Table of Contents
Employer's Supplemental Tax Guide
(Supplement to Circular E, Employer's Tax Guide (Publication 15)
(Rev. January 2002)
This publication supplements Circular E, Employer's Tax Guide. It contains specialized and detailed employment tax information supplementing the basic information provided in Circular E. Publication 15-B, Employer's Tax Guide to Fringe Benefits, contains information about the employment tax treatment of various types of noncash compensation. This publication contains:
Alternative methods and tables for figuring income tax withholding.
Combined income tax, employee social security tax, and employee Medicare tax withholding tables.
Tables for withholding on distributions of Indian gaming profits to tribal members.
Telephone help. You can call the IRS with your tax questions. Check your telephone book for the local number or call 1-800-829-1040.
Help for people with disabilities. Telephone help is available using TTY/TDD equipment. You can call 1-800-829-4059 with your tax question or to order forms and publications. You may also use this number for problem resolution assistance.
Ordering publications and forms. See page 61 for information on how to obtain forms and publications.
15 Circular E, Employer's Tax Guide
15-B Employer's Tax Guide to Fringe Benefits
51 Agricultural Employer's Tax Guide
225 Farmer's Tax Guide
509 Tax Calendars for 2002
515 Withholding of Tax on Nonresident Aliens and Foreign Corporations
535 Business Expenses
553 Highlights of 2001 Tax Changes
583 Starting a Business and Keeping Records
1635 Understanding Your EIn
Items To Note
Furnishing Form W-2 to employees electronically. You may set up a system to furnish Forms W-2 to employees who choose to receive them in this format beginning with Forms W-2 due after December 31, 2000. Each employee participating must consent electronically, and you must notify the employees of all hardware and software requirements to receive them. You may not send Form W-2 electronically to any employee who does not consent or who has revoked consent previously provided.
To furnish Forms W-2 electronically, you must meet the following disclosure requirements and provide a clear and conspicuous statement of each of them to your employees.
The employee must be informed that he or she may receive a paper Form W-2 if consent is not given to receive it electronically. The consent statement must be made electronically in a way that demonstrates that the employee can access the Form W-2 in the electronic form that will be used to furnish the statement.
The employee must be informed how to obtain a paper copy and whether any fee will be charged for a paper copy.
The employee may withdraw consent in writing at any time on 30 days notice. The employer will confirm the withdrawal in writing, and inform the employee of the consequences of the withdrawal.
The employer will notify the employee of the scope and duration of the consent.
The employer will inform the employee that the form may be required to be attached to his or her tax returns, and that the employee may need to print the forms.
The employer must furnish the electronic statements by the due date of the paper forms. The employer must notify the employees that the Forms W-2 will be posted on a web site by January 31. This notice may be delivered by mail, electronic mail, or in person.
For more information, see Temporary Regulation 31.6051-1T.
Electronic deposit requirement. Certain employers are required to make deposits of employment taxes using the Electronic Federal Tax Payment System (EFTPS). If you are required to use EFTPS and fail to do so, you may be subject to a 10% penalty. See Circular E for more information.
If you are not required to use EFTPS, you may participate voluntarily. To enroll in or get more information about EFTPS, call 1-800-945-8400 or 1-800-555-4477 or visit the EFTPS Web Site at www.eftps.gov.
Electronic submission of Forms W-4, W-4P, W-4S, W-4V, and W-5. You may set up a system to electronically receive any or all of the following forms from an employee or payee:
Form W-4, Employee's Withholding Allowance Certificate
Form W-4P, Withholding Certificate for Pension or Annuity Payments
Form W-4S, Request for Federal Income Tax Withholding From Sick Pay
Form W-4V, Voluntary Withholding Request
Form W-5, Employee's Advance Earned Income Credit Certificate
If you establish an electronic system to receive any of these forms, you do not need to process that form in a paper version.
For each form that you establish an electronic submission system for, you must meet the following requirements:
The electronic system must ensure that the information received by the payer is the information sent by the payee. The system must document all occasions of user access that result in a submission. In addition, the design and operation of the electronic system, including access procedures, must make it reasonably certain that the person accessing the system and submitting the form is the person identified on the form.
The electronic system must provide exactly the same information as the paper form.
The electronic submission must be signed with an electronic signature by the payee whose name is on the form. The electronic signature must be the final entry in the submission.
Upon request, you must furnish a hard copy of any completed electronic form to the IRS and a statement that, to the best of the payer's knowledge, the electronic form was submitted by the named payee. The hard copy of the electronic form must provide exactly the same information as, but need not be a facsimile of, the paper form. For Forms W-4 and W-5, the signature must be under penalty of perjury, and must contain the same language that appears on the paper version of the form. The electronic system must inform the employee that he or she must make a declaration contained in the perjury statement and that the declaration is made by signing the Form W-4 or W-5.
You must meet all recordkeeping requirements that apply to the paper forms.
For more information, see:
Form W-4--Regulations section 31.3402(f)(5)-1
Form W-5--Announcement 99-3 (99-3 IRB 15)
Forms W-4P, W-4S, and W-4V--Announcement 99-6 (99-4 IRB 24)
Chapter 1 - Who Are Employees?
Before you can know how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be--
An independent contractor.
A common-law employee.
A statutory employee.
A statutory nonemployee.
This discussion explains these four categories. A later discussion, Employee or Independent Contractor? (section 2), points out the differences between an independent contractor and an employee and gives examples from various types of occupations. If an individual who works for you is not an employee under the common-law rules (see section 2), you generally do not have to withhold Federal income tax from that individual's pay. However, in some cases you may be required to withhold under backup withholding requirements on these payments. See Circular E for information on backup withholding.
People such as lawyers, contractors, subcontractors, public stenographers, and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if you, the payer, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.
Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed. For a discussion of facts that indicate whether an individual providing services is an independent contractor or employee, see Employee or Independent Contractor? (section 2).
If you have an employer-employee relationship, it makes no difference how it is labeled. The substance of the relationship, not the label, governs the worker's status. Nor does it matter whether the individual is employed full time or part time.
For employment tax purposes, no distinction is made between classes of employees. Superintendents, managers, and other supervisory personnel are all employees. An officer of a corporation is generally an employee; however, an officer who performs no services or only minor services, and neither receives nor is entitled to receive any pay, is not considered an employee. A director of a corporation is not an employee.
You generally have to withhold and pay income, social security, and Medicare taxes on wages you pay to common-law employees. However, the wages of certain employees may be exempt from one or more of these taxes. See Employees of Exempt Organizations (section 3) and Religious Exemptions (section 4).
Leased employees. Under certain circumstances, a corporation furnishing workers to various professional people and firms is the employer of those workers for employment tax purposes. For example, a professional service corporation may provide the services of secretaries, nurses, and other similarly trained workers to its subscribers.
The service corporation enters into contracts with the subscribers under which the subscribers specify the services to be provided and the fee to be paid to the service corporation for each individual furnished. The service corporation has the right to control and direct the worker's services for the subscriber, including the right to discharge or reassign the worker. The service corporation hires the workers, controls the payment of their wages, provides them with unemployment insurance and other benefits, and is the employer for employment tax purposes. For information on employee leasing as it relates to pension plan qualification requirements, see Leased employees in Pub. 560, Retirement Plans for Small Business (SEP, SIMPLE, and Keogh Plans).
Additional information. For more information about the treatment of special types of employment, the treatment of special types of payments, and similar subjects, get Circular E or Circular A (for agricultural employers).
Four categories of workers who are independent contractors under common law are treated by statute as employees.
A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed for you must be the salesperson's principal business activity. See Salesperson in section 2.
Social security and Medicare taxes. Withhold social security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply.
The service contract states or implies that substantially all the services are to be performed personally by them.
They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).
The services are performed on a continuing basis for the same payer.
Federal unemployment (FUTA) tax. For FUTA tax, the term employee means the same as it does for social security and Medicare taxes, except that it does not include statutory employees in categories 2 and 3 above. Thus, any individual who is an employee under category 1 or 4 is also an employee for FUTA tax purposes and subject to FUTA tax.
Income tax. Do not withhold income tax from the wages of statutory employees.
Reporting payments to statutory employees. Furnish a Form W-2 to a statutory employee, and check "statutory employee" in box 15 (box 13 on the 2001 Form W-2). Show your payments to the employee as other compensation in box 1. Also, show social security wages in box 3, social security tax withheld in box 4, Medicare wages in box 5, and Medicare tax withheld in box 6. The statutory employee can deduct his or her trade or business expenses from the payments shown on Form W-2. He or she reports earnings as a statutory employee on line 1 of Schedule C or C-EZ (Form 1040). (A statutory employee's business expenses are deductible on Schedule C or C-EZ (Form 1040) and are not subject to the reduction by 2% of his or her adjusted gross income that applies to common-law employees.)
There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for all Federal tax purposes, including income and employment taxes, if:
Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked and
Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
Direct sellers. Direct sellers include persons falling within any of the following three groups:
Persons engaged in selling (or soliciting the sale of) consumer products in the home or place of business other than in a permanent retail establishment.
Persons engaged in selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis prescribed by regulations, for resale in the home or at a place of business other than in a permanent retail establishment.
Persons engaged in the trade or business of delivering or distributing newspapers or shopping news (including any services directly related to such delivery or distribution).
Direct selling includes activities of individuals who attempt to increase direct sales activities of their direct sellers and who earn income based on the productivity of their direct sellers. Such activities include providing motivation and encouragement; imparting skills, knowledge, or experience; and recruiting. For more information on direct sellers, see Pub. 911, Direct Sellers.
Licensed real estate agents. This category includes individuals engaged in appraisal activities for real estate sales if they earn income based on sales or other output.
Misclassification of Employees
Consequences of treating an employee as an independent contractor. If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker (the relief provisions, discussed below, will not apply). See Internal Revenue Code section 3509 for more information.
Relief provisions. If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required Federal information returns on a basis consistent with your treatment of the worker. You (or your predecessor) must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977.
Technical service specialists. This relief provision does not apply to a worker who provides services to another business (the client) as a technical service specialist under an arrangement between the business providing the worker, such as a technical services firm, and the client. A technical service specialist is an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work.
