Social Security Taxes and Deferred Compensation

An employer did not properly report and withhold FICA taxes for participants in its deferred compensation plan. A federal court has ruled that it is liable to the participants, because they will end up paying more FICA taxes due to the employer error. IRC §3121(v) is a special rule for SERPs and other types of non-qualified deferred compensation plans. It requires payment of FICA taxes up front when plan benefits first become vested. This saves a lot of taxes, for the employee and the employer, because the taxes owed for the retirement portion of FICA are capped at a taxable wage base — $118,500 in 2015 – and usually there is no payment owed on that due to other wages in the vesting year. In other words, §3121(v) makes it possible for participants in these plans (i) to skip the retirement portion of FICA altogether, (ii) to pay Medicare taxes (which are applied to all wages without a cap) only at the time of vesting, (iii) to skip all FICA on investment earnings after the vesting date, and (iv) to pay no FICA taxes on any of the payments they receive. This is a great deal for employers, too, because it lessens their FICA obligations.

However, if §3121(v) isn’t followed, each payment will be taxed for FICA just like any other wage payment. Retired persons, often without wages or earned income, now need to pay full FICA (not just a Medicare piece) until they hit the wage cap each year. In addition, investment earnings after the vesting date, which would not have been taxed for FICA due to §3121(v), now get taxed. The employer matches the employee payment, except for the extra 9/10 of 1% supplement on wages over $200,000. It’s an expensive process for those who do not know this obscure statute.

The recent federal case hinged on the fact that the plan document actually spelled out what the employer was supposed to do about taxes. If the plan had been silent on that point, it’s possible the employer would not have been found liable. However, the case is disturbing, because its principles could be applied to taxes which are more harmful than social security. Consider §409A (for deferred compensation) or §280G (for excess parachutes after a change in control).

Advice: review your payroll processes, deferred compensation plans, and change in control agreements carefully. The case is Davidson v. Henkel (DC MI), 07/24/2013.