Is Special Timing Rule for FICA Tax Withholding on Nonqualified Benefits Voluntary?

Tom Breitenbach

Under the special timing rule of Internal Revenue Code Section 3121(v), rather than applying FICA taxes at the time of distribution from a nonqualified plan, FICA taxes may be applied at the later of the performance of services or the elimination of any substantial risk of forfeiture (i.e., when vested). This special timing rule for nonqualified plans is generally viewed as favorable to the participants because it is likely that most or all participants will already exceed the FICA wage base ($118,500 for 2015) for imposition of the 6.2% social security tax in the year of performing services due to their regular wages. In other words, participants would not be subject to the 6.2% social security tax, and only the 1.45% Medicare tax would apply in the year of deferral. Also, any subsequent earnings on deferred amounts would not be subject to FICA taxes. If the special timing rule is not used, then FICA taxes apply years later when distributions occur, applying to the total distribution (including earnings), and in most cases with distributions occurring post-employment when the participants do not have wages that exhaust the FICA wage base. 

If an employer either chooses not to apply the special timing rule, or simply “forgets” due to ignorance of Code Section 3121(v), there is no violation of tax law because the taxes would be applied at the time of distribution. However, in Davidson v. Henkel Corp., E.D. Mich. No. 12-CV-14103, 2015 U.S. Dist. LEXIS 722, the court found that the employer’s failure to apply the special timing rule under its top hat plan violated the terms of the plan and resulted in an impermissible reduction in the retirees’ benefits.  The court found that the terms of the plan required the employer “to properly withhold the Participants’ taxes when they were assessable or due.” It probably did not help matters for the employer when it sent a letter to the participants admitting that FICA taxes had “not been properly withheld.” This case serves as an important reminder that benefits due employees are based on the express terms of the plan document, and ignorance of tax laws is no excuse if your plan document requires the special timing rule for FICA taxes. Employers, know what you are signing when you implement a plan!

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