This rule does not affect the determination of whether such workers are employees under the common-law rules. The common-law rules control whether the specialist is treated as an employee or an independent contractor. However, if you directly contract with a technical service specialist to provide services for your business rather than for another business, you may still be entitled to the relief provision. See Employee or Independent Contractor? below.
Chapter 2 - Employee or Independent Contractor?
An employer must generally withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. An employer does not generally have to withhold or pay any taxes on payments to independent contractors.
To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties as shown below.
Behavioral control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of--
Instructions the business gives the worker. An employee is generally subject to the business' instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work:
When and where to do the work
What tools or equipment to use
What workers to hire or to assist with the work
Where to purchase supplies and services
What work must be performed by a specified individual
What order or sequence to follow
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Financial control. Facts that show whether the business has a right to control the business aspects of the worker's job include:
The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.
The extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.
Type of relationship. Facts that show the parties' type of relationship include:
Written contracts describing the relationship the parties intended to create.
Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.
The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
IRS help. If you want the IRS to determine whether a worker is an employee, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
The following examples may help you properly classify your workers.
Building and Construction Industry
Example 1. Jerry Jones has an agreement with Wilma White to supervise the remodeling of her house. She did not advance funds to help him carry on the work. She makes direct payments to the suppliers for all necessary materials. She carries liability and workers' compensation insurance covering Jerry and others he engaged to assist him. She pays them an hourly rate and exercises almost constant supervision over the work. Jerry is not free to transfer his assistants to other jobs. He may not work on other jobs while working for Wilma. He assumes no responsibility to complete the work and will incur no contractual liability if he fails to do so. He and his assistants perform personal services for hourly wages. They are employees of Wilma White.
Example 2. Milton Manning, an experienced tilesetter, orally agreed with a corporation to perform full-time services at construction sites. He uses his own tools and performs services in the order designated by the corporation and according to its specifications. The corporation supplies all materials, makes frequent inspections of his work, pays him on a piecework basis, and carries workers' compensation insurance on him. He does not have a place of business or hold himself out to perform similar services for others. Either party can end the services at any time. Milton Manning is an employee of the corporation.
Example 3. Wallace Black agreed with the Sawdust Co. to supply the construction labor for a group of houses. The company agreed to pay all construction costs. However, he supplies all the tools and equipment. He performs personal services as a carpenter and mechanic for an hourly wage. He also acts as superintendent and foreman and engages other individuals to assist him. The company has the right to select, approve, or discharge any helper. A company representative makes frequent inspections of the construction site. When a house is finished, Wallace is paid a certain percentage of its costs. He is not responsible for faults, defects of construction, or wasteful operation. At the end of each week, he presents the company with a statement of the amount he has spent, including the payroll. The company gives him a check for that amount from which he pays the assistants, although he is not personally liable for their wages. Wallace Black and his assistants are employees of the Sawdust Co.
Example 4. Bill Plum contracted with Elm Corporation to complete the roofing on a housing complex. A signed contract established a flat amount for the services rendered by Bill Plum. Bill is a licensed roofer and carries workers' compensation and liability insurance under the business name, Plum Roofing. He hires his own roofers who are treated as employees for Federal employment tax purposes. If there is a problem with the roofing work, Plum Roofing is responsible for paying for any repairs. Bill Plum, doing business as Plum Roofing, is an independent contractor.
Example 5. Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, which she obtained through advertisements. Vera is an independent contractor.
Example. Rose Trucking contracts to deliver material for Forest Inc. at $140 per ton. Rose Trucking is not paid for any articles that are not delivered. At times, Jan Rose, who operates as Rose Trucking, may also lease another truck and engage a driver to complete the contract. All operating expenses, including insurance coverage, are paid by Jan Rose. All equipment is owned or rented by Jan, and she is responsible for all maintenance. None of the drivers are provided by Forest Inc. Jan Rose, operating as Rose Trucking, is an independent contractor.
Example. Steve Smith, a computer programmer, is laid off when Megabyte Inc. downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It is not clear how long it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the program. Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay Federal and state taxes, and receives no benefits from Megabyte. Megabyte will file a Form 1099-MISC. Steve does the work on a new high-end computer which cost him $7,000. Steve works at home and is not expected or allowed to attend meetings of the software development group. Steve is an independent contractor.
Example 1. Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week and is on duty in Bob's showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager's approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.
Example 2. Sam Sparks performs auto repair services in the repair department of an auto sales company. He works regular hours and is paid on a percentage basis. He has no investment in the repair department. The sales company supplies all facilities, repair parts, and supplies; issues instructions on the amounts to be charged, parts to be used, and the time for completion of each job; and checks all estimates and repair orders. Sam is an employee of the sales company.
Example 3. An auto sales agency furnishes space for Helen Bach to perform auto repair services. She provides her own tools, equipment, and supplies. She seeks out business from insurance adjusters and other individuals and does all the body and paint work that comes to the agency. She hires and discharges her own helpers, determines her own and her helpers' working hours, quotes prices for repair work, makes all necessary adjustments, assumes all losses from uncollectible accounts, and receives, as compensation for her services, a large percentage of the gross collections from the auto repair shop. Helen is an independent contractor and the helpers are her employees.
Example. Donna Yuma is a sole practitioner who rents office space and pays for the following items: telephone, computer, on-line legal research linkup, fax machine, and photocopier. Donna buys office supplies and pays bar dues and membership dues for three other professional organizations. Donna has a part-time receptionist who also does the bookkeeping. She pays the receptionist, withholds and pays Federal and state employment taxes, and files a Form W-2 each year. For the past 2 years, Donna has had only three clients, corporations with which there have been longstanding relationships. Donna charges the corporations an hourly rate for her services, sending monthly bills detailing the work performed for the prior month. The bills include charges for long distance calls, on-line research time, fax charges, photocopies, postage, and travel, costs for which the corporations have agreed to reimburse her. Donna is an independent contractor.
Example. Tom Spruce rents a cab from Taft Cab Co. for $150 per day. He pays the costs of maintaining and operating the cab. Tom Spruce keeps all fares he receives from customers. Although he receives the benefit of Taft's two-way radio communication equipment, dispatcher, and advertising, these items benefit both Taft and Tom Spruce. Tom Spruce is an independent contractor.
To determine whether salespersons are employees under the usual common-law rules, you must evaluate each individual case. If a salesperson who works for you does not meet the tests for a common-law employee, discussed earlier, you do not have to withhold income tax from his or her pay (see Statutory Employees earlier). However, even if a salesperson is not an employee under the usual common-law rules, his or her pay may still be subject to social security, Medicare, and FUTA taxes. To determine whether a salesperson is an employee for social security, Medicare, and FUTA tax purposes, the salesperson must meet all eight elements of the statutory employee test. A salesperson is an employee for social security, Medicare, and FUTA tax purposes if he or she:
Works full time for one person or company except, possibly, for sideline sales activities on behalf of some other person,
Sells on behalf of, and turns his or her orders over to, the person or company for which he or she works,
Sells to wholesalers, retailers, contractors, or operators of hotels, restaurants, or similar establishments,
Sells merchandise for resale, or supplies for use in the customer's business,
Agrees to do substantially all of this work personally,
Has no substantial investment in the facilities used to do the work, other than in facilities for transportation,
Maintains a continuing relationship with the person or company for which he or she works, and
Is not an employee under common-law rules.
Chapter 3 - Employees of Exempt Organizations
Many nonprofit organizations are exempt from income tax. Although they do not have to pay income tax themselves, they must still withhold income tax from the pay of their employees. However, there are special social security, Medicare, and Federal unemployment (FUTA) tax rules that apply to the wages they pay their employees.
Section 501(c)(3) organizations. Nonprofit organizations that are exempt from income tax under section 501(c)(3) of the Internal Revenue Code include any community chest, fund, or foundation organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, fostering national or international amateur sports competition, or for the prevention of cruelty to children or animals. These organizations are usually corporations and are exempt from income tax under section 501(a).
Social security and Medicare taxes. Wages paid to employees of section 501(c)(3) organizations are subject to social security and Medicare taxes unless one of the following situations applies:
The organization pays an employee less than $100 in a calendar year.
The organization is a church or church-controlled organization opposed for religious reasons to the payment of social security and Medicare taxes and has filed Form 8274, Certification by Churches and Qualified Church-Controlled Organizations Electing Exemption From Employer Social Security and Medicare Taxes, to elect exemption from social security and Medicare taxes. The organization must have filed for exemption before the first date on which a quarterly employment tax return (Form 941) would otherwise be due.
An employee of a church or church-controlled organization that is exempt from social security and Medicare taxes must pay self-employment tax if the employee is paid $108.28 or more in a year. However, an employee who is a member of a qualified religious sect can apply for an exemption from the self-employment tax by filing Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits. See Members of recognized religious sects opposed to insurance in section 4.
Federal unemployment tax. An organization that is exempt from income tax under section 501(c)(3) of the Internal Revenue Code is also exempt from the Federal unemployment (FUTA) tax. This exemption cannot be waived.
Note: An organization wholly owned by a state or its political subdivision should contact the appropriate state official for information about reporting and getting social security and Medicare coverage for its employees.
Other than section 501(c)(3) organizations. Nonprofit organizations that are not section 501(c)(3) organizations may also be exempt from income tax under section 501(a) or section 521. However, these organizations are not exempt from withholding income, social security, or Medicare tax from their employees' pay, or from paying FUTA tax. Two special rules for social security, Medicare, and FUTA taxes apply.
If an employee is paid less than $100 during a calendar year, his or her wages are not subject to social security and Medicare taxes.
If an employee is paid less than $50 in a calendar quarter, his or her wages are not subject to FUTA tax for the quarter.
The above rules do not apply to employees who work for pension plans and other similar organizations described in section 401(a).
Chapter 4 - Religious Exemptions
Special rules apply to the treatment of ministers for social security purposes. An exemption from social security is available for ministers and certain other religious workers and members of certain recognized religious sects. For more information on getting an exemption, see Pub. 517, Social Security and Other Information for Members of the Clergy and Religious Workers.
Ministers. Ministers are individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination. They are given the authority to conduct religious worship, perform sacerdotal functions, and administer ordinances and sacraments according to the prescribed tenets and practices of that religious organization.
