The rules for withholding federal income tax from salary and other compensation-related payments can be complicated. Recent legislative and regulatory changes to the withholding requirements for “supplemental wages” have added to this complexity. In an attempt to clarify the withholding requirements for supplemental wages, the IRS has issued Revenue Ruling 2008-29 which explains through a series of examples how income tax withholding should be determined for various types of payments.
Income Tax Withholding Basics
Employers are required to withhold income tax from all wages that are actually or constructively paid to their employees. The term “wages” is broadly defined to include all remuneration for services performed by an employee for his or her employer, including benefits and the cash value of remuneration paid in a form other than cash, subject to specific exclusions.
For purposes of applying the income tax withholding rules, there are two categories of wages: regular and supplemental. Regular wages are amounts paid by an employer for a payroll period at a regular hourly, daily or similar periodic rate or at a pre-determined fixed amount. Supplemental wages are all wages that are not regular wages, and include amounts that are paid with or without regard to a particular payroll period. Examples of supplemental wages are bonuses, back pay, commissions, non-qualified deferred compensation payments, taxable reimbursements and expense allowance payments, non-cash fringe benefits, amounts recognized on the exercise of a nonqualified stock option, and sick pay that is paid by a third-party agent of the employer.
Regular wages are required to be withheld based on the employee’s payroll period. Employers may elect to use either of two methods to determine how much must be withheld from regular wages. Each method requires that the amount of withholding be computed based on a specified withholding table. These withholding tables vary based on the length of the employee’s payroll period. In addition, these methods generally allow for adjustments based on withholding exemptions and allowances claimed by the employee.
Supplemental wages are subject to a more rigid set of rules for determining the amount of withholding:
- If the supplemental wages paid to an employee during a year exceed $1 million, the amount of supplemental wages in excess of $1 million is subject to withholding at a flat rate that is currently 35%. Under this method, withholding is computed without regard to any exemptions or allowances claimed by the employee. This is referred to as the “mandatory flat rate procedure.”
- If the supplemental wages paid to an employee during the year do not exceed $1 million, withholding can be satisfied by using either the “aggregate procedure” or the “optional flat rate procedure.”
- Under the aggregate procedure, the amount of withholding from supplemental wages is based on the withholding tables applicable for the payroll period for which the supplemental wages are paid. This method in effect combines the supplemental and regular wages into a single wage and requires withholding based on the method of withholding applicable to regular wages.
- The optional flat rate procedure allows for withholding at a single rate that is currently 25%. However, this more simplified method of determining the withholding amount is only available if all of the following conditions are met:The supplemental wages for the employee are not subject to the mandatory flat rate withholding procedure described above (i.e., the employee’s total supplemental wages for the year do not exceed $1 million).The supplemental wages are not paid concurrently with regular wages or they are otherwise separately stated on the employer’s payroll records.The employer has withheld income tax from regular wages that the employee has received during the same calendar year in which the supplemental wages are paid, or from regular wages paid to the employee in the previous calendar year.
- The supplemental wages for the employee are not subject to the mandatory flat rate withholding procedure described above (i.e., the employee’s total supplemental wages for the year do not exceed $1 million).
- The supplemental wages are not paid concurrently with regular wages or they are otherwise separately stated on the employer’s payroll records.
- The employer has withheld income tax from regular wages that the employee has received during the same calendar year in which the supplemental wages are paid, or from regular wages paid to the employee in the previous calendar year.
Clarifications in the Revenue Ruling
The new revenue ruling clarifies how these rules are to be applied in a number of different contexts. These contexts include commission arrangements, signing bonuses for newly hired employees, severance pay, vacation and sick leave pay, and payments of accumulated leave to terminating employees.
Commissions. While commissions generally qualify as supplemental wages, the optional flat rate method of withholding is not available in all circumstances. The revenue ruling notes that if an employee is never paid any regular wages in addition to her commissions, the employer must withhold income tax from those commissions using the aggregate procedure and cannot use the optional flat rate withholding method. As a result, the employer will need to determine a payroll period for the employee and withhold based on the withholding tables applicable for those payroll periods. The revenue ruling notes that for an employee who is paid commissions monthly, the payroll period would typically be each month that the employee provides services. Where employees are paid both a salary and commissions, the tax withholding on commissions can be performed using the optional flat rate method so long as income tax is appropriately withheld from the regular wages (i.e., the employee’s salary payments).
