Pension & Benefits Daily ™
Reproduced with permission from Pension & Benefits Daily, 70 PBD, 4/12/16. Copyright 姝 2016 by The Bureau of
National Affairs, Inc. (800-372-1033) http://www.bna.com
View From McDermott: Conduct Regular Reviews to Ensure Compliance With FICA
Tax Withholding Rules
BY RUTH WIMER, JOSEPH URWITZ
MIDENJAK
AND
MIA
I. Introduction
ponsors 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
S
Ruth Wimer ([email protected]) is a partner
in the law firm of McDermott Will & Emery
in Washington. She focuses her practice
on matters related to executive compensation,
including international issues, fringe benefits,
and qualified and nonqualified deferred
compensation.
Joe Urwitz ([email protected]) is a partner in
the law firm of McDermott Will & Emery in
Boston. He advises clients on a variety of
employee compensation issues, including nonqualified deferred compensation, equity
awards and employment and severance
arrangements.
Mia Midenjak ([email protected]) is an
associate in the law firm of McDermott Will &
Emery in Boston. She focuses her practice on
employee benefits matters.
COPYRIGHT 姝 2016 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
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
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‘‘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.
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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:
s 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.
s 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
COPYRIGHT 姝 2016 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
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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.
s 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 interestfree 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
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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.
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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 en-
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sure 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.
COPYRIGHT 姝 2016 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
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