A minister who performs services for you subject to your will and control is your employee. The common-law rules discussed in sections 1 and 2 should be applied to determine whether a minister is your employee or is self-employed. The earnings of a minister are not subject to income, social security, and Medicare tax withholding. They are subject to self-employment tax and income tax. You do not withhold these taxes from wages earned by a minister. However, you may agree with the minister to voluntarily withhold tax to cover the minister's liability for self-employment tax and income tax.
Form W-2. If your employee is an ordained minister, report all taxable compensation as wages in box 1 on Form W-2. Include in this amount expense allowances or reimbursements paid under a nonaccountable plan, discussed in section 5 of Circular E. Do not include a parsonage allowance (excludable housing allowance) in this amount. You may report a parsonage or rental allowance (housing allowance), utilities allowance, and the rental value of housing provided in a separate statement or in box 14 on Form W-2. Do not show on Form W-2 or 941 any amount as social security or Medicare wages, or any withholding for social security or Medicare taxes. If you withheld tax from the minister under a voluntary agreement, this amount should be shown in box 2 on Form W-2 as Federal income tax withheld. For more information on ministers, see Pub. 517.
Exemptions for ministers and others. Certain ordained ministers, Christian Science practitioners, and members of religious orders who have not taken a vow of poverty, who are subject to self-employment tax, may apply to exempt their earnings from the tax on religious grounds. The application must be based on conscientious opposition to public insurance because of personal religious considerations. The exemption applies only to qualified services performed for the religious organization. See Rev. Proc. 91-20, 1991-1 C.B. 524, for guidelines to determine whether an organization is a religious order or whether an individual is a member of a religious order.
To apply for the exemption, the employee should file Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners. See Pub. 517 for more information about Form 4361.
Members of recognized religious sects opposed to insurance. If you belong to a recognized religious sect or a division of such sect that is opposed to insurance, you may qualify for an exemption from the self-employment tax. To qualify, you must be conscientiously opposed to accepting the benefits of any public or private insurance that makes payments because of death, disability, old age, or retirement, or makes payments toward the cost of, or provides services for, medical care (including social security and Medicare benefits). If you buy a retirement annuity from an insurance company, you will not be eligible for this exemption. Religious opposition based on the teachings of the sect is the only legal basis for the exemption. In addition, your religious sect (or division) must have existed since December 31, 1950.
Self-employed. If you are self-employed and a member of a recognized religious sect opposed to insurance, you can apply for exemption by filing Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits, and waive all social security benefits.
Employees. The social security and Medicare tax exemption available to the self-employed who are members of a recognized religious sect opposed to insurance is also available to their employees who are members of such a sect. This applies to partnerships only if each partner is a member of the sect. This exemption for employees applies only if both the employee and the employer are members of such a sect, and the employer has an exemption. To get the exemption, the employee must file Form 4029.
An employee of a church or church-controlled organization that is exempt from social security and Medicare taxes can also apply for an exemption on Form 4029
Chapter 5 - Wages & Other Compensation
Circular E provides a general discussion of taxable wages. The following topics supplement those discussions.
Employee Achievement Awards
Do not withhold income, social security, or Medicare taxes on the fair market value of an employee achievement award if it is excludable from your employee's gross income. To be excludable from your employee's gross income, the award must be tangible personal property (not cash or securities) given to an employee for length of service or safety achievement, awarded as part of a meaningful presentation, and awarded under circumstances that do not indicate that the payment is disguised compensation. Excludable employee achievement awards also are not subject to FUTA tax.
Limits. The most you can exclude for the cost of all employee achievement awards to the same employee for the year is $400. A higher limit of $1,600 applies to qualified plan awards. These awards are employee achievement awards under a written plan that does not discriminate in favor of highly compensated employees. An award cannot be treated as a qualified plan award if the average cost per recipient of all awards under all your qualified plans is more than $400.
If during the year an employee receives awards not made under a qualified plan and also receives awards under a qualified plan, the exclusion for the total cost of all awards to that employee cannot be more than $1,600. The $400 and $1,600 limits cannot be added together to exclude more than $1,600 for the cost of awards to any one employee during the year.
Scholarship and Fellowship Payments
Only amounts you pay as a qualified scholarship to a candidate for a degree may be excluded from the recipient's gross income. A qualified scholarship is any amount granted as a scholarship or fellowship that is used for:
Tuition and fees required to enroll in, or to attend, an educational institution or
Fees, books, supplies, and equipment that are required for courses at the educational institution.
Any amounts you pay for room and board, and any amounts you pay for teaching, research, or other services required as a condition of receiving the scholarship, are not excludable from the recipient's gross income. A qualified scholarship is not subject to social security, Medicare, and FUTA taxes, or income tax withholding. For more information, see Pub. 520, Scholarships and Fellowships.
If you provide outplacement services to your employees to help them find new employment (such as career counseling, resume assistance, or skills assessment), the value of these benefits may be income to them and subject to all withholding taxes. However, the value of these services will not be subject to any employment taxes if:
You derive a substantial business benefit from providing the services (such as improved employee morale or business image) separate from the benefit you would receive from the mere payment of additional compensation, and
The employee would be able to deduct the cost of the services as employee business expenses if he or she had paid for them.
However, if you receive no additional benefit from providing the services, or if the services are not provided on the basis of employee need, then the value of the services is treated as wages and is subject to income tax withholding and social security and Medicare taxes. Similarly, if an employee receives the outplacement services in exchange for reduced severance pay (or other taxable compensation), then the amount the severance pay is reduced is treated as wages for employment tax purposes.
Withholding for Idle Time
Payments made under a voluntary guarantee to employees for idle time (any time during which an employee performs no services) are wages for the purposes of social security, Medicare, and FUTA taxes, and income tax withholding.
Treat back pay as wages in the year paid and withhold and pay employment taxes as required. If back pay was awarded by a court or government agency to enforce a Federal or state statute protecting an employee's right to employment or wages, special rules apply for reporting those wages to the Social Security Administration. These rules also apply to litigation actions, and settlement agreements or agency directives that are resolved out of court and not under a court decree or order. Examples of pertinent statutes include, but are not limited to, the National Labor Relations Act, Fair Labor Standards Act, Equal Pay Act, and Age Discrimination in Employment Act. Get Pub. 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration, and Form SSA-131, Employer Report of Special Wage Payments, for details.
Supplemental Unemployment Benefits
If you pay, under a plan, supplemental unemployment benefits to a former employee, all or part of the payments may be taxable and subject to income tax withholding, depending on how the plan is funded. Amounts that represent a return to the employee of amounts previously subject to tax are not taxable and are not subject to withholding. You should withhold income tax on the taxable part of the payments made, under a plan, to an employee who is involuntarily separated because of a reduction in force, discontinuance of a plant or operation, or other similar condition. It does not matter whether the separation is temporary or permanent. There are special rules that apply in determining whether benefits qualify as supplemental unemployment benefits that are excluded from wages for social security, Medicare, and FUTA purposes. To qualify as supplemental unemployment benefits for these purposes, the benefits must meet the following requirements:
Benefits are paid only to unemployed former employees who are laid off by the employer.
Eligibility for benefits depends on meeting prescribed conditions after termination.
The amount of weekly benefits payable is based upon state unemployment benefits, other compensation allowable under state law, and the amount of regular weekly pay.
The duration of the benefits is affected by the fund level and employee seniority.
The right to benefits does not accrue until a prescribed period after termination.
Benefits are not attributable to the performance of particular services.
No employee has any right to the benefits until qualified and eligible to receive benefits.
Benefits may not be paid in a lump sum.
Withholding on taxable supplemental unemployment benefits must be based on the withholding certificate (Form W-4) the employee gave you.
Golden Parachutes (Excessive Termination Payments)
A golden parachute is a contract entered into by a corporation and key personnel under which the corporation agrees to pay certain amounts to the key personnel in the event of a change in ownership or control of the corporation. Payments under golden parachute contracts, like any termination pay, are subject to social security, Medicare, and FUTA taxes, and income tax withholding.
Beginning with payments under contracts entered into, significantly amended, or renewed after June 14, 1984, no deduction is allowed to the corporation for excess parachute payments. The employee is subject to a 20% nondeductible excise tax to be withheld by the corporation on all excess payments. The payment is generally considered an excess parachute payment if it equals or exceeds three times the average annual compensation of the recipient over the previous 5-year period. The amount over the average is the excess parachute payment.
Example. An officer of a corporation receives a golden parachute payment of $400,000. This is more than three times greater than his or her average compensation of $100,000 over the previous 5-year period. The excess parachute payment is $300,000 ($400,000 minus $100,000). The corporation cannot deduct the $300,000 and must withhold the excise tax of $60,000 (20% of $300,000).
Exempt payments. Most small business corporations are exempt from the golden parachute rules. See Code section 280G for more information.
Interest-Free and Below-Market-Interest-Rate Loans
If an employer lends an employee more than $10,000 at an interest rate less than the current applicable Federal rate (AFR), the difference between the interest paid and the interest that would be paid under the AFR is considered additional compensation to the employee. This rule applies to a loan of $10,000 or less if one of its principal purposes is the avoidance of Federal tax.
This additional compensation to the employee is subject to social security, Medicare, and FUTA taxes, but not to income tax withholding. Include it in compensation on Form W-2 (or Form 1099-MISC for an independent contractor). The AFR is established monthly and published by the IRS each month in the Internal Revenue Bulletin. You can get these rates by calling 1-800-829-1040 or by accessing the IRS's Internet Web Site at www.irs.gov. For more information, see Pub. 15-B.
Workers' Compensation--Public Employees
State and local government employees, such as police officers and firefighters, sometimes receive payments due to injury in the line of duty under a statute that is not the general workers' compensation law of a state. If the statute limits benefits to work-related injuries or sickness and does not base payments on the employee's age, length of service, or prior contributions, the statute is "in the nature of" a workers' compensation law. Payments under the statute are not subject to FUTA tax or income tax withholding, but they are subject to social security and Medicare taxes to the same extent as the employee's regular wages. However, the payments are no longer subject to social security and Medicare taxes after the expiration of 6 months following the last calendar month in which the employee worked for the employer.
Leave Sharing Plans
If you establish a leave sharing plan for your employees that allows them to donate leave to other employees for medical emergencies, the amounts paid to the recipients of the leave are considered wages. These amounts are includible in the gross income of the recipients and are subject to social security, Medicare, and FUTA taxes, and income tax withholding. Do not include these amounts in the income of the donors.
