CHAPTER 4 INCOME TAX WITHHOLDING Developed by Lisa Swallow, CPA CMA MS Payroll Accounting 2010 Bernard J. Bieg and Judith A. Toland 1

 EE-ER relationship must exist for FIT withholding to apply  See Chapter 3 for how to determine status  Statutory nonemployees (direct sellers and qualified real estate agents) have no federal taxes withheld  Taxable wages for FIT withholding purposes  Wages/Salaries  Vacation  Supplemental payments  Bonuses/Commissions  Taxable fringe benefits (see next slide)  Tips  Cash awards Coverage Under Federal Income Tax (FIT) Withholding Laws 2

Fringe Benefits  Noncash fringe benefits treated as compensation  ER must withhold FIT unless specifically excluded  Examples include  Tickets to athletic events  Athletic club membership  Personal use of corporate car  Frequent flier miles  Stock options (when option exercised)  Complete list found in Figure 4-2 (page 4-6)  Specifically excluded fringe benefits include  Qualified employee discounts  Reduced tuition, meals & lodging if for employer benefit  Complete list found on page 4-4 3

How to Withhold FIT on Fringe Benefits  Value and withhold like supplemental wages (flat 25%)  ER must figure value of fringe benefits no later than 1/31  Value and add to regular pay - treat as one paycheck and withhold accordingly  Flexible reporting – option of treating benefits as being paid on any basis  For example - Can add $500 on 4 paychecks or entire $2,000 with one paycheck for withholding purposes, for example 4

FIT Withholding on Tips  Employee must report tips to ER by 10th of each month  Employer must withhold FIT and FICA based on this information (called “reported tips”)  Employer is not required to withhold on allocated tips - only reported tips  Tip allocation can be done one of three methods 5

FIT Withholding on Tips (continued)  What if taxes withheld > hourly wages to be paid?  For example blackjack dealer reported tips = $2,000 for one week; her FIT/FICA withholding will exceed her paycheck  EE gets no paycheck and pays quarterly estimated tax payments or  Can pay balance of tax with 1040 tax return 6

Traveling Expenses  Travel reimbursements made to an employee, paid under an “accountable plan”, are not subject to FIT withholding  An accountable plan is an IRS-approved plan  If there is not a plan in place, travel reimbursements are made under a non-accountable plan and considered wages  Therefore ER must withhold FIT 7

What is Exempt from FIT  Law excludes certain payments including:  Ministers’ wages/salaries  Advances  Educational assistance  If maintains/improves job status  $5,250 per year of employer provided assistance for undergraduate or graduate is tax-free (also applies to down-sized employees)  Qualified moving expense reimbursements  Transportation in a commuter highway vehicle/transit pass up to $230/month value See page 4-6 for comprehensive list of exemptions 8

What is Exempt from FIT  Contribution to cafeteria plans  Employee can choose between cash (pay) or qualified (nontaxable) benefits (list on page 4-7)  Contribution to Flexible-Spending Accounts  These are salary reductions whereby EE puts pretax dollars into a trust account to be used for health care, certain insurance premiums and dependent care  These dollars do not have FIT or FICA withheld on them  Forfeited if not used!!  Health Savings Accounts (HSA)  If EE has high-deductible health insurance, can contribute annually to an HSA pretax to meet out of pocket medical bills  Archer Medical Savings Accounts  Apply to small employers (50 or fewer employees) and are set up with high-deductible insurance plans 9

What is Exempt from FIT (Pretax salary reductions)  Contributions to tax-deferred retirement accounts  Types of retirement plans  401(k), 403(b), 457 or SIMPLE plans  Contributions are made pretax for FIT purposes  However, ER must still withhold and match FICA  Additional ‘make up amounts’ allowed to be contributed if age 50 or older (see page 4-9 for annual contribution amounts)  Individual Retirement Accounts [IRAs]  For certain taxpayers, the lesser of $5000 or 100% of earned income may be contributed pretax to a retirement account  Conditions must be met for deductibility  Additional contributions allowed if age 50 or older  Roth IRAs accommodate nondeductible contributions 10

How Does an Employer Know Amount to Withhold for FIT?  Best for EE if FIT withholding = tax liability  Goal is no refund and no tax due  Employee completes W-4  See W-4 “ Employee’s Withholding Allowance Certificate” in Figure 4-3 on page 4-11  Identify number of withholding allowances  One allowance for self (if not claimed by other person)  One for each dependent  Special allowances such as itemized deductions, other compensation, tax credits, etc. - use worksheet on back of W-4 to calculate 11

Completing Form W-4  Choose “Single” or “Married” or “Married, but withhold at higher single rate” box  Q: Why would an EE choose the last option listed above? (line 3)  A: Because possibly other sources of taxable income  Exempt status  Can claim if taxpayer had no income tax liability last year and none expected this year (line 7)  Valid for one year and must be reclaimed each year  Can’t claim exempt if:  Dependent on someone else’s tax return and  Income exceeds $950 (including more than $300 unearned income)  Some individuals are automatically exempt Note: Never advise employee as to how many allowances to claim 12

Other Situations on W-4  If EE doesn’t provide a completed W-4, ER withholds as if single and zero allowances (highest rate)  EE can change W-4  When ER receives amended W-4, has 30 days to change  EE must change within 10 days for decrease in # of allowances  Lose child as an allowance (custody)  Become single  If there’s an increase in # of allowances, can change or leave in effect  Unauthorized changes/additions invalidate W-4  ER can establish electronic W-4 system but must provide paper option if employee requests this 13

Validity of W-4  Employers are not required to verify authenticity  If form is altered, employer cannot accept invalid form  Can then ask for new W-4 to be submitted  Or, if a new hire, withhold at single and zero withholding rates 14

