Do the Right Thing, or Else…

What happens when a company makes an honest mistake and seeks IRS assistance in rectifying the problem? See below for an explanation of how the solution did not fairly address the consideration of the affected former employees. The former employees sued and won.

In tax practice, as in life, mistakes do happen. The right thing to do is to fix the mistakes. That means that all affected parties are to be treated fairly and in accordance contracts, etc. The latest illustration below, by a way of court case (Davidson v. Henkel Corp.), makes a clear point that it is important to make sure that all affected parties are treated fairly and equitably.

The facts of the case are as follows, the Company had a “Top Hat” retirement plan. Generally, a “Top Hat” plan is a retirement plan for selected top management; its participants are usually highly compensated. The plan allowed the plan participants to defer receiving income until retirement. This is a common arrangement for retirees so that they can take advantage of lower income tax rates during the retirement years. This particular plan was set up so that the tax would only be assessed upon the retirement of the participant. The plan also had specific language stating the Company is required to “properly” withhold appropriate taxes while the funds were in control of the Company. 

In 2003, one of the plan participants (Davidson) retired and began receiving his monthly benefit. The Company, no doubt inadvertently, did not withhold any FICA (commonly known together as Social Security Tax and Medicare Tax ) on those payments for 8 years. In 2011, Henkel realized it made a mistake and sought to rectify the problem. The Company did the following:

1. Consulted with IRS’s Chief Counsel Office on the best way to resolve the failure to timely file and pay FICA tax.
2. Remitted the full payment of FICA to the IRS on behalf of effected plan beneficiaries.
3. Did not deduct the full amount of FICA from plan beneficiaries’ account but instead began reducing the monthly benefit payment for a period of a year to year and a half.
4. Planned to adjust affected beneficiaries’ monthly payments from January 2012.

Davidson protested this treatment and in its response the Company confirmed that it should have applied FICA tax to the present value of the deferred benefit. The company insisted it was “doing the right thing”. In response to the company’s statement, Davidson filed a class action suit against Henkel for improperly reducing his plan benefits.

Generally, in the case of non-qualified deferred compensation plan, such as in this case, the FICA is applied to the present value of the future benefit at the time of participant’s retirement. In Davidson’s case, it would have been 2003, the year of his retirement. Presumably, he had received compensation during that year, and since the compensation subject to Social Security portion of FICA had a ceiling, very little tax would have been due. Davidson insisted that Henkel made a mistake by not following a special timing rule that proscribes that FICA is accessed on the present value at his retirement. As a result of Henkel’s action, Davidson suffered an impermissible reduction in benefits.

After interpreting the applicable provisions and the provisions under the Henkel’s plan, the court ultimately sided with Davidson. The court held that Henkel’s intention to take money from the plan participants for the untimely paid, and thus higher in amount, FICA tax that Henkel paid to IRS constitutes a breach of the plan. The failure to use special timing rule resulted in higher tax to the participant, and in this case, the Company itself admitted that FICA tax was payable at the time of Davidson’s retirement. Furthermore, the court indicated that while no tax rules were broken per se, the plan provisions were not followed and the Company’s admission to the same pointed to the fact that there was indeed a breach of contract.

This case underscores the point that while honest mistakes do happen, the remedy must take into account all applicable facts. The taxpayers should not concentrate only on the applicable income tax law, but should also consider any other applicable law to ensure that all transaction participants are treated fairly and equitably.