Nonqualified Deferred Compensation Plans
Social security, Medicare, and FUTA taxes. Employer contributions to nonqualified deferred compensation or nonqualified pension plans are treated as social security, Medicare, and FUTA wages when the services are performed or the employee no longer has a substantial risk of forfeiting the right to the deferred compensation, whichever is later. This is true whether the plan is funded or unfunded.
Amounts deferred are subject to social security, Medicare, and FUTA taxes unless the value of the amount deferred cannot be determined; for example, if benefits are based on final pay. If the value of the future benefit is based on any factors that are not yet reasonably determinable, you may estimate the value of the future benefit and withhold and pay social security, Medicare, and FUTA taxes on that amount. If amounts that were not determinable in prior periods are now determinable, they are subject to social security, Medicare, and FUTA taxes on the amounts deferred plus the income attributable to those amounts deferred. For more information, see Regulations sections 31.3121(v)(2)-1 and 31.3306(v)(2)-1.
Income tax withholding. Amounts deferred under nonqualified deferred compensation plans are not subject to income taxes until benefit payments begin. Withhold income tax on nonqualified plans as follows:
Funded plan. Withhold when the employees' rights to amounts are not subject to substantial risk of forfeiture or are transferable free of such risk. A funded plan is one in which an employer irrevocably contributes the deferred compensation to a separate fund, such as an irrevocable trust.
Unfunded plan. Generally, withhold when you make payments to the employee, either constructively or actually.
Employer payments made by an educational institution or a tax-exempt organization to purchase a tax-sheltered annuity for an employee (annual deferrals) are included in the employee's social security and Medicare wages if the payments are made because of a salary reduction agreement. They are not included in box 1 on Form W-2 in the year the deferrals are made and are not subject to income tax withholding.
Contributions to a Simplified Employee Pension (SEP)
An employer's SEP contributions to an employee's individual retirement arrangement (IRA) are excluded from the employee's gross income. These excluded amounts are not subject to social security, Medicare, and FUTA taxes, or income tax withholding. However, any SEP contributions paid under a salary reduction agreement (SARSEP) are included in wages for purposes of social security and Medicare taxes and FUTA. See Pub. 560, for more information about SEPs.
Salary reduction simplified employee pensions (SARSEP) repealed. You may not establish a SARSEP after 1996. However, SARSEPs established before January 1, 1997, may continue to receive contributions.
SIMPLE Retirement Plans
Employer and employee contributions to a savings incentive match plan for employees (SIMPLE) retirement account (subject to limitations) are excludable from the employee's income and are exempt from Federal income tax withholding. An employer's nonelective (2%) or matching contributions are exempt from social security, Medicare, and FUTA taxes. However, an employee's salary reduction contributions to a SIMPLE are subject to social security, Medicare, and FUTA taxes. For more information about SIMPLE retirement plans, see Pub. 560
Chapter 6 - Sick Pay Reporting
Special rules apply to the reporting of sick pay payments to employees. How these payments are reported depends on whether the payments are made by the employer or a third party, such as an insurance company.
Sick pay is usually subject to social security, Medicare, and FUTA taxes. For exceptions, see Social Security, Medicare, and FUTA Taxes on Sick Pay later. Sick pay also may be subject to either mandatory or voluntary Federal income tax withholding, depending on who pays it.
Sick pay generally means any amount paid under a plan because of an employee's temporary absence from work due to injury, sickness, or disability. It may be paid by either the employer or a third party, such as an insurance company. Sick pay includes both short- and long-term benefits. It is often expressed as a percentage of the employee's regular wages.
Payments That Are Not Sick Pay
Sick pay does not include the following payments:
Disability retirement payments. Disability retirement payments are not sick pay and are not discussed in this section. Those payments are subject to the rules for income tax withholding from pensions and annuities. See section 9.
Workers' compensation. Payments because of a work-related injury or sickness that are made under a workers' compensation law are not sick pay and are not subject to employment taxes. But see Workers' Compensation--Public Employees in section 5.
Medical expense payments. Payments under a definite plan or system for medical and hospitalization expenses, or for insurance covering these expenses, are not sick pay and are not subject to employment taxes.
Payments unrelated to absence from work. Accident or health insurance payments unrelated to absence from work are not sick pay and are not subject to employment taxes. These include payments for:
Permanent loss of a member or function of the body,
Permanent loss of the use of a member or function of the body, or
Permanent disfigurement of the body.
Example. Donald was injured in a car accident and lost an eye. Under a policy paid for by Donald's employer, Delta Insurance Co. paid Donald $5,000 as compensation for the loss of his eye. Because the payment was determined by the type of injury and was unrelated to Donald's absence from work, it is not sick pay and is not subject to employment taxes.
Sick Pay Plan
A sick pay plan is a plan or system established by an employer under which sick pay is available to employees generally or to a class or classes of employees. This does not include a situation in which benefits are provided on a discretionary or occasional basis with merely an intention to aid particular employees in time of need.
You have a sick pay plan or system if the plan is in writing or is otherwise made known to employees, such as by a bulletin board notice or your long and established practice. Some indications that you have a sick pay plan or system include references to the plan or system in the contract of employment, employer contributions to a plan, or segregated accounts for the payment of benefits.
Definition of employer. The employer for whom the employee normally works, a term used in the following discussion, is either the employer for whom the employee was working at the time the employee became sick or disabled or the last employer for whom the employee worked before becoming sick or disabled, if that employer made contributions to the sick pay plan on behalf of the sick or disabled employee.
Note: Contributions to a sick pay plan through a cafeteria plan (by direct employer contributions or salary reduction) are employer contributions unless they are aftertax employee contributions (included in taxable wages).
Third-Party Payers of Sick Pay
Employer's agent. An employer's agent is a third party that bears no insurance risk and is reimbursed on a cost-plus-fee basis for payment of sick pay and similar amounts. A third party may be your agent even if the third party is responsible for determining which employees are eligible to receive payments. For example, if a third party provides administrative services only, the third party is your agent. If the third party is paid an insurance premium and is not reimbursed on a cost-plus-fee basis, the third party is not your agent. Whether an insurance company or other third party is your agent depends on the terms of the agreement with you.
A third party that makes payments of sick pay as your agent is not considered the employer and generally has no responsibility for employment taxes. This responsibility remains with you. However, under an exception to this rule, the parties may enter into an agreement that makes the third-party agent responsible for employment taxes. In this situation, the third-party agent should use its own name and EIN (rather than your name and EIN) for the responsibilities it has assumed.
Third party not employer's agent. A third party that makes payments of sick pay other than as an agent of the employer is liable for income tax withholding (if requested by the employee) and the employee part of the social security and Medicare taxes. The third party is also liable for the employer part of the social security and Medicare taxes and the FUTA tax, unless the third party transfers this liability to the employer for whom the employee normally works. This liability is transferred if the third party takes the following steps:
Withholds the employee social security and Medicare taxes from the sick pay payments.
Makes timely deposits of the employee social security and Medicare taxes.
Notifies the employer for whom the employee normally works of the payments on which employee taxes were withheld and deposited. The third party must notify the employer within the time required for the third party's deposit of the employee part of the social security and Medicare taxes. For instance, if the third party is a monthly schedule depositor, it must notify the employer by the 15th day of the month following the month in which the sick pay payment is made because that is the day by which the deposit is required to be made. The third party should notify the employer as soon as information on payments is available so that an employer required to make electronic deposits can make them timely. For multi-employer plans, see the special rule discussed next.
Multi-employer plan timing rule. A special rule applies to sick pay payments made to employees by a third-party insurer under an insurance contract with a multi-employer plan established under a collectively bargained agreement. If the third-party insurer making the payments complies with steps 1 and 2 above and gives the plan (rather than the employer) the required timely notice described in step 3 above, then the plan (not the third-party insurer) must pay the employer part of the social security and Medicare taxes and the FUTA tax. Similarly, if, within 6 business days of the plan's receipt of notification, the plan gives notice to the employer for whom the employee normally works, the employer (not the plan) must pay the employer part of the social security and Medicare taxes and the FUTA tax.
Reliance on information supplied by the employer. A third party that pays sick pay should request information from the employer to determine amounts that are not subject to employment taxes. Unless the third party has reason not to believe the information, it may rely on that information as to the following items:
The total wages paid the employee during the calendar year.
The last month in which the employee worked for the employer.
The employee contributions to the sick pay plan made with aftertax dollars.
The third party should not rely on statements regarding these items made by the employee.
Social Security, Medicare, and FUTA Taxes on Sick Pay
Employer. If you pay sick pay to your employee, you must generally withhold employee social security and Medicare taxes from the sick pay. You must timely deposit employee and employer social security and Medicare taxes and FUTA tax. There are no special deposit rules for sick pay. See section 11 of Circular E for more information on the deposit rules.
Amounts not subject to social security, Medicare, or FUTA taxes. The following payments, whether made by the employer or a third party, are not subject to social security, Medicare, or FUTA taxes (different rules apply to income tax withholding):
Payments after employee's
death or disability retirement. Social security, Medicare, and FUTA
taxes do not apply to amounts paid under a definite plan or system, as
defined under Sick Pay Plan earlier, on or after the termination of
the employment relationship because of death or disability retirement.
However, even if there is a definite plan or system, amounts paid to a former employee are subject to social security, Medicare, and FUTA taxes if they would have been paid even if the employment relationship had not terminated because of death or disability retirement. For example, a payment to a disabled former employee for unused vacation time would have been made whether or not the employee retired on disability. Therefore, the payment is wages and is subject to social security, Medicare, and FUTA taxes.
Payments after calendar
year of employee's death. Sick pay paid to the employee's estate or
survivor after the calendar year of the employee's death is not subject to
social security, Medicare, or FUTA taxes. (Also see Amounts not subject
to income tax withholding under Income Tax Withholding on Sick Pay later.)
Example. Sandra became entitled to sick pay on November 30, 2001, and died December 26, 2001. On January 14, 2002, Sandra's sick pay for the period from December 19 through December 26, 2001, was paid to her survivor. The payment is not subject to social security, Medicare, or FUTA taxes.