FIT Withholding on Other Income Sources  Pensions (W-4P) in excess of $19,000 per year  Withhold as if married with 3 allowances unless complete W-4P to change amount of tax withholding  Third party payer of sick pay (W-4S)  Government payments such as Social Security by completing a W-4V  This request is voluntary 15

Employer Calculates FIT Withholding  Use either wage-bracket method (easiest) or  Percentage method (only use if one of the following situations apply)  Highly compensated individual  Compensated annually, semiannually or daily  Need to know  Single/married, how often paid, gross pay and # of allowances Note: also other methods, rarely used, for withholding (see page 4-18) 16

Example #1 Calculating FIT Withholding FACTS: Annual salary is $40,144 - paid biweekly – Married 4 - what is FIT withholding?  Biweekly gross $40,144/26 = $1,  Can use wage bracket tables to look up married, biweekly and 4 allowances  FIT withholding = $41 17

Example #2 Calculating FIT Withholding FACTS: Annual salary is $84,400 – paid semimonthly – Married 1 - what is FIT withholding?  Semimonthly gross is $84,400/24 = $3,  Must use percentage method  To Do:  Subtract amount of allowances* (semimonthly/1) from gross  $3, $ = $3,  FIT equals $ (.25)($3, – $3,152.00) = $ *From 2009 Table of Allowances found in Appendix 18

Example #3 Calculating FIT Withholding FACTS: Monthly salary is $3,000 - paid biweekly – Single 2 - what is FIT withholding?  Annualize salary $3,000 x 12 = $36,000  Biweekly gross $36,000/26 = $1,  Can use wage bracket tables to look up single, biweekly and 2 allowances  FIT withholding = $119 19

Example #4 Calculating FIT Withholding FACTS: Annual salary is $336,000 - paid monthly - Single 2 - what is FIT withholding?  Monthly gross is $336,000/12 = $28,000  Must use percentage method  To Do:  Subtract amount of allowances (monthly/2) from gross  $28,000 - ($ x 2) = $27,  FIT equals $3, (.33)($27, $14,467.00) = $7,

Example #5 Calculating FIT Withholding FACTS: Annual salary is $485,000 - paid semimonthly - Married 4 - what is FIT withholding?  Semimonthly gross is $485,000/24 = $20,  Must use percentage method  To Do:  Subtract amount of allowance (semimonthly/4) from gross  $20, – ($ x 2) = $19,  FIT equals $4, (.35)($19, – $15,863.00) = $5,

Supplemental Wages Withholding  Examples include  Vacation pay (treated differently than other supplemental wages)  Severance pay, bonuses and commissions  Exercised nonqualified stock options  How to withhold  With regular pay (treat as one paycheck and withhold accordingly) or  Paid Separately  Method A – Add supplemental and regular wages from recent payroll; calculate FIT as if it were single regular payroll payment  Method B - 25% flat supplemental withholding (35% for amounts in excess of $1,000,000) 22

Gross-Up Supplemental Wages  If want to distribute intended amount of supplemental check, must ‘gross up’ this amount  For example, an employer wants her employee to receive a $700 bonus check (net)  To do: divide desired net check by total of [1.00 – tax rates]  FIT tax rate =.25  OASDI tax rate =.062  HI tax rate =.0145  $700/[1.00 – ( )] = $ 1, grossed up bonus  Then subtract taxes to get $700 desired net bonus Note: in many states there is a required withholding rate for state income tax! 23

Advance EIC  Earned income credit (EIC) is intended to offset living expenses for eligible employees  Credit can be claimed on 1040 and taxpayer receives lump sum (Can get up to $5,028/year with two qualifying children) or  Can get advance EIC on each paycheck by filing Form W-5  Can only get advanced earned income credit if have at least one qualifying child  Advance EIC does not change amount employers must withhold from wages 24

Advance EIC (continued)  EE may only have one certificate on file at a time  If married, both spouses can have certificate  Have to file a new certificate each year  Have to revoke in 10 days if ineligible  Figure 4-8 on page 4-22 shows Form W-5  Employers must notify employees who have no income tax withholding that they may be eligible for advanced EIC  Calculate using IRS-provided tables (partial replication on page 4-23)  On Form 941 advanced EIC shows up as a reduction from total taxes to calculate net employer taxes due for quarter  Advance EIC is treated as having been paid to the IRS 25

Wages and Tax Statement (W-2)  Form W-2 informs employees of wages and withholding taxes  Hard copy to EE on or before 1/31 or  Can post on secure web site so EE can access individual W-2  Send to SSA on or before 2/28  If issuing 250+ W-2s must use magnetic media and have until 3/31 to electronically file  Can request extension of time via FIRE at  W-3 is transmittal form  941s must tie to W-3  Various penalties for filing incorrect or late W-2s  Must file W-2c and W-3c (if correcting) 26

Returns – Quarterly & Informational  Quarterly reports of taxable wages required (see figure 4-14 on page 4-31 for major returns that must be completed)  Employers must file information returns for compensation paid to independent contractors (IC)  1099-MISC with 1096 as transmittal  See Figure 4-16 (page 4-33)  Must issue to IC paid if paid at least $600 & aren’t incorporated  IC must submit taxpayer identification number (TIN) on W-9 to hiring agent  If TIN not supplied orally, in writing or on W-9, then must withhold federal income tax = 28% of payments made 27

Withholding State & Local Income Taxes  In states with state income tax (SIT) and localities with local income tax, generally the payroll department must  File periodic withholding returns to report wages and withholding  Prepare reconciliation returns to compare deposits to withholdings  File annual statements to report annual wages paid and applicable taxes/fees withheld  Issue information returns to report payments to individuals not subject to withholding  Three different methods of withholding SIT 28