The revenue ruling also addresses commission arrangements under which employees are paid a fixed monthly draw that is adjusted each month to take in account the commissions actually earned by the employee. The revenue ruling confirms that the draw payments should be treated as a supplemental wage. However, if the draw is the sole form of compensation being paid to the employee, only the aggregate withholding procedure can be used. As a result, the employer would need to determine payroll periods for the employee, which would generally be based on the frequency with which the draw was paid, and the employer would need to withhold on the draw payments based on the applicable withholding tables for those payroll periods.
The revenue ruling also addresses commission arrangements under which payments are made intermittently due to a requirement that the earned commissions exceed a specified dollar amount. The revenue ruling explains how the employer should identify the payroll period and applicable withholding table when using the aggregate method to determine withholding for such commissions.
Signing Bonuses. Signing bonuses paid to newly hired employees are supplemental wages. If the bonus exceeds $1 million, the amount of the bonus in excess of the $1 million limit is subject to mandatory flat rate withholding (at the 35% withholding rate). For any bonus amount less than the $1 million limit, the employer may use either the aggregate procedure or the mandatory flat rate procedure (applying the current 35% rate). The revenue ruling notes that the optional flat rate withholding procedure, which currently allows for use of a 25% withholding rate, cannot be used for the amount of the bonus up to $1 million if the signing bonus is paid before any salary is paid because the employer would not have yet withheld income tax on any regular wages and thus would not have satisfied one of the eligibility conditions for use of the optional flat rate method.
Severance Pay. The revenue ruling clarifies that severance paid in the form of salary continuation for a specific period of time following termination of employment is a supplemental wage because it is paid after the employee’s employment has terminated. The fact that the severance pay is paid during a fixed period does not cause it to be treated as regular wages. If the severance pay will not exceed the $1 million annual limit (when aggregated with any other supplemental wages already paid to the employee for that year), the employer has a choice of withholding based on either the aggregate procedure or the optional flat rate procedure.
Vacation and Sick Pay. The revenue ruling addresses the lump sum payment of an annual vacation and sick leave allowance. The arrangement described in the revenue ruling involves an allowance that is intended to compensate employees for unpaid vacation or sick leave previously taken during the year, but which is paid regardless of whether the employee was actually absent during the year. The revenue ruling concludes that such an allowance is a supplemental wage payment because it was not paid at a regular rate for the current payroll period. In addition, because the payment was not paid concurrently with other wages, it qualifies for the optional flat rate withholding method assuming that income taxes were withheld from the employee’s regular wages during the current or prior year.
The other example in the revenue ruling involves a situation in which an employer pays its employees at a different rate of pay while they are absent because of sickness than the rate paid for regular worked time. The revenue ruling concludes that the fact that the sick pay is paid at a different rate causes it to qualify as supplemental wages. As a result, the sick pay is eligible for aggregate withholding or, if income taxes have been withheld from the employee’s regular wages in the current or prior year, the optional flat rate withholding method may be used.
Payouts of Accumulated Leave. Many governmental employers allow employees to accumulate unused annual leave from year to year. This unused leave is then paid out (typically in a single lump sum) at the time the employee retires or otherwise terminates employment. The revenue ruling confirms that such a payout of earned but unused accumulated leave should be treated as a supplemental wage payment. As a result, the payout can be aggregated with regular wages for withholding under the aggregate method. In addition, if the employer separately states the leave cash-out amount in its payroll records and has withheld income tax from regular wages paid to the employee in the current or the preceding year, the employer may also withhold tax using the optional flat rate method.Vacation and Sick Pay. The revenue ruling addresses the lump sum payment of an annual vacation and sick leave allowance. The arrangement described in the revenue ruling involves an allowance that is intended to compensate employees for unpaid vacation or sick leave previously taken during the year, but which is paid regardless of whether the employee was actually absent during the year. The revenue ruling concludes that such an allowance is a supplemental wage payment because it was not paid at a regular rate for the current payroll period. In addition, because the payment was not paid concurrently with other wages, it qualifies for the optional flat rate withholding method assuming that income taxes were withheld from the employee’s regular wages during the current or prior year.
Lessons for Employers
The revenue ruling provides some helpful guidelines for determining the appropriate income tax withholding methods for certain types of payments. In addition, the ruling provides insight as to how to analyze whether other types of payments should be treated as supplemental wages. Employers should review their existing withholding procedures to confirm that those procedures are appropriately structured to identify payments that are supplemental wages. In addition, employers should confirm that their procedures are designed to properly determine the required amount of income taxes that must be withheld from those payments.