Payments to an employee entitled to disability insurance benefits. Payments to an employee when the employee is entitled to disability insurance benefits under section 223(a) of the Social Security Act are not subject to social security and Medicare taxes. This rule applies only if the employee became entitled to the Social Security Act benefits before the calendar year in which the payments are made, and the employee performs no services for the employer during the period for which the payments are made. These payments are subject to FUTA tax.
Payments that exceed the
applicable wage base. Social security and FUTA taxes do not apply to
payments of sick pay that, when combined with the regular wages and sick
pay previously paid to the employee during the year, exceed the applicable
wage base. Because there is no Medicare tax wage base, this exception does
not apply to Medicare tax. The social security tax wage base for 2002 is
$84,900. The FUTA tax wage base is $7,000.
Example. If an employee receives $80,000 in wages from an employer in 2002 and then receives $10,000 of sick pay, only the first $4,900 of the sick pay is subject to social security tax. All of the sick pay is subject to Medicare tax. None of the sick pay is subject to FUTA tax. See Example of Figuring and Reporting Sick Pay later.
Payments after 6 months
absence from work. Social security, Medicare, and FUTA taxes do not
apply to sick pay paid more than 6 calendar months after the last calendar
month in which the employee worked.
Example 1. Ralph's last day of work before he became entitled to receive sick pay was December 10, 2001. He was paid sick pay for 9 months before his return to work on September 9, 2002. Sick pay paid to Ralph after June 30, 2002, is not subject to social security, Medicare, or FUTA taxes.
Example 2. The facts are the same as in Example 1, except that Ralph worked 1 day during the 9-month period, on February 15, 2002. Because the 6-month period begins again in March, only the sick pay paid to Ralph after August 31, 2002, is exempt from social security, Medicare, and FUTA taxes.
Payments attributable to
employee contributions. Social security, Medicare, and FUTA taxes do
not apply to payments, or parts of payments, attributable to employee
contributions to a sick pay plan made with aftertax dollars.
(Contributions to a sick pay plan made on behalf of employees with
employees' pretax dollars under a cafeteria plan are employer
Group policy. If both the employer and the employee contributed to the sick pay plan under a group insurance policy, figure the taxable sick pay by multiplying it by the percentage of the policy's cost that was contributed by the employer for the 3 policy years before the calendar year in which the sick pay is paid. If the policy has been in effect fewer than 3 years, use the cost for the policy years in effect or, if in effect less than 1 year, a reasonable estimate of the cost for the first policy year.
Example. Alan is employed by Edgewood Corporation. Because of an illness, he was absent from work for 3 months during 2002. Key Insurance Company paid Alan $2,000 sick pay for each month of his absence under a policy paid for by contributions from both Edgewood and its employees. All the employees' contributions were paid with aftertax dollars. For the 3 policy years before 2002, Edgewood paid 70% of the policy's cost and its employees paid 30%. Because 70% of the sick pay paid under the policy is due to Edgewood's contributions, $1,400 ($2,000 × 70%) of each payment made to Alan is taxable sick pay. The remaining $600 of each payment that is due to employee contributions is not taxable sick pay and is not subject to employment taxes. Also, see Example of Figuring and Reporting Sick Pay later.
Income Tax Withholding on Sick Pay
The requirements for income tax withholding on sick pay and the methods for figuring it differ depending on whether the sick pay is paid by:
An agent of the employer (defined earlier), or
A third party that is not the employer's agent.
Employer or employer's agent. Sick pay paid by you or your agent is subject to mandatory income tax withholding. An employer or agent paying sick pay generally determines the income tax to be withheld based on the employee's Form W-4. The employee cannot choose how much will be withheld by giving you or your agent a Form W-4S, Request for Federal Tax Withholding From Sick Pay. Sick pay paid by an agent is treated as supplemental wages. If the agent does not pay regular wages to the employee, the agent may choose to withhold income tax at a flat 27% rate, rather than at the wage withholding rate.
Third party not an agent. Sick pay paid by a third party that is not your agent is not subject to mandatory income tax withholding. However, an employee may elect to have income tax withheld by submitting Form W-4S to the third party.
If Form W-4S has been submitted, the third party should withhold income tax on all payments of sick pay made 8 or more days after receiving the form. The third party may, at its option, withhold income tax before 8 days have passed.
The employee may request on Form W-4S to have a specific whole dollar amount withheld. However, if the requested withholding would reduce any net payment below $10, the third party should not withhold any income tax from that payment. The minimum amount of withholding that the employee can specify is $20 a week.
Withhold from all payments at the same rate. For example, if $25 is withheld from a regular full payment of $100, then $20 (25%) should be withheld from a partial payment of $80.
Amounts not subject to income tax withholding. The following amounts, whether paid by you or a third party, are not wages subject to income tax withholding.
Payments after the employee's death. Sick pay paid to the employee's estate or survivor at any time after the employee's death is not subject to income tax withholding, regardless of who pays it.
Payments attributable to employee contributions. Payments, or parts of payments, attributable to employee contributions made to a sick pay plan with aftertax dollars are not subject to income tax withholding. For more information, see the corresponding discussion in Amounts not subject to social security, Medicare, or FUTA taxes earlier.
Depositing and Reporting
This section discusses who is liable for depositing social security, Medicare, FUTA, and withheld income taxes on sick pay. These taxes must be deposited under the same rules that apply to deposits of taxes on regular wage payments. See Circular E for information on the deposit rules.
This section also explains how sick pay should be reported on Forms W-2, W-3, 940 or 940-EZ, and 941.
Sick Pay Paid by Employer or Agent
If you or your agent (defined earlier) make sick pay payments, you deposit taxes and file Forms W-2, W-3, 940 or 940-EZ, and 941 under the same rules that apply to regular wage payments.
However, the agreement between the parties may require your agent to carry out responsibilities that would otherwise have been borne by you. In this situation, your agent should use its own name and EIN (rather than yours) for the responsibilities it has assumed.
Reporting sick pay on Form W-2. You may either combine the sick pay with other wages and prepare a single Form W-2 for each employee, or you may prepare separate Forms W-2 for each employee, one reporting sick pay and the other reporting regular wages. A Form W-2 must be prepared even if all the sick pay is nontaxable (see Box 12 below in the list of information that must be included on Form W-2). All Forms W-2 must be given to the employees by January 31.
The Form W-2 filed for the sick pay must include the employer's name, address, and EIN; the employee's name, address, and SSN; and the following information:
Box 1 - Sick pay the employee must include in income.
Box 2 - Any Federal income tax withheld from the sick pay.
Box 3 - Sick pay subject to employee social security tax.
Box 4 - Employee social security tax withheld from the sick pay.
Box 5 - Sick pay subject to employee Medicare tax.
Box 6 - Employee Medicare tax withheld from the sick pay.
Box 12 - Any amount not subject to Federal income tax because the employee contributed to the sick pay plan (enter code J).
Sick Pay Paid by Third Party
The rules for a third party that is not your agent depend on whether liability has been transferred as discussed under Third-Party Payers of Sick Pay earlier.
To figure the due dates and amounts of its deposits of employment taxes, a third party should combine:
The liability for the wages paid to its own employees and
The liability for payments it made to all employees of all its clients. This does not include liability transferred to the employer.
Liability not transferred to the employer. If the third party does not satisfy the requirements for transferring liability for FUTA tax and the employer's part of the social security and Medicare taxes, the third party reports the sick pay on its own Forms 940 (or 940-EZ) and 941. In this situation, the employer has no tax responsibilities for sick pay.
The third party must deposit social security, Medicare, FUTA, and withheld income taxes using its own name and EIN. The third party must give each employee to whom it paid sick pay a Form W-2 by January 31 of the following year. The Form W-2 must include the third party's name, address, and EIN instead of the employer information. Otherwise, the third party must complete Form W-2 as shown in Reporting sick pay on Form W-2 earlier.
Liability transferred to the employer. Generally, if a third party satisfies the requirements for transferring liability for the employer part of the social security and Medicare taxes and for the FUTA tax, the following rules apply.
Deposits. The third party must make deposits of withheld employee social security and Medicare taxes and withheld income tax using its own name and EIN. You must make deposits of the employer part of the social security and Medicare taxes and the FUTA tax using your name and EIN. In applying the deposit rules, your liability for these taxes begins when you receive the third party's notice of sick pay payments.
Form 941. The third party and you must each file Form 941. Line 9 of each Form 941 must contain a special adjusting entry for social security and Medicare taxes. These entries are required because the total tax liability for social security and Medicare taxes (employee and employer parts) is split between you and the third party.
Employer. You must include third-party sick pay onlines 2, 6a, and 7a of Form 941. (There are no entries for sick pay on lines 3 through 5.) After completing line 8, subtract on line 9 the employee social security and Medicare taxes withheld and deposited by the third party. Enter that amount in the "Sick Pay" space provided. If line 9 includes adjustments unrelated to sick pay, show those amounts in the spaces provided and the total in the line 9 entry space on the right.
Third party. The third party must include on Form 941 the employee part of the social security and Medicare taxes (and income tax, if any) it withheld. The third party does not include on line 2 any sick pay paid as a third party but does include on line 3 any income tax withheld. On line 6a, the third party enters the total amount it paid subject to social security taxes. This amount includes both wages paid to its own employees and sick pay paid as a third party. The third party completes line 7a in a similar manner. On line 9, the third party subtracts the employer part of the social security and Medicare taxes that you must pay. The third party enters the amount you must pay on line 9 in the "Sick Pay" space provided. If line 9 includes adjustments unrelated to sick pay, the third party shows those amounts in the spaces provided and the total of all adjustments in the line 9 entry space.
Form 940 or 940-EZ. You, not the third party, must prepare Form 940 or 940-EZ for sick pay.
Third-party sick pay recap Forms W-2 and W-3. The third party must prepare a "third-party sick pay recap" Form W-2 and a "third-party sick pay recap" Form W-3. These forms, previously called "dummy" forms, do not reflect sick pay paid to individual employees, but instead show the combined amount of sick pay paid to all employees of all clients of the third party. The recap forms provide a means of reconciling the wages shown on the third party's Form 941. However, see Optional rule for Form W-2 later. Do not file the recap Form W-2 and W-3 electronically or on magnetic media.
