Increase In Withholding Taxes on "Supplemental Wages" Over $1 Million

On July 24, 2006, the Internal Revenue Service (IRS) issued final rules reflecting the changes made by the American Jobs Creation Act of 2004 ("Jobs Act"). The Jobs Act increases the wage withholding rate from the third-lowest tax rate for single filers (25% in 2006) to the maximum tax rate in effect (35% in 2006) once an employee's supplemental wages exceed $1 million for a calendar year.

Supplemental wages include bonuses, nonstatutory stock options, restricted stock, severance, deferred compensation, and other types of payments that are not regular base salary or hourly wages.

The final rules, which are effective for wages paid on or after January 1, 2007, should prove helpful to all employers, not just those that have employees with supplemental wages that exceed $1 million, as they (1) provide detailed guidance as to how employers should classify particular wage payments as regular wages or supplemental wages and (2) outline the procedures for withholding on supplemental wages both below and in excess of $1 million.

The final regulations define "supplemental wages" to include any wages paid by an employer that are not "regular wages." "Regular wages" are defined as amounts paid by an employer for a payroll period either at a regular hourly rate or in a predetermined fixed amount, typically base salary. Wages that vary from payroll period to payroll period based on factors other than the amount of time worked are supplemental wages, for example bonuses, stock options or deferred compensation.

Importantly, the final regulations eliminate the rule that a payment can qualify as supplemental wages only if regular wages have been paid to an employee. For example, if a former employee is receiving payments of nonqualified deferred compensation from the employer, those payments will be supplemental wages regardless of whether the former employee has received any regular wages in that year (or in any prior year) from the employer.

The final regulations also list specific examples of supplemental wages, namely:

Ø Bonuses;

Ø Commissions;

Ø Wages paid under reimbursement or other expense allowance arrangements;

Ø Wages paid as noncash fringe benefits;

Ø Nonqualified deferred compensation includible in wages;

Ø Income recognized on the exercise of a nonstatutory stock option;

Ø Wages from imputed income for health coverage for a non-dependent;

Ø Wage income recognized on the lapse of a restriction on restricted property transferred from an employer to an employee, e.g. restricted stock;

Ø Tips;

Ø Overtime pay;

Ø Back pay; and

Ø Sick pay paid by a third party agent of the employer.

Under the final rules, employers are permitted, at their option, to treat tips and overtime pay as regular wages and such treatment is not required to be applied uniformly to all employees of the employer. All other payments listed above, however, must always be treated as supplemental wages.

With respect to the procedures for withholding on supplemental wages, the final regulations provide that, if an employee has less than $1 million in supplemental wages during the calendar year, there are two withholding procedures available to the employer: (1) the aggregate procedure and (2) optional flat rate withholding. Under the aggregate procedure, an employer calculates the amount of withholding due first by aggregating the amount of supplemental wages with regular wages paid for the current payroll period or the most recent payroll period in the year of the payment, and then treating the aggregate as if it were a single payment of regular wages using the employee's last Form W-4 on file.

Optional flat rate withholding allows employers to disregard the amount of regular wages paid to the employee as well as the withholding allowances claimed by the employee on his Form W-4. Optional flat rate withholding is available only in situations where supplemental wages of less than $1 million for the year are being paid and there has been withholding on regular wages during the current or the preceding year. The final regulations list the specific rates applicable for purposes of optional flat rate withholding from August 6, 2001 going forward (the rate is 25% in 2006).

For supplemental wages in excess of $1 million, mandatory withholding applies. Mandatory withholding requires that an employer must not only ignore the employee's withholding allowances claimed on his Form W-4, but ignore any requests for additional withholding as well. Under the Jobs Act, employers must withhold on supplemental wages in excess of $1 million at the highest income tax rate under the Code, which for taxable years beginning in 2005 is 35%.

To address employers' concerns about how they will be able to track when an employee is subject to mandatory withholding, the final regulations, in conjunction with a revenue procedure that the IRS will issue in the near future, will provide employers with a number of special rules and options for making this determination.

Special rules set out in the final regulations provide that:

Ø Current IRS guidance for calculating the amount of noncash fringe benefits that are wages will apply to mandatory withholding;

Ø Income from disqualifying dispositions of stock acquired pursuant to the exercise of statutory stock options is not supplemental wages;

Ø Items reportable in Box 1 of Form W-2, even if not subject to income tax withholding, may be treated by employers as supplemental wages;

Ø Employers may apply mandatory withholding to the entire amount of any single supplemental wage payment that will result in the employee exceeding the $1 million threshold (the proposed regulations would have required employers to apply mandatory withholding only to the portion of the payment exceeding $1 million);

Ø Salary deferral amounts must be allocated to the gross regular wage payments or to the gross supplemental wage payments from which they are actually deducted; and

Ø An employer may apply an optional de minimis rule, which permits an employer to disregard supplemental wage payments made by a third party agent to an employee in determining whether the employee has reached the $1 million threshold, if the agent has made total wage payments (both regular and supplemental) of less than $100,000 to the employee during the calendar year.

Should you have any questions on supplemental wage withholding, please call or e-mail your contact in the Employee Benefits Group at Ice Miller.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.