeiture no longer exists. Because of the timing difference, using the general rule results in larger amounts being subjected to FICA tax. This larger amount comes from the fact that the payments actually received include earnings and are not discounted to the present value as under the special timing rule.
In Davidson, since payments were made monthly after retirement, the amount to be included in wages is the present value of payments to be made under the plan. Henkel Corporation failed to include the present value of benefits in FICA wages at the time the employees retired. Once the corporation realized its mistake, it paid all past-due FICA tax on past monthly payments and notified the affected employees, informing them that their future monthly payments would be reduced for FICA taxes.
The case filed by the employees highlights the employer's role with respect to FICA tax and properly reporting wages. Even though the FICA tax at issue was an employee liability and Henkel Corporation corrected it using the proper procedures, the court upheld the employees' argument because it was Henkel Corporation's actions and failure to apply the special timing rule that caused employees' future benefit amounts to be reduced.
Many employers voluntarily gross-up employees for tax liabilities that result from the employer's actions, similar to when employee awards increase an employee's taxable income and the employer does not intend to subject them to a liability. Henkel Corporation did not choose to make employees whole for the additional liability, since the actions they took to correct the issue still fell within allowable tax provisions.
The ruling indicates that what may seem like a voluntary employer decision to gross employees up for tax liabilities that employees incur as a result of an employer's error may not actually be voluntary. The decision in this case may also support an employee's claim for damages when an employer's error causes the employee to be liable for the penalty tax provisions of section 409A.
Employers that have failed to use the special timing rule do have the opportunity to amend the payroll and Form W-2 filings if the date the value of the payments under the plan became ascertainable and no longer subject to a substantial risk of forfeiture (the vesting date) is still an open year for payroll tax purposes. Payroll taxes are open until April 15 of the fourth year following the end of the employee's tax year. This deadline is a hard close, as the IRS will no longer enter into a closing agreement to accept a payment of tax with respect to a closed year.
The specific issue in this case was not that the corporation realized the mistake several years after the employees retired so that FICA tax had also been late under the general timing rule. (One employee retired in 2003 and started receiving payments, and it was 2011 before the corporation was alerted to the FICA failure.) The corporation paid all past due taxes, and only reduced employee payments by the FICA liability of those employees. The employees' argument was also not that the employer should be responsible for paying all of the employees' payroll taxes. The important issue in the case was that actions by the employer increased the employees' total liability at no fault of, and completely outside the control of, the employees.
The court held that Henkel Corporation's failure to apply the special timing rule violated the terms of the nonqualified deferred compensation agreement. Specifically, section 4.4 of the agreement provided that Henkel Corporation was responsible for withholding taxes from participant accounts while the amounts were controlled by the company (i.e., prior to distribution to the participants). The court stated, "the plan vests Defendants with control over Participants' funds and required the Defendants to properly handle tax withholding from those funds."
Even though this language did not specifically require Henkel Corporation to use the special timing rule and the general timing rule adheres to the tax law, the court ruled that Henkel Corporation acted "inconsistent[ly] with the purpose and terms of the plan."
The former employees' argument was upheld under the civil enforcement provisions of section 502(a) of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA most notably provides rules for qualified plans similar to the requirements of section 401 in the tax code. The Henkel Corporation nonqualified plan was a "top hat" plan, which is generally exempt from most ERISA provisions, but even nonqualified plans are subject to the enforcement provisions of ERISA. Therefore, although the corporation did not violate any tax rules (once the problem was found and corrected), it was still liable to employees for failing to comply with rules that would have put the employees in a better position.