Employees? pay and taxable fringe benefits are subject to federal income tax withholding, FICA withholding, and state income tax withholding. Employers pay a matching share of FICA taxes; only employers pay federal unemployment taxes, or FUTA.
States collect unemployment contributions, or SUTA, from employers. FUTA and SUTA taxes are paid quarterly.? Some states collect unemployment taxes from employees, and still others collect disability taxes from employees.?
Employers must withhold taxes when employees are actually or constructively paid.? Employees are constructively paid when their wages are credited to the account of, or set apart for, employees so they can draw on them at any time.? Withholding is based on pay periods.? Employers choose their pay periods, which must comport with state wage payment laws.? There are weekly, biweekly, semimonthly, monthly, quarterly, semiannual, annual and daily/miscellaneous pay periods.? There are two basic withholding methods: the wage-bracket method and the percentage method.
Regardless of the withholding method, how much income tax to withhold from an employee?s pay is based on the number of withholding allowances and the marital status as indicated on the W-4 form?he/she has provided.? Withholding allowances are calculated on a pay-period basis, and have dollar values.?
FICA withholding is a fixed percentage.? The employee?s total FICA tax is 7.65%.? The Social Security portion of FICA is 6.2%, and taxes are assessed on a wage base that is indexed?for inflation?every year.? Wages exceeding the Social Security wage base aren?t taxable.? The Medicare portion of FICA is 1.45%; all wages are subject to the Medicare portion of FICA, since there is no wage base.? Employers always pay a matching share of FICA; these taxes are paid when the amounts withheld from employees? pay are deposited.?
The wage-bracket method of income tax withholding is based on wage-bracket tables that are issued by the IRS every year.? Different tables apply, based on pay periods and employees? marital status.? The wage-bracket method is not computer-friendly.? Under this method, you locate the proper table for your pay period and the employee?s marital status.? Then, based on the number of withholding allowances claimed, and the amount of wages, you find the amount of federal taxes to withhold.?
The percentage method of income tax withholding is also based on pay periods and employees? marital status.? The percentage method is computer-friendly.? To use the percentage method:
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Multiply the value of one withholding allowance for your pay period by the number of allowances the employee claims.
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Subtract that amount from the employee?s wages.
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Determine the amount to withhold from the appropriate percentage-method table.??
Withholding on supplemental pay up to $1 million?
Supplemental pay is any compensation paid to employees that?s paid in addition to regular wages.? Supplemental pay is taxable and subject to FICA and income tax withholding.? Supplemental pay includes, but isn?t limited to, the following payments:?
- bonuses;?
- commissions;?
- overtime pay;?
- accumulated sick pay;?
- severance pay;?
- vacation pay paid in addition to regular wages for a vacation period;?
- non-qualified deferred compensation;?
- gain from the exercise of non-qualified stock options;?
- gain from the lapse of a restriction on employer property;?
- cash awards and prizes;?
- back pay and retroactive pay increases for current employees.?
Taxable fringe benefits may also be treated as supplemental pay.? These payments include, but aren?t limited to, the following payments:?
- group-term life insurance exceeding $50,000;?
- dependent care benefits exceeding $5,000;?
- non-deductible moving expenses;?
- expense allowances paid under non-accountable plans;
- wages that are attributable to imputed income for health benefits for non-dependents;?
- wages that are attributable to benefits that don?t qualify as de minimis fringe benefits;?
- wages that are attributable to benefits that don?t qualify as qualified employee discounts or no-additional-cost services;
- wages that are attributable to non-excludable meals; and?
- recoveries from employment-based lawsuits (except lawsuits brought under the Family and Medical Leave Act).?
The IRS is flexible when it comes to withholding on supplemental wages.? You have three options.
- Treat the supplemental pay as regular wages.
- Use the 25% flat supplemental withholding rate for supplemental pay under $1 million.? If you pay supplemental wages separately (or combine them in a single payment and specify the amount of regular and supplemental pay) and, sometime during the current or preceding year, withhold income taxes from regular wages, you may withhold a flat 25% from supplemental pay.? Since this is a flat withholding method, you ignore employees? W-4s.
- Use the aggregation method.? To use this method, you figure withholding on regular pay.? Then add supplemental pay and regular pay for the most recent pay period.? Figure withholding on the total, and then subtract the tax already withheld from regular pay.? Withhold the remaining tax from the supplemental pay.??
Withholding on supplemental pay exceeding $1 million?
