The Internal Revenue Service (IRS) lays out rules, regulations, definitions and calculations in Publication 15 – (Circular E) Employer’s Tax Guide. This guide is updated annually and can be found online by clicking here. It is highly recommended that this publication be downloaded and reviewed by employers on an annual basis.
The IRS defines supplemental wages as “wage payments to an employee that are not regular wages.” “Regular” wages can practically be defined as regular salary, base salary or base rate. It’s the regular wages you pay an employee for doing their job, exclusive of any other incentive, bonus or any other additional wages or income.
Below are some examples of common supplemental wages. This list is not exhaustive and does not include all the possible types of supplemental wages that may be paid to an employee.
- Benefit Accrual Payouts
- Awards, Prizes and Gifts
- Severance Pay
- Retroactive Pay
- Non Deductible Moving Expenses
- Taxable Fringe Benefits
- Non-Accountable Expense Reimbursement
The biggest difference between regular wages and supplemental wages is their tax treatment. The IRS mandates one of three methods in calculating an employee’s check with supplemental pay.
The IRS makes a very clear distinction between regular wages and supplemental wages and that any supplemental wages are to be taxed differently than regular wages. The acceptable methods of calculating these taxes override what the employee is claiming on their W4 for regular wages. It is important to remember that it is the EMPLOYER that determines the tax calculation method, not the employee. The employee cannot request that a certain amount of taxes be withheld or that taxes be withheld at a lower rate. Also, once the decision is made by the employer on the method, the method must be applied to all employees, no exceptions.
So how do you determine how to calculate the appropriate withholdings? There are two categories of supplemental payment rules which are based on the amount of supplemental wages an employee will receive in a calendar year. If the employee will receive less than $1,000,000, there are two methods to choose from. If the employee will make more than $1,000,000 in supplemental wages, only one method is available.
Employees with Supplemental Earnings Less Than $1,000,000 Annually
Method 1 – Supplemental Wages Combined with Regular Wages
If you do not differentiate between regular wages and any sort of supplemental wages (i.e., everything is classified as Regular) then Federal Income Tax (FIT) is withheld on the total amount as if the total was a single payment for that regular pay period.
Another way of looking at this is that this is the method used to calculate taxes due when Overtime (OT) is paid to an employee on a single check, along with their regular wages for a pay period. The OT wages are added to regular pay and the taxes are then calculated at the higher rate of pay for that pay period only. The higher pay amount does not carry forward to the next pay period.
Method 2 – Supplemental Wages Identified Separately From Regular Wages
If the supplemental wages are identified as a separate earnings type other than regular, there are two methods for calculating the withholding due.
Withhold Federal Income Tax (FIT) at a 25% rate. No other percentage is allowed.
If the supplemental wages are paid concurrently with regular wages, add the supplemental wages to the concurrently paid regular wages. If there are no concurrently paid regular wages, add the supplemental wages to alternatively, either the regular wages paid or to be paid for the current payroll period or the regular wages paid for the preceding payroll period. Figure the income tax withholding as if the total of the regular wages and supplemental wages is a single payment. Subtract the tax withheld from the regular wages. Withhold the remaining tax from the supplemental wages. If there were other payments of supplemental wages paid during the payroll period made before the current payment of supplemental wages, aggregate all the payments of supplemental wages paid during the payroll period with the regular wages paid during the payroll period, calculate the tax on the total, subtract the tax already withheld from the regular wages and the previous supplemental wage payments, and withhold the remaining tax.
Due to the complicated nature of this calculation, it is recommended that the standard 25% withholding rate be used.
Employees with Supplemental Earnings More Than $1,000,000 Annually
If any employee receives in excess of $1,000,000 per calendar year in supplemental wage payments, all supplemental wage payments made that exceed the $1,000,000 threshold are to be taxed at 35%.
If you have any questions about how to correctly tax supplemental payments to employees, please contact your Client Account Manager and they will be happy to walk through the regulations with you, as well as make any necessary changes to your company setup.
PCS Customer Service Team
Legal Disclaimer: This article is intended for informational purposes only and by no means should replace or substitute other legal documents (governmental or non-governmental) reflecting similar content or advice. If you have any questions concerning your situation or the information provided, please consult with an attorney, CPA or HR Professional.
Tags: Awards and Prizes, Benefit Accrual Payouts, Bonus, Commission, Gifts, Non-Accountable Expense Reimbursement, Non-Deductible Moving Expenses, Overtime, Payroll Control Systems, PCS, Retroactive Pay, Severence Pay, Supplemental Wage Taxation, Supplemental Wages, Taxable Fringe Benefits, Withholding Tax