Recent Case Opens Door to Civil Enforcement Claims for Negligent FICA Tax Withholding

by McDermott Will & Emery

A District Court in Eastern Michigan recently rejected a motion to dismiss a participant’s benefit claim, holding that an employer legally could be liable to a participant in a nonqualified deferred compensation plan when the employer did not properly withhold FICA tax in the manner most advantageous to the participant. As a best practice, plan administrators should scrutinize any participant communications or claim responses because they can open the door to estoppel claims under ERISA.

The Federal District Court in Eastern Michigan recently rejected a motion to dismiss a participant’s benefit claim, holding that an employer legally could be liable to a participant in a nonqualified deferred compensation plan when the employer did not properly withhold FICA tax in the manner most advantageous to the participant.  Plaintiff John Davidson participated in the Henkel Corporation Deferred Compensation and Supplemental Retirement Plan (the Plan), a top hat nonqualified deferred compensation plan maintained by Henkel Corporation (the Company) that included defined benefit payments.  Beginning with his retirement in 2003, the Company withheld FICA tax on each monthly defined benefit payment under the Plan.  In 2011, the Company discovered and informed Davidson that it had failed to withhold FICA taxes from his Plan benefits in accordance with the favorable “special timing rule” applicable to deferred compensation.

The Company remitted the full amount of the FICA taxes due to that date on behalf of Davidson and reimbursed itself by reducing his monthly benefit payments effective as of January 1, 2012.  Davidson brought suit against the Company and the Plan (the Defendants) in the U.S. District Court for the Eastern District of Michigan (Southern Division) (the Court) under the Employee Retirement Income Security Act of 1974 (ERISA), alleging that his benefits were wrongfully reduced as a result of the Defendants’ failure to follow the special timing rule for withholding of FICA taxes on vested deferred compensation.

FICA Taxes and Nonqualified Deferred Compensation Plans

The “general timing rule” of Section 3102(a) of the Internal Revenue Code (the Code) requires that employers deduct FICA taxes from an employee’s wages when they are actually or constructively paid.  However, U.S. Department of the Treasury Regulations under Section 3121 provide a “special timing rule” applicable to FICA taxes on payments from nonqualified deferred compensation plans.  In general, for an individual account type of nonqualified deferred compensation plan, the special timing rule provides that FICA tax is due on the date on which the right to the compensation is no longer subject to a substantial risk of forfeiture (i.e., fully vested and nonforfeitable). 

On the other hand, for certain defined benefit type of deferred compensation plans, FICA tax is due when amounts are “reasonably ascertainable,” which is usually at the time the participant retires or terminates service and no longer earns benefits under the plan.  Treasury Regulations also include a “non-duplication rule,” which eliminates additional FICA withholding on payments subject to the special timing rule.  Thus, when the special timing and non-duplication rules are properly applied to a defined benefit type of nonqualified deferred compensation benefit, the participant’s entire benefit is subject to FICA taxes only at one time and likewise is subject to the FICA dollar limit only at that time.  Conversely, if an employer fails to apply these rules, the general FICA timing rule applies, and FICA taxes are assessed on a payment-by-payment basis, which can result in overall higher FICA dollar limits and thus greater taxation.

Claims for Recovery of Benefits under ERISA and Equitable Estoppel

The Court held that the Defendants may be liable under ERISA because the Plan gave Defendants discretionary control over the tax treatment of the participant’s benefits and obligated the Defendants to properly manage FICA tax withholding.  Importantly, the Court noted that the Defendants appeared to admit their failure to properly manage FICA withholding when the Company replied in response to Davidson’s claim letter “… at the time [you] commenced receipt of this benefit, [the Company] should have applied FICA tax to the present value of your nonqualified plan benefit.”

In addition, the Court held that Davidson properly asserted his ERISA equitable estoppel claim.  The U.S. Court of Appeals for the Sixth Circuit recognizes equitable estoppel as a viable theory for recovery in ERISA cases and recently extended the doctrine’s application to ERISA-governed pension plans in Bloemker v. Laborers’ Local 265 Pension Fund.  Post-Bloemker, plaintiffs can invoke equitable estoppel when (1) plan terms are unambiguous, (2) he or she can demonstrate the traditional elements of estoppel and (3) certain extraordinary circumstances exist that shift the balance of the equities strongly in favor of the plaintiff.  The Court concluded that Davidson properly asserted an equitable estoppel claim under ERISA by showing that the Defendants were grossly negligent in determining FICA taxes and also in negotiating with the IRS on such taxes, and later reducing benefit payments, without Davidson’s input. 

Future Impact on Sponsors of Nonqualified Deferred Compensation Arrangements

Sponsors of nonqualified deferred compensation arrangements should review their participant communications and FICA computation withholding procedures.  Those plan sponsors with discretionary authority over the determination and distribution of benefits from top hat plans must recognize that any mistake made in determining FICA withholding could provide a basis for participants to assert claims under ERISA.  Further, as a matter of prudent practice, plan administrators should carefully scrutinize any participant communications or claim responses because such materials can open the door to estoppel claims under ERISA.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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