Nonqualified Deferred Compensation
In general, a nonqualified deferred compensation plan allows an executive to defer the “receipt” and income taxation of a portion of his compensation to a tax period after the period in which the compensation is earned (i.e., the time when the services giving rise to the compensation are performed).
The payment of the compensation is generally deferred until some specified event, such as the individual’s retirement, death, disability, or other termination of service, or until a specified time in the future (e.g., ten years).
When the deferred compensation is ultimately paid out to the executive, it will then be subject to income tax as compensation. However, that pay-out period may extend over several years, at which time the executive’s effective income tax rate may also be lower.
In general, nonqualified deferred compensation arrangements are contractual arrangements between the employer and the executive. They may be structured in whatever form achieves the goals of the parties and, so, may vary greatly in design.
Income Tax
The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the executive earning the compensation depends on the facts and circumstances of the arrangement. A variety of tax principles and Internal Revenue Code (“IRC”) provisions may be relevant in making this determination, including:
– The doctrine of constructive receipt;
– The economic benefit doctrine,
– The provisions of IRC Section 83 (relating to transfers of property in connection with the performance of services); and
– The provisions of IRC Section 409A.
Generally, the compensation is includable in income when it is actually or constructively received by the employee (as when it is made available so that he could draw upon it at any time, without substantial limitations), when the employee realizes the economic benefit of the compensation (as when he can pledge it to secure a loan), or when the deferral plan fails to satisfy the requirements of Section 409A.
FICA Tax
Nonqualified deferred compensation is generally taken into account as wages for FICA purposes at the time when the services giving rise to the compensation are performed (thereby giving rise to the right to a deferral). At that time, as a rule, employers are generally required to withhold and remit FICA taxes. However, if the deferred compensation is subject to a substantial risk of forfeiture (not vested), it will not be included in FICA wages until it becomes vested.
A federal district court recently considered the case of an employer that failed to timely withhold FICA taxes.
The Plan
Executive participated in Employer’s Deferred Compensation and Supplemental Retirement and Investment Plan (the “Plan”), a nonqualified retirement plan.
The Plan was designed to provide a supplemental retirement benefit for a select group of management or highly compensated employees. This was to be accomplished by permitting the Participants to defer a portion of their compensation, which was not taken into account under the normal Employer’s Retirement Plan. Under the Plan, the participants would defer their compensation until the time of their retirement. Presumptively, at retirement, the participants would be taxed in a lower tax bracket, thereby decreasing their overall tax liability.
Executive retired in 2003 and began receiving his monthly supplemental benefit under the Plan. Eight years later, in 2011, a letter was sent from the Employer to all participants, informing them that Employer had “determined that [FICA] payroll taxes associated with [their] nonqualified retirement benefits [were not] properly withheld.” The letter further stated: “At the time of your retirement, FICA taxes were payable on the present value of all future non-qualified retirement payments [the “Special Timing Rule”]. Therefore, you are subject to FICA Taxes on your non-qualified retirement payments on a ‘pay as you go’ basis for 2008 and beyond, which are the tax years that are still considered ‘open’ for retroactive payment purposes.”
In the letter, Employer also informed participants that Employer: (1) remitted the full payment of FICA tax owed to the IRS on behalf of Plaintiffs; (2) did not deduct the entire amount owed for FICA taxes from the participants’ accounts, but instead reimbursed itself by reducing the participants’ monthly benefit payments for a 12 to 18 month period; and (3) planned to adjust participants’ monthly payments under the Plan, effective January 2012.
Executive commenced an action against Employer to challenge the change to his benefits resulting from the Employer’s having failed to withhold FICA taxes at the time of vesting, based upon the actuarial present value of his benefits under the Plan, and asserting damages in the amount of the additional FICA taxes withheld by the Employer from the actual payment of benefits under the Plan.
Executive asserted that Employer’s administration of the Plan resulted in a reduction of his benefits. He did not seek to enjoin the ongoing collection and payment of his FICA taxes, nor did he dispute that FICA taxes were owed based on the distribution of his benefits. Rather, he maintained that his promised benefits were reduced because of Employer’s mistake in failing to timely withhold the FICA taxes. That reduction, Executive asserted, should have been borne by Employer.
Executive sought summary judgment on its claim that Employer committed a FICA error in violation of the Plan. After reviewing the Plan and the evidence presented, the Court found that Executive was entitled to summary judgment.
The Court found that while nothing in the Code mandates the use of the Special Timing Rule (which allows the Employer to use the present value of future payments, at the time of vesting, for purposes of determining the FICA tax due), the failure to take advantage of the Special Timing Rule in this case resulted in higher taxes. Despite the fact that Employer did not violate federal law, the Court found that Employer violated provisions of the Plan and the Plan’s purpose because the Plan vested Employer with control over executive’s funds and required Employer to properly handle tax withholding from those funds.
The undisputed facts of this case indicated that Employer did not timely withhold the Executive’s taxes while the funds were within Employer’s control as required by the Plan. It was undisputed that Employer did not properly withhold and pay FICA taxes at the time they were initially due under the Code (in this case, in the year of retirement based on the value of amounts to be paid to from the non-qualified retirement plan).
Rather than properly withholding the Executive’s taxes as required by the Plan, Employer paid these taxes at the time of each benefit payment. Employer then placed the Executive on a pay-as-you-go basis, which, at that point, was the only way to adhere to the law. This approach resulted in the Executive’s owing more in FICA taxes than he would have owed had Employer properly and timely paid taxes when they were due.
Accordingly, the Court found that the Executive was entitled to summary judgment because Employer failed to adhere to the purpose and terms of the Plan resulting in a reduced benefit to the Plaintiffs.
Lessons
One of the most common reasons employers use deferred compensation arrangements is to induce or reward certain behavior; e.g., to retain the services of an employee, or to encourage the employee to attain certain performance goals.
In order to attain these goals, however, it is important that the employer abide by the terms of the deferred compensation plan and by the applicable tax rules. The failure to do so may not only defeat the purpose of the plan, by adversely affecting the executives covered by the plan, but may also result in additional economic costs to the employer when it is forced to hold those executives harmless from the consequences resulting from such failure.