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Income Tax Withholding: Coverage, Allowances, and Calculations

This chapter explores the coverage under the Federal Income Tax Withholding Law, types of withholding allowances, and how to compute the amount of FIT withheld using various methods. It also covers the completion of critical quarterly and year-end information returns and the impact of state/local income taxes on the payroll accounting process.

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Income Tax Withholding: Coverage, Allowances, and Calculations

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  1. Payroll Accounting 2013 Bernard J. Bieg and Judith A. Toland CHAPTER 4 INCOME TAX WITHHOLDING Developed by Lisa Swallow, CPA CMA MS

  2. Learning Objectives • Explain coverage under the Federal Income Tax (FIT) Withholding Law • Explain types of withholding allowances that may be claimed and purpose/use of Form W-4 • Compute amount of FIT withheld using various methods • Explain completion of critical quarterly and year-end information returns and impact of state/local income taxes on payroll accounting process

  3. Coverage Under FIT Withholding Laws • Employee-employer relationship must exist for FIT withholding laws to apply • See Chapter 3 for guidance on determining status • Statutory nonemployees (direct sellers and qualified real estate agents) have no federal taxes withheld • Taxable wages for FIT withholding purposes – gross amount of following items are taxable • Wages/Salaries • Vacation pay • Supplemental payments • Bonuses/Commissions • Taxable fringe benefits (see next slide) • Tips • Cash awards • See Figure 4-1 on page 4-3 for other types of taxable payments LO-1

  4. FringeBenefits • Noncash fringe benefits treated as compensation • Employer must withhold FIT unless specifically excluded • Examples of noncash fringe 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 • De minimis fringe benefits (like personal use of corporate cell phone) • Complete list found on page 4-4 or consult Circular E, Employer’s Tax Guide LO-1

  5. How to Withhold FIT on Fringe Benefits • Value and withhold like supplemental wages (flat 25%) • Employer must figure value of fringe benefits no later than 1/31 (except if use special period rule) • Value and add to regular pay - treat as one paycheck and withhold accordingly • Flexible reporting – option of treating benefits as being paid on one or more dates in the same calendar year, even if benefit received at one time • For example, can add entire $2,000 value of country club membership or add $500 on each of 4 paychecks – then calculate withholding accordingly Note: Employer can choose not to withhold FIT on employee’s personal use of corporate car LO-1

  6. FITWithholding on Tips • Employee must report tips to employer 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 allocatedtips - onlyreportedtips • Tip allocation can be done one of three methods – hours worked, gross receipts or good faith agreement LO-1

  7. FIT Withholding on Tips • What if taxes withheld > hourly wages to be paid? • For example blackjack dealer in South Lake Tahoe reports tips = $2,000 for one week; her FIT/FICA withholding will exceed her gross paycheck • In that situation, she gets no paycheck and pays quarterly estimated tax payments or • Can pay balance of tax when she files1040 tax return LO-1

  8. 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; must meet three rules • Business connected • Adequate accounting within reasonable time period • Employee returns advanced cash in excess of substantiated expenses • If there is not a plan in place, travel reimbursements are made under a non-accountable plan and considered wages • Therefore employer must withhold FIT LO-1

  9. 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 $125/month value See Figure 4-2 on page 4-6 for comprehensive list of exempt payments LO-1

  10. Pretax Salary Reductions are Exempt from FIT • Contribution to cafeteria plans • Employee can choose between cash (pay) or qualified (nontaxable) benefits (list of potential benefits found on page 4-7) • Contribution to Flexible-Spending Accounts • The employee 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 employee has high-deductible health insurance, can contribute annually to a HSA to meet out of pocket medical bills • Archer Medical Savings Accounts • For small employers that have high-deductible insurance plans LO-1

  11. Tax-Deferred Retirement Contributions Exempt from FIT • Contributions to tax-deferred retirement accounts are monies set aside from current paychecks that will be paid out to employee upon retirement • Types of retirement plans • 401(k), 403(b), 457(b) or SIMPLE plans • Contributions are made pretax for FIT purposes • However, employer 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 (IRA) • In 2013, depending upon certain conditions, an employee can contribute lesser of $5,000 or 100% of earned income pretax to a retirement account • If made through payroll deductions, generally employer does not need to comply with ERISA • Roth IRAs are used for nondeductible contributions LO-1

  12. Problems • 4 – 1 A, 4 – 7 A, 4 – 11 A

  13. How Much to Withhold for FIT • Best for employee 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 (page 4-11) • The W-4 identifies number of withholding allowances; employee can take: • One allowance for self (if not claimed by other person) and one allowance for each dependent • Special allowances such as itemized deductions, other compensation, tax credits, etc. - use worksheet on back of W-4 to calculate • Employer must retain W-4 as long as its in effect and for four years thereafter See IRS Publication 919 How Do I Adjust My Tax Withholding if an employee needs to calculate his/her FIT withholding www.irs.gov/pub/irs-pdf/p919.pdf LO-2

  14. 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 LO-2

  15. Other Situations on W-4 • If employee doesn’t provide a completed W-4, employer must withhold as if single and zero allowances (highest rate) • Employee can change W-4 • When employer receives amended W-4, has 30 days to change • Employee must change within 10 days for decrease in # of allowances • If there’s an increase in # of allowances, can change or leave in effect • Additional/voluntary withholding agreements • Can effect additional FIT withholding by either reducing number of withholding allowances or request specific additional amount be withheld on line 6 • Employer can establish electronic W-4 system, but must provide paper option if employee requests • Unauthorized changes/additions invalidate W-4 • Employers should submit W-4s to IRS only when requested; penalties imposed for willfully filing false Form W-4s LO-2

