This Time The Employer Is Responsible For The Withholding Error

I recently blogged (here and here) about a situation involving Verizon withholding US taxes from payments to former employees who never lived or worked in the U.S. The employees attempted to recover the withheld taxes from Verizon on a breach of fiduciary duty claim against the employer and also attempted to have the withholding taxes refunded directly from the IRS but filed the refund claim too late. Another recent withholding case might result in recovery for the former employees.

To understand this case, we need to review the Social Security (FICA) taxation of nonqualified deferred compensation benefits. Nonqualified deferred compensation payments are generally taxed for income tax purposes at the time that the benefits are paid or made available to the individual. In contrast, nonqualified deferred compensation payments are taxed for FICA tax purposes at the earlier of when the amounts are paid or when they vest. Thus, if benefits under a nonqualified deferred compensation plan vest when an employee reaches a retirement age, FICA taxation applies at that time to the present value of the entire benefit. If that taxation occurs in a year in which the employee has already been paid an amount equal to the FICA wage base ($113,700 in 2013), then the individual is required to pay only the Medicare portion of the FICA tax, a relatively small amount. Although there is generally no cap on the wages subject to Medicare taxation, the Medicare tax is only 1.45% of the benefit rather than 6.2%, which is the Social Security portion of the FICA tax.[1]

In a recent federal district court decision, a former employee filed a class action seeking to recover amounts withheld as taxes from his nonqualified deferred compensation benefit. That benefit vested on his retirement and his employer should have withheld and paid FICA taxes on the present value of the benefit at that time; however, the employer failed to do so. A number of years later, the employer determined that it had mishandled the FICA taxes at retirement. Because of that mishandling, under the FICA tax regulations, the employer was now required to withhold FICA taxes from each benefit payment as it was made. The employer paid the back FICA taxes to the IRS and reimbursed itself by reducing the former employee’s monthly benefit payments for several months. The employer also began withholding FICA taxes from each benefit payment.

The former employee sued claiming harm because the amount of FICA taxes to be paid from each benefit payment is quite a bit more than the amount that would have been owed had the FICA taxes been imposed at the time of retirement. The employer claimed that the suit was one to stop withholding which is not permitted under the tax code. The district court disagreed, saying that the suit was one for benefit payments, namely, the full monthly payment which would be owed if the withholding had been properly handled in the first instance. Rather than a suit to stop withholding, it was instead a suit for damages, with the damages being measured by the amount of the withholding. The court allowed the suit to proceed on that basis.

FICA tax withholding from nonqualified deferred compensation plans can be a tricky business. Although we do not know how this case will ultimately be decided, it highlights the risks that employers face if they fail to follow the rules.

[1] Under the Affordable Care Act, beginning in 2013, there is an additional Medicare tax of 0.9% imposed on wages above $200,000 ($250,000 for married taxpayers filing joint returns; $125,000 for married taxpayers filing separate returns).  My colleague Jeff Cairns blogged about this new tax last year.


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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