Under a special timing rule contained in the federal tax regulations, benefits earned under many nonqualified deferred compensation arrangements are subject to Social Security and Medicare employment taxes (FICA taxes) as of the date when services are performed or, if later, when there is no longer a substantial risk of forfeiture (i.e., at the time the benefits vest). While the use of the special timing rule is mandatory, many employers fail to apply this rule. This failure can expose employers to various tax penalties and, as one recent case illustrates, subject employers to claims from participants for the value of lost benefits.
The application of the special timing rule is generally beneficial to employers and employees for a variety of reasons, including:
- Once FICA taxes are imposed on a participant’s vested nonqualified deferred compensation benefits, no additional FICA taxes are imposed on such benefits or the future earnings credited thereon (commonly referred to as the non-duplication rule).
- Most participants earn nonqualified deferred compensation benefits in working years in which their earnings exceed the taxable wage base for purposes of Social Security taxes. Accordingly, the special timing rule potentially allows such benefits to escape Social Security tax when earned, and the non-duplication rule allows such benefits (including the earnings thereon) to escape Social Security tax when paid.
- Participants and employers are also shielded from future FICA tax rate increases.
It’s important to note, however, that if an employer fails to properly apply the special timing rule, the non-duplication rule will not apply and all future benefit distributions (including the earnings thereon) will be subject to FICA taxes at the rates in effect at such time. Additionally, the failure to properly follow the special timing rule could subject employers to claims from participants for the value of lost benefits.
In Davidson v. Henkel Corp., 2013 WL 3863981 (E.D. Mich. 2013), the court allowed a participant’s ERISA-based claims to proceed against his employer in a suit seeking to recover benefits lost as a result of the employer’s failure to properly apply the special timing rule to benefits earned under a top-hat plan. This failure resulted in the participant’s nonqualified deferred compensation benefits being subjected to FICA taxes on a “pay as you go” basis (i.e., all benefit distributions, including the earnings thereon, were subject to FICA taxes). Accordingly, the participant brought suit against the employer and the plan asserting that his benefits under the plan were wrongfully reduced due to the fact that he lost the benefit of the non-duplication rule, thereby requiring him to pay FICA taxes on the full value of each benefit payment. While the court dismissed the participant’s state law claims based on ERISA pre-emption, the court allowed the participant’s ERISA-based federal common law contract claim and equitable estoppel claims to proceed.
The Davidson case serves as an important reminder for employers to review their existing payroll withholding procedures to make sure that the special timing rule is being properly administered. In this regard, nonqualified deferred compensation benefits can be provided in many forms, including, among others, account balance plans (e.g., elective deferred compensation arrangements), non-account balance plans (e.g., Supplemental Executive Retirement Plans (SERPs)) and phantom stock arrangements. Additionally, certain types of equity awards can fall within the definition of non-qualified deferred compensation depending on their terms (e.g., restricted stock units (RSUs) with delayed payment dates or deferral features).
With respect to time-based RSUs, employers also frequently fail to properly withhold FICA tax where the award provides for vesting at retirement. For example, awards of RSUs are commonly structured to vest and payout upon the satisfaction of a specified service period (e.g., a three-year vesting period). It is also common for an RSU award to provide for accelerated vesting if the participant retires during the vesting period on or after the attainment of a specified age (e.g., age 55 or 62). In this situation, however, the IRS will treat the award as vested for purposes of FICA tax on the grant date if the participant has satisfied the conditions to retire as of such date or, alternatively, on the date the participant becomes retirement-eligible during the vesting period.
It’s Not Too Late– For purposes of satisfying the employer’s FICA withholding obligations under the special timing rule, the tax regulations also contain a rule of administrative convenience. Under this rule, an employer may treat nonqualified deferred compensation benefits that have become vested during the year as taxable and subject to withholding on any later date within the same calendar year. For example, if an employee’s deferred compensation benefits became vested in April (or any other date in current calendar year), the employer may take this vested benefit into account in the final payroll in December (e.g., December 31). Additionally, to the extent a failure to apply the special timing rule relates to one or more prior tax years, employers should consider taking corrective action for open tax years (i.e., three years from April 15 following the year the benefit vested). Accordingly, as 2014 comes to an end, employers should review their employment tax reporting and withholding obligations for nonqualified deferred compensation benefits.