The third party fills out the third-party sick pay recap Form W-2 as follows:
Box b - Third party's EIN.
Box c - Third party's name and address.
Box e - "Third-Party Sick Pay Recap" in place of the employee's name.
Box 1 - Total sick pay paid to all employees.
Box 2 - Any Federal income tax withheld from the sick pay.
Box 3 - Sick pay subject to employee social security tax.
Box 4 - Employee social security tax withheld from sick pay.
Box 5 - Sick pay subject to employee Medicare tax.
Box 6 - Employee Medicare tax withheld from the sick pay.
The third party attaches the third-party sick pay recap Form W-2 to a separate recap Form W-3, on which only boxes b, e, f, g, 1, 2, 3, 4, 5, 6, and 12 are completed. Enter "Third-Party Sick Pay Recap" in box 12. Only the employer makes an entry in box 14 of Form W-3.
Optional rule for Form W-2. You and the third party may choose to enter into a legally binding agreement designating the third party to be your agent for purposes of preparing Forms W-2 reporting sick pay. The agreement must specify what part, if any, of the payments under the sick pay plan is excludable from the employees' gross incomes because it is attributable to their contributions to the plan. If you enter into an agreement, the third party prepares the actual Forms W-2, not the third-party sick pay recap Form W-2 as discussed earlier, for each employee who receives sick pay from the third party. If the optional rule is used:
The third party does not provide you with the sick pay statement described below and
You (not the third party) prepare third-party sick pay recap Forms W-2 and W-3. These recap forms are needed to reconcile the sick pay shown on your Form 941.
Sick pay statement. The third party must furnish you with a sick pay statement by January 15 of the year following the year in which the sick pay was paid. The statement must show the following information about each employee who was paid sick pay:
The employee's name.
The employee's SSN (if social security, Medicare, or income tax was withheld).
The sick pay paid to the employee.
Any Federal income tax withheld.
Any employee social security tax withheld.
Any employee Medicare tax withheld.
Example of Figuring and Reporting Sick Pay
Dave, an employee, was seriously injured in a car accident on January 1, 2001. Dave's last day of work was December 31, 2000. The accident was not job related.
Key, an insurance company that was not an agent of the employer, paid Dave $2,000 each month for 10 months, beginning in January 2001. Dave submitted a Form W-4S to Key, requesting $210 be withheld from each payment for Federal income tax. Dave received no payments from Edgewood, his employer, from January 2001 through October 2001. Dave returned to work in November 2001.
For the policy year in which the car accident occurred, Dave paid a part of the premiums for his coverage, and Edgewood paid the remaining part. The plan was, therefore, a "contributory plan." During the 3 policy years before the calendar year of the accident, Edgewood paid 70% of the total of the net premiums for its employees' insurance coverage, and its employees paid 30%.
Social security and Medicare taxes. For social security and Medicare tax purposes, taxable sick pay was $8,400 ($2,000 per month × 70% = $1,400 taxable portion per payment; $1,400 × 6 months = $8,400 total taxable sick pay). Only the six $2,000 checks received by Dave from January through June are included in the calculation. The check received by Dave in July (the seventh check) was received more than 6 months after the month in which Dave last worked.
Of each $2,000 payment Dave received, 30% ($600) is not subject to social security and Medicare taxes because the plan is contributory and Dave's aftertax contribution is considered to be 30% of the premiums during the 3 policy years before the calendar year of the accident.
FUTA tax. Of the $8,400 taxable sick pay (figured the same as for social security and Medicare taxes), only $7,000 is subject to the FUTA tax because the FUTA contribution base is $7,000.
Income tax withholding. Of each $2,000 payment, $1,400 ($2,000 × 70%) is subject to voluntary income tax withholding. In accordance with Dave's Form W-4S, $210 was withheld from each payment ($2,100 for the 10 payments made during 2001).
Liability transferred. For the first 6 months following the last month in which Dave worked, Key was liable for social security, Medicare, and FUTA taxes on any payments that constituted taxable wages. However, Key could have shifted the liability for the employer part of the social security and Medicare taxes (and for the FUTA tax) during the first 6 months by withholding Dave's part of the social security and Medicare taxes, timely depositing the taxes, and notifying Edgewood of the payments.
If Key shifted liability for the employer part of the social security and Medicare taxes to Edgewood and provided Edgewood with a sick pay statement, Key would not prepare a Form W-2 for Dave. However, Key would prepare third-party sick pay recap Forms W-2 and W-3. Key and Edgewood must each prepare Form 941. Edgewood must also report the sick pay and withholding for Dave on Forms W-2, W-3, and 940.
As an alternative, the parties could have followed the optional rule described under Optional rule for Form W-2 earlier. Under this rule, Key would prepare Form W-2 even though liability for the employer part of the social security and Medicare taxes had been shifted to Edgewood. Also, Key would not prepare a sick pay statement, and Edgewood, not Key, would prepare the recap Forms W-2 and W-3 reflecting the sick pay shown on Edgewood's Form 941.
Liability not transferred. If Key did not shift liability for the employer part of the social security and Medicare taxes to Edgewood, Key would prepare Forms W-2 and W-3 as well as Forms 941 and 940. In this situation, Edgewood would not report the sick pay.
Payments received after 6 months. The payments received by Dave in July through October are not subject to social security, Medicare, or FUTA taxes, because they were received more than 6 months after the last month in which Dave worked (December 2000). However, Key must continue to withhold income tax from each payment because Dave furnished Key a Form W-4S. Also, Key must prepare Forms W-2 and W-3, unless it has furnished Edgewood with a sick pay statement. If the sick pay statement was furnished, then Edgewood must prepare Forms W-2 and W-3.
Chapter 7 - Special Rules for Paying Taxes
If two or more related corporations employ the same individual at the same time and pay this individual through a common paymaster, which is one of the corporations, the corporations are considered a single employer. They have to pay, in total, no more in social security and Medicare taxes than a single employer would.
Each corporation must pay its own part of the employment taxes and may deduct only its own part of the wages. The deductions will not be allowed unless the corporation reimburses the common paymaster for the wage and tax payments. See Regulations section 31.3121(s)-1 for more information.
You must submit an application for authorization to act as an agent to the IRS service center where you will be filing returns. A Form 2678, Employer Appointment of Agent, properly completed by each employer, must be submitted with this application. See Rev. Proc. 70-6, 1970-1 C.B. 420, Rev. Proc. 84-33, 1984-1 C.B. 502, and the separate Instructions for Forms W-2 and W-3 for procedures and reporting requirements. Form 2678 does not apply to FUTA taxes reportable on Form 940.
Magnetic tape filing of Forms 940 and 941. Reporting agents filing Forms 940 and 941 for a large number of employers may file them on magnetic tape. For authorization to file using this method, reporting agents must submit a Form 8655, Reporting Agent Authorization for Magnetic Tape/Electronic Filers, completed by each employer. See Rev. Proc. 96-18, 1996-1 C.B. 637, for the procedures for filing Forms 940 and 941 on magnetic tape. You can find Rev. Proc. 96-18 on page 73 of Internal Revenue Bulletin 1996-4 at www. irs.gov.Also, see Pub. 1314 (Form 940) and Pub. 1264 (Form 941) for the tape specifications.
Electronic filing of Form 941. The 941e-file program accepts and processes Form 941 electronically in the Electronic Data Interchange (EDI) format. The program allows a reporting agent taxpayer to electronically file Form 941 using a personal computer, modem, and commercial tax preparation software. See Rev. Proc. 96-17, 1996-1 C.B. 633 and Rev. Proc. 99-39, 1999-43 IRB 532 for procedural information. You can find Rev. Proc. 96-17 on page 69 of Internal Revenue Bulletin 1996-4, and Rev. Proc. 99-39 on page 532 of Internal Revenue Bulletin 1999-43, at www.irs.gov. Also see Pub. 1855 for technical specifications.
Payment of Employment Taxes by Disregarded Entities
Employment taxes for employees of a qualified subchapter S subsidiary or other entity disregarded as an entity separate from its owner may be reported and paid under one of the following methods:
By its owner (as if the employees of the disregarded entity are employed directly by the owner) using the owner's name and taxpayer identification number or
By each entity recognized as a separate entity under state law using the entity's own name and taxpayer identification number.
If the second method is chosen, the owner retains responsibility for the employment tax obligations of the disregarded entity. For more information, see Notice 99-6, 1999-3 C.B. 321. You can find Notice 99-6 on page 12 of Internal Revenue Bulletin 1999-3 at www.irs.gov.
Lender, Surety, or Other Third-Party Payers
Any lender, surety, or other person who pays wages, or supplies funds specifically to pay wages directly to the employees of an employer, or to the employee's agent, is responsible for any required withholding on those wages. The third party is also liable for any interest and penalties accruing on these accounts. This includes the withholding of income, social security, Medicare, and railroad retirement taxes.
Note: These rules do not apply to a person acting only as an agent, or to third-party payers of sick pay, discussed in section 6.
If a third party supplies funds to an employer so that the employer can pay the employees' wages, and if the third party knows that the employer will not pay or deposit the taxes that are required to be withheld when due, then the third party must pay the taxes withheld from the employees' wages but not paid by the employer. However, the third party does not have to pay more than 25% of the amount that is specifically supplied for paying wages. The third-party supplier must also pay interest on the taxes if they are paid after the due date of the employer's return.
Third parties are liable only for payment of the employees' parts of payroll taxes. They are not liable for the employer's part. The employer must file an employment tax return for wages that he or she or a third party pays and must furnish Forms W-2 to employees for the wages paid and taxes withheld. The employer also remains liable for any withholding taxes not paid by the third party.
Liability of trustee in bankruptcy. A trustee in bankruptcy must withhold, report, and pay income, social security, and Medicare taxes from the payment of priority claims for employees' wages earned prior to, but unpaid at the time of, an employer's bankruptcy.
How to pay withheld tax. Third parties who pay employment taxes must file two copies of Form 4219, Statement of Liability of Lender, Surety, or Other Person for Withholding Taxes. A separate set of forms must be filed for each employer and calendar quarter.
Form 4219 must be filed with the IRS service center where the employer for whom wages were paid, or funds were supplied, files Federal employment tax returns.