  16. FIT Withholding on Other Income Sources • Pensions (W-4P) in excess of $19,680 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 benefits, by completing a W-4V • This request is voluntary LO-2

  17. Employer Calculates FIT Withholding • Textbook used 2012 tax tables for FIT rates • Use either wage-bracket method (easiest) or • Percentage method (only use if one of the following situations apply) • Highly compensated individual • Compensated annually or semiannually • Need to know • Single/married, how often paid, gross pay and # of allowances Note: also other methods, rarely used, for withholding (see pages 4-17 - 4-18) LO-3

  18. Example #1 Calculating FIT Withholding FACTS: Noni’s annual salary is $40,144 – she is paid biweekly and her W-4 shows “Married with 4.” What is her FIT withholding? Biweekly gross $40,144/26 = $1,544.00 Can use wage bracket tables to look up married, biweekly and 4 allowances FIT withholding = $65 LO-3

  19. Example #2 Calculating FIT Withholding FACTS: John earns an annual salary of $84,400 and is paid biweekly. His W-4 shows “Married with 1.” What is his FIT withholding? Biweekly gross is $84,400/26 = $3,246.15 Must use percentage method Steps to percentage method: Subtract allowance amount * (biweekly allowance for1) from gross $3,246.15 - $146.15* = $3,100.00 FIT equals $374.40 + (.25)($3,100.00 - $3,031.00) = $391.65 *From Table of Allowances found in Appendix LO-3

  20. Example#3 Calculating FIT Withholding FACTS: Maggie earns an annual salary of $336,000 and is paid monthly. Her W-4 shows “Married with 2 .” What is FIT withholding? Monthly gross is $336,000/12 = $28,000 Must use percentage method Steps: Subtract allowance amount (monthly allowance for 2) from gross $28,000 - $633.34 = $27,366.66 FIT equals $4055.42 + (.33)($27,366.66 - $18,796.00) = $6,883.74 LO-3

  21. Example #4 Calculating FIT Withholding FACTS: Belinda earns a monthly salary of $3,000 and is paid biweekly. Her W-4 says “Single with 2.” What is her FIT withholding? Annualize salary $3,000 x 12 = $36,000 Biweekly gross $36,000/26 = $1,384.62 Can use wage bracket tables to look up single, biweekly and 2 allowances FIT withholding = $136 LO-3

  22. Example#5 Calculating FIT Withholding FACTS: Ferhart’s annual salary is $485,000 – he is paid semimonthly. His W-4 says “Married with 4.” What is his FIT withholding? Semimonthly gross is $485,000/24 = $20,208.33 Must use percentage method Steps: Subtract allowance amounts (semimonthly allowance for 4) from gross $20,208.33 – $633.32 = $19,575.01 FIT equals $4,377.63 + (.35)($19,575.01 - $16,519.00) = $5,447.23 LO-3

  23. SupplementalWages Withholding • Examples include • Vacation pay (treated differently than other supplemental wages) • Severance pay, bonuses and commissions • How to withhold • With regular pay (treat as one paycheck and withhold accordingly) • Except if amount indicated separately (then use flat rates – see below) 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) LO-3

  24. Gross-Up Supplemental Wages • If want to give an employee the intended amount of supplemental check, must “gross up” this amount • For example, an employer wants Dov, an employee, to receive a $700 net bonus check • To do: Must divide desired net check by [1.00 – tax rates] • FIT tax rate = .25 • OASDI tax rate = .042 • HI tax rate = .0145 • $700/[1.00 – (.25 + .042 + .0145)] = $1,009.37 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! LO-3

  25. Problem • 4 – 3A, 4 – 4 A, 4 – 8 A , 4 – 9 A, 4 – 10 A

  26. Wages and Tax Statement (W-2) • Employers required to furnish Form W-2 to employees (and also must send copies to federal and state/local governments • Reports wages and withholding taxes • Instructions for completing in Figure 4-8 (pages 4-22 and 4-23) • Hard copy to employee on or before 1/31 or • Can post on secure web site so employee can access individual W-2 • If issuing 250+ W-2s, must use magnetic media and have until 3/31 • Can request extension of time via FIRE at http://fire.irs.gov • W-3 is transmittal form and 941s must tie to W-3 • Various penalties for filing incorrect or late W-2s • Must file W-2c and W-3c (if correcting) LO-4

  27. Returns – Quarterly & Informational • Quarterly reports of taxable wages required (see Figure 4-11 (pages 4-27 and 4-28) for major required returns) • Payroll income tax withholdings reported on Form 941 • Employers must file information returns for compensation paid to independent contractors (IC) • 1099-MISC with 1096 as transmittal - See Figure 4-13 (page 4-29) • Must issue to IC if paid at least $600 and aren’t incorporated • IC must submit taxpayer identification number (TIN) on W-9 to hiring agent • If this is not done, then hiring agent must withhold federal income tax = 28% of payments made • Nonpayrollitems (like withholding on independent contractors, pensions, IRAs, etc. ) reported on Form 945 LO-4

  28. 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 withheld • Issue information returns to report payments to individuals not subject to withholding • Three different methods of withholding SIT – full taxation, leftover taxation and reciprocity • Most states require employers to withhold tax from both nonresidents and residents, unless a reciprocal agreement is in place LO-4

  29. Problems • 4 – 12 A, 4 – 13 A

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