District court rules on special timing rule for FICA tax withholding on deferred compensation

Tax Hot Topics
Tax Hot TopicsIn Davidson v. Henkel, No. 12-cv-14104 (E.D. Mich. 2015), a federal district court ruled that an employer violated the terms of its nonqualified deferred compensation plan by failing to withhold Federal Insurance Contribution Act (FICA) taxes using the “special timing rule.” As a result, the employer was liable to the plan participants for the additional FICA taxes owed on the deferred compensation.

There are two timing rules for determining when compensation is included as wages subject to FICA tax. The “general timing rule” provides that the compensation is included in wages at the time it is actually or constructively paid to the employee. An exception to the general timing rule is the “special timing rule,” which applies to nonqualified deferred compensation.

The special timing rule provides that the present value of the deferred compensation is included in FICA wages at the later of the date on which the services are performed to earn the right to the compensation, or the date the deferred compensation becomes vested. Once the present value of the deferred compensation is included in wages under the special timing rule, no amount of the deferred compensation, including earnings, is included in FICA wages when the deferred compensation is paid to the employee.

If the present value of the deferred compensation is not included in FICA wages upon vesting in accordance with the special timing rule, and the vesting year is closed under the statute of limitations, then the deferred compensation must be included in FICA wages under the general timing rule (i.e., included in wages when paid to the employee).

Under the facts of the case, John Davidson, a former employee of Henkel Corporation, along with other retirees, vested in nonqualified deferred compensation from prior years, and began receiving payments of the deferred compensation after retirement. Henkel failed to apply the special timing rule for withholding FICA taxes, and as a result was required to apply the general timing rule. So, instead of the employees paying FICA tax on the present value of the deferred compensation, they were required to pay FICA tax on the full value of the amount paid. Davidson argued that if the special timing rule had been used, some of the employees may have reached the Social Security wage cap in the year of vesting, resulting in some or all of the deferred compensation not being subject to Social Security tax. Alternatively, the full amount of each separate payment was likely subject to Social Security tax because the employee would not reach the Social Security wage cap during retirement years.

The U.S. District Court for the Eastern District of Michigan ruled that based on the language in the plan documents, the purpose of the plan was to reduce taxation to participants, which implicitly required use of the special timing rule.  Henkel’s failure to apply the special timing rule violated the terms of the plan. Accordingly, the court ruled in favor of the employees.


Eddie Adkins
T +1 202-521-1565

Tax professional standards statement
This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax adviser to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.