Each Form 4219 must be accompanied by a check or money order made payable to the "United States Treasury." To avoid interest, full payment should be made on or before the due date of the employer's Federal employment tax return.
Employee's Portion of Taxes Paid by Employer
If you pay your employee's social security and Medicare taxes without deducting them from the employee's pay, you must include the amount of the payments in the employee's wages for income tax withholding and social security, Medicare, and FUTA taxes. This increase in the employee's wage payment for your payment of the employee's social security and Medicare taxes is also subject to employee social security and Medicare taxes. This again increases the amount of the additional taxes you must pay.
Note: This discussion does not apply to household and agricultural employers. If you pay a household or agricultural employee's social security and Medicare taxes, these payments must be included in the employee's wages. However, this wage increase due to the tax payments made for the employee is not subject to social security or Medicare taxes as discussed in this section.
To figure the employee's increased wages in this situation, divide the stated pay (the amount you pay without taking into account your payment of employee social security and Medicare taxes) by a factor for that year. This factor is determined by subtracting from 1 the combined employee social security and Medicare tax rate for the year the wages are paid. For 2002, the factor is .9235 (1 - .0765). If the stated pay is more than $78,405.15 (2002 wage base $84,900 × .9235), follow the procedure described under Stated pay of more than $78,405.15 in 2002 below.
Stated pay of $78,405.15 or less in 2002. For an employee with stated pay of $78,405.15 or less in 2002, figure the correct wages (wages plus employer-paid employee taxes) and withholding to report by dividing the stated pay by .9235. This will give you the wages to report in box 1 and the social security and Medicare wages to report in boxes 3 and 5 of Form W-2.
To figure the correct social security tax to enter in box 4 and Medicare tax to enter in box 6, multiply the amounts in boxes 3 and 5 by the withholding rates (6.2% and 1.45%) for those taxes, and enter the results in boxes 4 and 6.
Example. Donald Devon hires Lydia Lone for only 1 week during 2002. He pays her $300 for that week. Donald agrees to pay Lydia's part of the social security and Medicare taxes. To figure her reportable wages, he divides $300 by .9235. The result, $324.85, is the amount he reports as wages in boxes 1, 3, and 5 of Form W-2. To figure the amount to report as social security tax, Donald multiplies $324.85 by the social security tax rate of 6.2% (.062). The result, $20.14, is entered in box 4 of Form W-2. To figure the amount to report as Medicare tax, Donald multiplies $324.85 by the Medicare tax rate of 1.45% (.0145). The result, $4.71, is entered in box 6 of Form W-2. Although he did not actually withhold these amounts from Lydia, he will report these amounts as taxes withheld on Form 941 and is responsible for matching these amounts with the employer share of these taxes.
For FUTA tax and income tax withholding, Lydia's weekly wages are $324.85.
Stated pay of more than $78,405.15 in 2002. For an employee with stated pay of more than $78,405.15 in 2002, the correct social security wage amount is $84,900 (the first $78,405.15 of wages × .9235). The stated pay in excess of $78,405.15 is not subject to social security tax because the tax only applies to the first $84,900 of wages (stated pay plus employer-paid employee taxes). Enter $84,900 in box 3 of Form W-2. The social security tax to enter in box 4 is $5,263.80 (84,900 x .062).
To figure the correct Medicare wages to enter in box 5 of Form W-2, subtract $78,405.15 from the stated pay. Divide this amount by .9855 (1 - .0145) and add $84,900. For example, if stated pay is $100,000, the correct Medicare wages are figured as follows:
$100,000 - $78,405.15 = $21,594.85
$21,594.85 × .9855 = $21,912.58
$21,912.58 + $84,900 = $106,812.58
The Medicare wages are $106,812.58. Enter this amount in box 5 of Form W-2. The Medicare tax to enter in box 6 is $1,548.78 ($106,812.58 × .0145).
Although these employment tax amounts are not actually withheld, report them as withheld on Form 941, and pay this amount as the employer's share of the social security and Medicare taxes. If the wages for income tax purposes in the preceding example are the same as for social security and Medicare purposes, the correct wage amount for income tax withholding is $106,812.58 ($100,000 + $5,263.80 + $1,548.78), which is included in box 1 of Form W-2.
International Social Security Agreements
The United States has social security agreements with many countries to eliminate dual taxation and coverage under two social security systems. Under these agreements, sometimes known as totalization agreements, you generally must pay social security taxes only to the country where you work. Employees and employers who are subject only to foreign social security taxes under these agreements are exempt from U.S. social security taxes, including the Medicare portion.
The United States has social
security agreements with the following countries: Austria, Belgium, Canada,
Finland, France, Germany, Greece, Ireland, Italy, Korea, Luxembourg, the
Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United
Kingdom. Additional agreements are expected in the future. For more
information, see Pub. 519, U.S. Tax Guide for Aliens, or contact:
Social Security Administration
Office of International Programs
P.O. Box 17741
Baltimore, MD 21235-7741
If you have access to the Internet, you can get more information from the SSA at www.ssa.gov/international
Chapter 8 - Pensions & Annuities
Generally, pension and annuity payments are subject to Federal income tax withholding. The withholding rules apply to the taxable part of payments from an employer pension, annuity, profit-sharing, stock bonus, or other deferred compensation plan. The rules also apply to payments from an individual retirement arrangement (IRA), an annuity, endowment, or life insurance contract issued by a life insurance company. There is no withholding on any part of a distribution that is not expected to be includible in the recipient's gross income.
Generally, recipients of payments described above can choose not to have withholding apply to their pensions or annuities (however, see Mandatory Withholding below). The election remains in effect until the recipient revokes it. The payer must notify the recipient that this election is available.
Generally, periodic payments are pension or annuity payments made for more than 1 year that are not eligible rollover distributions (see discussion below). Periodic payments include substantially equal payments made at least once a year over the life of the employee and/or beneficiaries or for 10 years or more. For withholding purposes, these payments are treated as if they are wages. You can figure withholding by using the recipient's Form W-4P, Withholding Certificate for Pension or Annuity Payments, and the income tax withholding tables and methods in Circular E or the alternative tables and methods in this publication.
Recipients of periodic payments can give you a Form W-4P to specify the number of withholding allowances and any additional amount they want withheld. They may also claim exemption from withholding on Form W-4P or revoke a previously claimed exemption. If they do not submit a Form W-4P, you must figure withholding by treating a recipient as married with three withholding allowances. See Form W-4P for more information.
Withhold 10% of the taxable part of a nonperiodic payment that is not an eligible rollover distribution. The recipient may request additional withholding on Form W-4P or claim exemption from withholding.
Payments delivered outside the United States. The election to be exempt from income tax withholding does not apply to any periodic or nonperiodic payment delivered outside the United States or its possessions to a U.S. citizen or resident alien. See Form W-4P for more information.
A nonresident alien can elect exemption from withholding only if he or she certifies to the payer that he or she is not (1) a U.S. citizen or resident alien or (2) an individual to whom Internal Revenue Code section 877 applies (concerning expatriation to avoid tax). The certification must be made in a statement to the payer under penalties of perjury. However, nonresident aliens who choose such exemption will be subject to withholding under Code section 1441. See Pub. 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, and the Instructions for Form 1042-S.
Eligible rollover distributions. Withhold 20% of an eligible rollover distribution unless the recipient elected to have the distribution paid in a direct rollover to an eligible retirement plan, including an IRA. An eligible rollover distribution is the taxable part of any distribution from a qualified plan, governmental section 457 plan (for distributions after December 31, 2001), or tax-sheltered annuity (but not an IRA) except:
One of a series of substantially equal periodic payments (at least annually) made for the life or life expectancy of the employee and the employee's beneficiary or for a specified period of 10 years or more.
Any part of a distribution that is a minimum distribution required by Code section 401(a)(9).
A hardship distribution. A distribution will qualify for hardship if it is (a) made on account of immediate and heavy need and (b) necessary to satisfy the need. This includes medical and educational expenses and costs for purchasing a new residence, or to prevent eviction or foreclosure on a current residence.
Other exceptions apply. For details see the Instructions for Forms 1099-R and 5498.
You are not required to withhold 20% of an eligible rollover distribution that, when added to other rollover distributions made to one person during the year, is less than $200.
A recipient of an eligible rollover distribution cannot claim exemption from the 20% withholding. However, a recipient may elect to have more than 20% withheld using Form W-4P. Do not provide the recipient a Form W-4P for eligible rollover distributions unless he or she wishes to request additional withholding in excess of the mandatory 20%.
Notice to recipient (section 402(f) notice). Generally, you must provide a written explanation to the recipient at least 30 but no more than 90 days before making an eligible rollover distribution. You must explain the rollover rules, special tax treatment for lump-sum distributions, direct rollover option, and the mandatory 20% withholding rule. Notice 2000-11 (2006 IRB 572), contains a model notice you can use to satisfy this requirement. You can find Notice 2000-11 on page 572 of Internal Revenue Bulletin 2000-6 at www.irs.gov.
Similar rules apply to distributions from tax-sheltered annuities. The IRS has issued regulations on these requirements under sections 401(a)(31), 402, 403(b), and 3405.
Depositing and Reporting Withholding
Report income tax withholding from pensions and annuities on Form 945, Annual Return of Withheld Federal Income Tax. Do not report these liabilities on Form 941. You must furnish the recipients and the IRS with Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Deposit withholding from pensions and annuities combined with any other nonpayroll withholding reported on Form 945 (e.g., backup withholding). Do not combine the Form 945 deposits with deposits for payroll taxes. Circular E and the separate Instructions for Form 945 include information on the deposit rules.
Chapter 9 - Alternative Methods for Figuring Withholding
You may use various methods of figuring income tax withholding. The methods described below may be used instead of the common payroll methods provided in Circular E. Use the method that best suits your payroll system and employees.
Annualized wages. Using your employee's annual wages, figure the withholding using the Percentage Method, Table 7-Annual Payroll Period, in Circular E. Divide the amount from the table by the number of payroll periods, and the result will be the amount of withholding for each payroll period.
Average estimated wages. You may withhold the tax for a payroll period based on estimated average wages, with necessary adjustments, for any quarter. For details, see Regulations section 31.3402(h)(1)-1.
