Tread Carefully on Taxes for Severance and Deferred Comp



Two recent court cases show the dangers that lurk for employers. Employers would be wise to note the words of the 19th century English jurist Lord Bramwell: "Like mothers, taxes are often misunderstood, but seldom forgotten.'' Two recent federal court cases dealing with Social Security and Medicare taxes underscore that point -- and why it’s important for employers to tread carefully when it comes to severance plans and deferred compensation plans. Both must be designed -- and administered -- prudently. Otherwise, employers risk running afoul of the Internal Revenue Service or getting dragged into court by a disgruntled former employee. In particular, employers offering severance plans need to recognize that these plans are subject to Social Security and Medicare, or FICA, taxes -- unless the plans are tied to state unemployment benefits. Employers also should analyze the effect that severance pay will have on state benefits. When operating deferred compensation plans for executives, employers also need to account for FICA correctly under the so-called “special timing rule” -- or risk inciting the legal wrath of former employees. Supreme Court clarifies that severance pay is subject to FICA In March, the U.S. Supreme Court ruled that severance payments to laid-off employees -- that aren’t tied to state unemployment benefits -- are taxable wages subject to FICA taxes. The case, United States v. Quality Stores Inc., resolved two conflicting sets of lower court rulings:
  • The U.S. Court of Appeals for the 6th Circuit ruled that severance pay wasn’t subject to FICA.
  • The U.S. Court of Appeals for the 3rd, 8th, and Federal Circuits held severance pay was subject to FICA.
The Supreme Court said the plain meaning of the statute providing that wages are remuneration for employment means that severance payments are indeed wages. Additionally, the history of Internal Revenue Service Code section 3102(o) demonstrated that the statute was meant to require income tax withholding on severance payments that were tied to state unemployment benefits, even though the IRS had ruled they were not wages -- the reason for the ruling was to let recipients be eligible for the benefits in states that would not pay such benefits if the taxpayer was still receiving “wages” from a former employer. Code section 3102(o) requires income tax withholding on state unemployment benefits so former employees won’t get hit with a large year-end income tax bill. The high court noted that the IRS rulings exempting severance payments tied to state unemployment benefits weren’t at issue, so it didn’t address whether those rulings were consistent with the definition of wages under federal tax law. The decision resolved thousands of FICA refund cases pending before the IRS. Some experts speculate the agency may now revisit its past rulings on severance tied to state unemployment benefits. District Court case underscores risk of improper FICA withholding on deferred compensation Last July, a U.S. District Court in Michigan refused to dismiss a case filed by an executive that alleged his former employer mishandled the FICA tax on deferred compensation in a supplemental retirement plan. The case, Davidson v. Henkel Corp., highlights the risk for employers as well as executives if the FICA tax treatment of nonqualified deferred compensation plans isn’t applied correctly. The case involved the “special timing rule” and the so-called “non-duplication rule” for FICA taxes on vested deferred compensation. Typically with FICA taxes, compensation is taken into account when it’s actually or constructively paid under the general timing rule. The special timing rule provides that deferred compensation is subject to FICA taxes on the later of the date the compensated services were performed -- or the date on which the right to the deferred compensation was no longer subject to a substantial risk of forfeiture (vested). The non-duplication rule provides that once an amount of deferred compensation is accounted for under the special timing rule, neither that amount nor any earnings tied to that amount should be treated as wages for FICA tax purposes any longer. Conversely, if deferred compensation isn’t accounted for under the special timing rule, payments of the deferred compensation and related earnings should be considered wages under the general timing rule for FICA. Davidson involved an executive who participated in a nonqualified supplemental retirement plan designed to permit participants to defer a portion of their salary and bonus compensation that exceeded the amount of compensation that could be considered under the employer’s qualified pension plan. The benefits under the supplemental plan were paid at retirement and not vested until then. The executive retired in 2003 and began receiving annuity payments from the nonqualified plan. The employer failed to take into account the executive’s deferred compensation under the supplemental plan when the money vested at his retirement in 2003 under the special timing rule. Under tax regulations, the employer should have taken into account the present value of the benefits in that year, under the special timing rule. Had the employer taken the present value of the benefits into account in 2003, a substantial amount of the deferred compensation would have escaped taxation. In 2011, the employer realized the error following an internal investigation and notified the executive that, beginning in 2012, all payments from the supplemental plan would be subject to FICA withholding (under the general timing rule). In addition, the employer paid the IRS the employer and employee portion of all past FICA taxes due from 2003-2011. Beginning in 2012, the employer also began reimbursing itself for the employee portion of the FICA tax by reducing the executive’s benefit payments. The executive sued his former employer under the Employee Retirement Income Security Act (ERISA) and state law, arguing that because of the employer’s failure to properly account for the deferred compensation under the special timing rule the executive lost the benefit of the non-duplication rule. The executive also argued that instead of his entire benefit being subject to FICA in one year, payments were now subject to FICA tax each year, reducing his benefits. In addition, the executive maintained, the employer violated its fiduciary duties under ERISA by acting in its own self-interest when it reached a settlement with the IRS and reduced his benefits to reimburse itself. The employer tried to get the case dismissed, claiming the court lacked jurisdiction because the lawsuit dealt with a tax refund. The court rejected those arguments, saying that the executive was not claiming that his benefit was erroneously subject to FICA tax -- rather that the employer’s failure to account correctly for the benefits for FICA tax purposes caused his benefit to be reduced. The court did hold that ERISA preempted the executive’s state law claims, but it refused to dismiss the executive’s case to enforce his promised benefit. Therefore, the case is proceeding to trial. Read more: Tread Carefully on Taxes for Severance and Deferred Comp | Insurance Thought Leadership

Scott Galbreath

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Scott Galbreath

Scott E. Galbreath is the head of employee benefits and executive compensation services at the Burton law firm and has more than 25 years of experience in ERISA, employee benefits and executive compensation. His practice areas include counseling for-profit, tax-exempt and governmental clients on all aspects of employee benefits.

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