A special income tax withholding rule applies to employees who will receive more than $1 million in supplemental pay during a calendar year.? On the amount of supplemental pay that exceeds $1 million, you must withhold a flat 35%, regardless of the employee?s W-4 form.?
Once employees and their supplemental payments are identified, you must track that supplemental pay to determine when $1 million will be reached.? This is trickier than it appears, since you must track supplemental payments made by other corporations in your controlled group, and payments made by third-party payers of sick pay and other employer agents.?
Under an optional de minimis rule, an employer?s agent (e.g., a third-party payer of sick pay) who makes total payments of regular and supplemental pay of less than $100,000 may disregard supplemental pay paid by the employer and other agents of the employer.? Similarly, the employer can ignore supplemental pay of less than $100,000 paid by that third party and other employer agents.? These payments, therefore, don?t count toward the $1 million threshold.? Once the $100,000 is reached, however, supplemental pay tracking is required by the employer and its agents.? No abuse: You can?t split employees? supplemental pay among several entities.? Under an anti-abuse rule, this de minimis rule won?t apply in situations where an employer has created an arrangement with five or more agents, if a principal effect is to evade flat withholding.??
Under another optional rule of administrative convenience, you may count all W-2, Box 1 amounts that are taxable but not subject to withholding as supplemental pay to determine when the $1 million threshold is reached.? These payments include:?
- group-term life insurance exceeding $50,000;?
- amounts attributable to disqualifying dispositions of stock received on the exercise of incentive stock options;?
- imputed interest on employee loans;?
- the value of personal use of company cars.??
The Box 1 approach isn?t trouble-free, however.? First, these payments usually aren?t valued until later in the year.? Second, using this administrative rule will pump up employees? supplemental pay, so they?ll get to the $1 million mark sooner, rather than later.? As a result, employees may be overwithheld.?
You have two withholding choices, once the $1 million supplemental pay mark is reached, or anticipated to be reached.?
- You can split the withholding by applying your regular supplemental withholding method (i.e., the aggregate method or the flat 25% rate method) to the amount up to $1 million, and the flat 35% withholding to the amount above $1 million.?
- You can withhold 35% from the entire payment, including the amount below $1 million.? Employees will be overwithheld with this method, though.??
You can?t gross-up supplemental pay to avoid flat withholding.?
Withholding such large amounts will impact your tax deposit schedule.? Rule: If you accumulate undeposited taxes of $100,000 or more on any day of a deposit period, you must deposit that tax by the next banking day, regardless of whether you?re a monthly or semiweekly depositor.? Deposit schedules for the remainder of the year may be impacted, as well.
Withholding on non-cash fringe benefits?
Taxable, non-cash fringe benefits are subject to withholding.? These fringes may include, for example, in-kind dependent care that exceeds $5,000, the value of taxable meals, personal use of company cars, and non-cash prizes and awards.?
The value of non-cash fringes is generally the fair market value.? For withholding purposes, if you can?t determine the actual value of non-cash fringes during the year, you can withhold based on a reasonable estimate, provided actual valuations are made by January 31 of the succeeding year.?
You may consider non-cash fringes as paid on a pay period basis, or another basis, such as on a monthly or quarterly basis, as long as you consider them paid in full by the end of the year.? Choosing a short period will be advantageous to employees, since their tax bill will be spread out throughout the year.?
The special accounting rule allows you to treat the value of non-cash fringes that are ?paid? during the last two months of a calendar year, or any shorter period within those last two months, as paid in the next year.? Non-cash fringes that are carried over into the next year are subject to income tax withholding at the new year?s rates, and to the new year?s FICA tax, if the employee had maxed out on the Social Security portion of FICA during the preceding year.
Since there?s no cash from which you can withhold, the value of non-cash fringes is called imputed income.? To withhold, you impute (add) the fringe?s value into the employee?s regular cash wages, withhold on the total, and then subtract the tax withheld and the fringe?s value to arrive at the employee?s take-home tax.? Alternatively, you could withhold income tax on the value of the non-cash fringe at the flat 25% supplemental withholding rate.?
Grossing up?
Very often, employers will pay the employee?s income and FICA taxes.? When this happens, the employer?s payment is itself income to the employee, which must be taxed.? To stop is upward spiral of taxation, you must gross up the payment and the taxes.?
To perform a gross up, divide the payment by a ?factor? for that year.? This factor is determined by subtracting the 25% flat supplemental withholding rate and the combined employee FICA tax rate from 1.? The generic formula for performing a gross up looks like this:
??????????????????? Amount of original pay = Grossed up pay
1?? .25 ? .0765 (or 0.6735)
If you?re located in a state that imposes an income tax, you must also factor the state income tax rate into the denominator.