Cumulative wages. An employee may ask you, in writing, to withhold tax on cumulative wages. If you agree to do so, and you have paid the employee for the same kind of payroll period (weekly, biweekly, etc.) since the beginning of the year, you may figure the tax as follows:
Add the wages you have paid the employee for the current calendar year to the current payroll period amount. Divide this amount by the number of payroll periods so far this year including the current period. Figure the withholding on this amount, and multiply the withholding by the number of payroll periods used above. Use the percentage method shown in Circular E. Subtract the total withholding calculated from the total tax withheld during the calendar year. The excess is the amount to withhold for the current payroll period. (See Rev. Proc. 78-8, 1978-1 C.B. 562, for an example of the cumulative method.)
Part-year employment. A part-year employee who figures income tax on a calendar-year basis may ask you to withhold tax by the part-year employment method. The request must be in writing and must contain the following information:
The last day of any employment during the calendar year with any prior employer.
A statement that the employee uses the calendar year accounting period.
A statement that the employee reasonably anticipates he or she will be employed by all employers for a total of no more than 245 days in all terms of continuous employment (defined below) during the current calendar year.
Complete the following steps to figure withholding tax by the part-year method:
Add the wages to be paid to the employee for the current payroll period to any wages you have already paid the employee in the current term of continuous employment.
Add the number of payroll periods used in step 1 to the number of payroll periods between the employee's last employment and current employment. To find the number of periods between the last employment and current employment, divide (a) the number of calendar days between the employee's last day of earlier employment (or the previous December 31, if later) and the first day of current employment by (b) the number of calendar days in the current payroll period.
Divide the step 1 amount by the total number of payroll periods from step 2.
Find the tax in the withholding tax tables on the step 3 amount. Be sure to use the correct payroll period table and to take into account the employee's withholding allowances.
Multiply the total number of payroll periods from step 2 by the step 4 amount.
Subtract from the step 5 amount the total tax already withheld during the current term of continuous employment. Any excess is the amount to withhold for the current payroll period.
(See Regulations section 31.3402(h)(4)-1(c)(4) for examples of the part-year method.)
Term of continuous employment. A term of continuous employment may be a single term or two or more following terms of employment with the same employer. A continuous term includes holidays, regular days off, and days off for illness or vacation. A continuous term begins on the first day an employee works for you and earns pay. It ends on the earlier of the employee's last day of work for you or, if the employee performs no services for you for more than 30 calendar days, the last workday before the 30-day period. If an employment relationship is ended, the term of continuous employment is ended, even if a new employment relationship is established with the same employer within 30 days.
Other methods. You may use other methods and tables for withholding taxes, as long as the amount of tax withheld is consistently about the same as it would be under the percentage method shown in Circular E. If you develop an alternative method or table, you should test the full range of wage and allowance situations to be sure that they meet the tolerances contained in Regulations section 31.3402(h)(4)-1 as shown in the chart below.
Formula Tables for Percentage
(for Automated Payroll Systems)
Two formula tables for percentage method withholding are on pages 23 and 24. The differences in the Alternative Percentage Method formulas and the steps for figuring withheld tax for different payroll systems are shown in this example.
|If wages exceeding the allowance amount are over $124 but not over $355:|
|Method:||Income Tax Withheld:|
|Percentage (Pub. 15)||10% of excess over $124|
|Alternative 1 (Page 23)||10% of such wages minus $12.40|
|Alternative 2 (Page 24)||Such wages minus $124, times 10% of remainder|
When employers use the percentage method in Circular E or the formula tables for percentage method withholding in this publication, the tax for the pay period may be rounded to the nearest dollar. If rounding is used, it must be used consistently. Withheld tax amounts should be rounded to the nearest whole dollar by (1) dropping amounts under 50 cents and (2) increasing amounts from 50 to 99 cents to the next higher dollar. This rounding will be considered to meet the tolerances under section 3402(h)(4).
Wage Bracket Percentage Method Tables (for Automated Payroll Systems)
Wage Bracket Percentage
(for Automated Payroll Systems)
The Wage Bracket Percentage Method Tables show the gross wage brackets that apply to each withholding percentage rate for employees with up to nine withholding allowances. These tables also show the computation factors for each number of withholding allowances and the applicable wage bracket. The computation factors are used to figure the amount of withholding tax by a percentage method.
Two kinds of Wage Bracket Percentage Method Tables are shown. Each has tables for married and single persons for weekly, biweekly, semimonthly, and monthly payroll periods.
The difference between the two kinds of tables is the reduction factor subtracted from wages before multiplying by the applicable percentage withholding rate. In the tables for Computing Income Tax Withholding From Gross Wages on pages 26-29, the reduction factor includes both the amount for withholding allowances claimed and a rate adjustment factor as shown in the Alternative 2--Tables for Percentage Method Withholding Computations on page 24. In the tables for Computing Income Tax Withholding From Wages Exceeding Allowance Amount on pages 30-33, the reduction factor does not include an amount for the number of allowances claimed.
Use the kind of wage bracket table that best suits your payroll system. For example, some pay systems automatically subtract from wages the allowance amount for each employee before finding the amount of tax to withhold. The tables for Computing Income Tax Withholding From Wages Exceeding Allowance Amount can be used in these systems. The reduction factors in these tables do not include the allowance amount that was automatically subtracted before applying the table factors in the calculation. For other systems that do not separately subtract the allowance amount, use the tables for Computing Income Tax Withholding From Gross Wages.
When employers use the Wage Bracket Percentage Method Tables, the tax for the period may be rounded to the nearest dollar. If rounding is used, it must be used consistently. Withheld tax amounts should be rounded to the nearest whole dollar by (1) dropping amounts under 50 cents and (2) increasing amounts from 50 to 99 cents to the next higher dollar. Such rounding will be deemed to meet the tolerances under section 3402(h)(4).
Combined Income Tax,
Employee Social Security Tax, &
Employee Medicare Tax Withholding Tables
If you want to combine amounts to be withheld as income tax, employee social security tax, and employee Medicare tax, you may use the combined tables on pages 35-54.
Combined withholding tables for single and married taxpayers are shown for weekly, biweekly, semimonthly, monthly, and daily or miscellaneous payroll periods. The payroll period and marital status of the employee determine the table to be used.
If the wages are greater than the highest wage bracket in the applicable table, you will have to use one of the other methods for figuring income tax withholding described in this publication or in Circular E. For wages that do not exceed $84,900, the combined social security tax rate and Medicare tax rate is 7.65% each for both the employee and the employer for wages paid in 2002. You can figure the employee social security tax by multiplying the wages by 6.2%, and you can figure the employee Medicare tax by multiplying the wages by 1.45%.
The combined tables give the correct total withholding only if wages for social security and Medicare taxes and income tax withholding are the same. When you have paid more than the maximum amount of wages subject to social security tax ($84,900 in 2002) in a calendar year, you may no longer use the combined tables.
If you use the combined withholding tables, use the following steps to find the amounts to report on your Form 941, Employer's Quarterly Federal Tax Return.
Employee social security tax withheld. Multiply the wages by 6.2%.
Employee Medicare tax withheld. Multiply the wages by 1.45%.
Income tax withheld. Subtract the amounts from steps 1 and 2 from the total tax withheld.
You can figure the amounts to be shown on Form W-2, Wage and Tax Statement, in the same way.
Chapter 11 - Tables for
Withholding on Distributions of
Indian Gaming Profits to Tribal Members
If you make certain payments to members of Indian tribes from gaming profits, you must withhold Federal income tax. You must withhold if (1) the total payment to a member for the year is over $7,700 and (2) the payment is from the net revenues of class II or class III gaming activities (classified by the Indian Gaming Regulatory Act) conducted or licensed by the tribes.
A class I gaming activity is not subject to this withholding requirement. Class I activities are social games solely for prizes of minimal value or traditional forms of Indian gaming engaged in as part of tribal ceremonies or celebrations.
Class II. Class II includes (1) bingo and similar games, such as pull tabs, punch boards, tip jars, lotto, and instant bingo, and (2) card games that are authorized by the state or that are not explicitly prohibited by the state and played at a location within the state.
Class III. A class III gaming activity is any gaming that is not class I or class II. Class III includes horse racing, dog racing, jai alai, casino gaming, and slot machines.
To figure the amount of tax to withhold each time you make a payment, use the table on page 56 for the period for which you make payments. For example, if you make payments weekly, use table 1; if you make payments monthly, use table 4. If the total payments to an individual for the year are $7,700 or less, no withholding is required.
Example: A tribal member is paid monthly. The monthly payment is $5,000. Using Table 4, Monthly Distribution Period, figure the withholding as follows:
Subtract $2,971 from the $5,000 payment for a remainder of $2,029. Multiply this amount by 27%, for a total of $547.83. Add $324.35, for total withholding of $872.18.
Depositing and reporting withholding. Combine the Indian gaming withholding with all other nonpayroll withholding (e.g., backup withholding and withholding on gambling winnings). Generally, you must deposit the amounts withheld by electronic funds transfer (see page 2) or at an authorized financial institution using Form 8109, Federal Tax Deposit Coupon. See Circular E, Employer's Tax Guide, for a detailed discussion of the deposit requirements.
Report Indian gaming withholding on Form 945, Annual Return of Withheld Federal Income Tax. For more information, see Form 945 and its instructions. Also, report the payments and withholding to tribal members and to the IRS on Form 1099-MISC, Miscellaneous Income (see the Instructions for Forms 1098-MISC.).
Cents-per-mile rule. The standard mileage rate you can use under the cents-per-mile rule to value the personal use of a vehicle you provide to an employee in 2002 is 36.5 cents a mile. See Cents-Per-Mile Rule in section 3.
Increase in public transit subsidy. Beginning January 1, 2002, the maximum benefit an employee may exclude for combined commuter highway vehicle transportation and transit passes increases to $100. See Qualified Transportation Benefits in section 2.
Extension and expansion of exclusion for educational assistance plans. The exclusion for educational assistance has been extended to years after 2001. Expenses for graduate level courses may be excluded for courses beginning after 2001. See Educational Assistance in section 2.
Increase in adoption plan exclusion. Beginning with 2002, the amount of payments and reimbursements that can be excluded under an adoption assistance plan increases to $10,000 for each eligible child. This amount also applies to special needs adoptions. For more information, see Adoption Assistance in section 2.
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