CHAPTER 4 INCOME TAX WITHHOLDING Developed by Lisa Swallow, CPA CMA MS Payroll Accounting 2012 Bernard J. Bieg and Judith A. Toland

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

 Employee-employer relationship must exist for FIT withholding to apply  See Chapter 3 for how to determine status  Statutory nonemployees (direct sellers and qualified real estate agents) have no federal taxes withheld  Taxable wages for FIT withholding purposes  Wages/Salaries  Vacation  Supplemental payments  Bonuses/Commissions  Taxable fringe benefits (see Figure 4-1 on page 4-3)  Tips  Cash awards Coverage Under FIT Withholding Laws LO-1

FIT Withholding on Tips  Employee must report tips to employer by 10th of each month  Employer must withhold FIT and FICA based on this information (called “reported tips”)  Employer is not required to withhold on allocated tips - only reported tips  Tip allocation can be done one of three methods – hours worked, gross receipts or good faith agreement LO-1

What is Exempt from FIT  Law excludes certain payments including  Ministers’ wages/salaries  Advances  Educational assistance  If maintains/improves job status  $5,250 per year of employer provided assistance for undergraduate or graduate is tax-free (also applies to down-sized employees)  Qualified moving expense reimbursements  Transportation in a commuter highway vehicle/transit pass up to $230/month value See page 4-6 for comprehensive list of exempt payments LO-1

Pretax Salary Reductions are Exempt from FIT  Contribution to cafeteria plans  Employee can choose between cash (pay) or qualified (nontaxable) benefits (list on page 4-7)  Contribution to Flexible-Spending Accounts  The employee puts pretax dollars into a trust account to be used for health care, certain insurance premiums and dependent care  These dollars do not have FIT or FICA withheld on them  Forfeited if not used!!  Health Savings Accounts (HSA)  If employee has high-deductible health insurance, can contribute annually to an HSA to meet out of pocket medical bills  Archer Medical Savings Accounts  For small employers that have high-deductible insurance plans LO-1

Tax-Deferred Retirement Contributions Exempt from FIT  Contributions to tax-deferred retirement accounts  Types of retirement plans  401(k), 403(b), 457(b) or SIMPLE plans  Contributions are made pretax for FIT purposes  However, employer must still withhold and match FICA  Additional ‘make up amounts’ allowed to be contributed if age 50 or older (see page 4-9 for annual contribution amounts)  Individual Retirement Accounts (IRA)  For certain taxpayers, the lesser of $5,000 or 100% of earned income may be contributed pretax to a retirement account  Conditions must be met for deductibility  $6,000 annual contribution allowed if age 50 or older  Roth IRAs are used for nondeductible contributions LO-1

How Does Employer Know Amount to Withhold for FIT?  Best for employee if FIT withholding = tax liability  Goal is no refund and no tax due  Employee completes W-4  See W-4 (Employee’s Withholding Allowance Certificate) in Figure 4-3 on page 4-11  Identify number of withholding allowances  One allowance for self (if not claimed by other person)  One for each dependent  Special allowances such as itemized deductions, other compensation, tax credits, etc. - use worksheet on back of W-4 to calculate See IRS Publication 919 How Do I Adjust My Tax Withholding if an employee needs to calculate his/her FIT withholding LO-2

Completing Form W-4  Choose “Single” or “Married” or “Married, but withhold at higher single rate” box  Q: Why would an EE choose the last option listed above? (line 3)  A: Because possibly other sources of taxable income  Exempt status  Can claim if taxpayer had no income tax liability last year and none expected this year (line 7)  Valid for one year and must be reclaimed each year  Can’t claim exempt if:  Dependent on someone else’s tax return and  Income exceeds $950 (including more than $300 unearned income)  Some individuals are automatically exempt Note: Never advise employee as to how many allowances to claim LO-2

Gross-Up Supplemental Wages  If want to distribute intended amount of supplemental check, must ‘gross up’ this amount  For example, an employer wants her employee to receive a $700 bonus check (net)  To do: Divide desired net check by total of [1.00 – tax rates]  FIT tax rate =.25  OASDI tax rate =.062  HI tax rate =.0145  $700/[1.00 – ( )] = $1, grossed up bonus  Then subtract taxes to get $700 desired net bonus Note: in many states there is a required withholding rate for state income tax! LO-3

Returns – Quarterly & Informational  Quarterly reports of taxable wages required (see Figure 4-12 on page 4-29 for major returns that must be completed)  Employers must file information returns for compensation paid to independent contractors (IC)  1099-MISC with 1096 as transmittal  See Figure 4-13 on page 4-31  Must issue to IC if paid at least $600 and aren’t incorporated  IC must submit taxpayer identification number (TIN) on W-9 to hiring agent  If TIN not supplied orally, in writing or on W-9, then must withhold federal income tax = 28% of payments made LO-4

Withholding State & Local Income Taxes  In states with state income tax (SIT) and localities with local income tax, generally the payroll department must  File periodic withholding returns to report wages and withholding  Prepare reconciliation returns to compare deposits to withholdings  File annual statements to report annual wages paid and applicable taxes/fees withheld  Issue information returns to report payments to individuals not subject to withholding  Three different methods of withholding SIT – full taxation, left over taxation and reciprocity LO-4