If supplemental pay exceeds the Social Security wage base, the following formula can be used:
????????????????????? Amount of original pay = Grossed up pay
1 ? .25 ? .0145 (or 0.7355)
?
FAQs about withholding and paying taxes
1.? An employee is claiming that his wages aren?t subject to federal income tax withholding because he?s a member of the clergy and has taken a vow of poverty.? He also wants us to pay his gross earnings to his church, instead of him.? What do I do?
Ignore him and continue to withhold.? Merely taking a vow of poverty doesn?t give employees an opt-out of federal income taxes.? Moreover, even members of the clergy are subject to income taxes when they?re not working in their religious capacity.? Finally, under the long-standing judicial doctrine of assignment of income, you must pay and tax income to the person who earned it, so telling you to pay his church is a non-starter.?
2.? Can we withhold taxes if an employee never filed a Form W-4?
Yes, you are still required to withhold income and FICA taxes.? If an employee doesn?t give you a completed Form W-4, withhold income taxes as if he or she is single, claiming no withholding allowances.
3.? Employees are reimbursed for the business use of their cell phones.? To make it easier, management has suggested that employees receive a flat $50 a month.? Would this change impact withholding??
Yes.? You can?t reimburse employees a flat amount without them having to prove to you that their calls were business-related.? Reimbursements under those circumstances are 100% taxable, because they would be considered paid under a non-accountable plan.? Reimbursing employees for the business use of their cell phones is similar to other business reimbursements.? Provided they substantiate their business calls, those calls may be reimbursed tax-free.? Even if you consider the flat amount to be an advance, employees must still substantiate their business use and timely return any unused portion of the advance to you.? Unreturned amounts are fully taxable.??
4.? My company collects all the frequent flyer miles for our employees? business travel.? As an incentive award, the company provides a free round-trip ticket to an employee that?s been ?purchased? with these frequent flyer milers.? Is this taxable and subject to withholding?? If so, how is it valued?
Yes, since it?s compensation paid in the form of miles.? The value is the fair market value of the round-trip ticket.
5.? When and how can an employee defer a portion of his salary?? Does the employee need to be an owner?
Technically, unless you?re referring to the very familiar pre-tax deductions into qualified plans (e.g., cafeteria plans or 401(k) plans), or willing to create a non-qualified deferred compensation plan, the answer is no.? Under tax code section 451, you must withhold once employees are actually or constructively paid.? Employees constructively receive their pay when it?s credited to their accounts or set apart for them, so they can draw on the funds at any time.? In other words, there is no substantial restriction on the time or manner of actual payment.? Usually, constructive receipt is expressed as a choice ? as soon as employees exercise control over their pay, by actually receiving a check (note that checks are net of withholding anyway and need not be cashed, just received) or opting for direct deposit, you must withhold.?
6.? The CEO has suggested that we pay employees? accrued vacation pay in two lump sums ? by July 15 for amounts accrued between January 1 and June 30, and by January 15 for amounts accrued during the second half of a year.? Withholding would be based on the number of weeks the accrued payments represent.? In other words, this withholding method treats the lump sums as a collection of weekly payments.? Employees would net more money this way.? Would this get the go-ahead from the IRS?
Probably not.? The IRS allows employers to devise their own withholding methods, but alternatives are allowed only if the proposed method applies to all wages, not just to supplemental pay.? Alternative methods must approximate the IRS?s withholding formulas, which this won?t.? Tax regulations prohibit employers from using an alternative method if the principal purpose is to consistently produce withholding amounts that are less, though approximate, to the amounts that would be withheld using an IRS withholding formula.
7.? If an employee exercises incentive stock options (ISOs), he wouldn?t have taxable wage income.? So what does he have if we buy back his ISOs before he exercises them?? capital gains or taxable income?
The employee has taxable wage income, not capital gains.? According to courts that have addressed this issue, cash an employee receives in exchange for unexercised options is ordinary income, subject to income and FICA tax withholding.? Their reasoning: Since the options were received in the course of employment, they?re as taxable as any wage income would be.
8.? Our board of directors has proposed establishing an employee-funded, but separate, charity that makes grants and loans to employees who experience temporary financial hardship.? The charity will be funded with after-tax payroll deductions.? Will the charity?s payments to employees be taxable?
Amounts withheld from employees? pay qualify as tax-deductible charitable contributions.?? Payments made to qualified employees won?t be taxable.
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Public release date: 7-May-2012
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