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

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

3.  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 next slide)  Tips  Cash awards Coverage Under FIT Withholding Laws LO-1

4. Fringe Benefits  Noncash fringe benefits treated as compensation  Employer must withhold FIT unless specifically excluded  Examples of noncash fringe include  Tickets to athletic events  Athletic club membership  Personal use of corporate car  Frequent flier miles  Stock options (when option exercised)  Complete list found in Figure 4-2 (page 4-6)  Specifically excluded fringe benefits include  Qualified employee discounts  Reduced tuition, meals & lodging if for employer benefit  Complete list found on page 4-4 LO-1

5. How to Withhold FIT on Fringe Benefits  Value and withhold like supplemental wages (flat 25%)  Employer must figure value of fringe benefits no later than 1/31  Value and add to regular pay - treat as one paycheck and withhold accordingly  Flexible reporting – option of treating benefits as being paid on any basis.  For example, can add $500 on 4 paychecks or entire $2,000 with one paycheck and calculate withholding accordingly. Note: Employer can choose not to withhold FIT on employee’s personal use of corporate car LO-1

6. 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

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

8. Traveling Expenses  Travel reimbursements made to an employee, paid under an “accountable plan”, are not subject to FIT withholding  An accountable plan is an IRS-approved plan (must meet three rules)  If there is not a plan in place, travel reimbursements are made under a non-accountable plan and considered wages  Therefore employer must withhold FIT LO-1

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

10. Pretax Salary Reductions are Exempt from FIT  Contribution to cafeteria plans  Employee can choose between cash (pay) or qualified (nontaxable) benefits (list 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

11. 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

12. 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

13. 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

14. Other Situations on W-4  If employee doesn’t provide a completed W-4, employer must withhold as if single and zero allowances (highest rate)  Employee can change W-4  When employer receives amended W-4, has 30 days to change  Employee must change within 10 days for decrease in # of allowances  Lose child as an allowance (custody)  Become single  If there’s an increase in # of allowances, can change or leave in effect  Unauthorized changes/additions invalidate W-4  Employer can establish electronic W-4 system, but must provide paper option if employee requests LO-2

15. FIT Withholding on Other Income Sources  Pensions (W-4P) in excess of $19,200 per year  Withhold as if married with 3 allowances unless complete W-4P to change amount of tax withholding  Third party payer of sick pay (W-4S)  Government payments such as Social Security by completing a W-4V  This request is voluntary LO-2

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

17. Example #1 Calculating FIT Withholding FACTS: Noni’s annual salary is $40,144 – she is paid biweekly and her W-4 shows “Married with 4”. What is her FIT withholding?  Biweekly gross $40,144/26 = $1,544.00  Can use wage bracket tables to look up married, biweekly and 4 allowances  FIT withholding = $69 LO-3

18. Example #2 Calculating FIT Withholding FACTS: John earns an annual salary of $84,400 and is paid biweekly. His W-4 shows “Married with 1”. What is his FIT withholding?  Biweekly gross is $84,400/26 = $3,246.15  Must use percentage method  To Do:  Subtract amount of allowances* (biweekly allowance for1) from gross  $3,246.15 - $142.31 = $3,103.84  FIT equals $365.40 + (.25)($3,103.84 – $2,958.00) = $401.86 *From 2011 Table of Allowances found in Appendix LO-3

19. Example #3 Calculating FIT Withholding FACTS: Maggie earns an annual salary of $336,000 and is paid monthly. Her W-4 shows “Married with 2”. What is FIT withholding?  Monthly gross is $336,000/12 = $28,000  Must use percentage method  To Do:  Subtract amount of allowances (monthly allowance for 2) from gross  $28,000 - ($308.33 x 2) = $27,383.34  FIT equals $3,959.52 + (.33)($27,383. 34 - $18,350.00) = $6,940.52 LO-3

20. Example #4 Calculating FIT Withholding FACTS: Belinda earns a monthly salary of $3,000 and is paid biweekly. Her W-4 says “Single with 2”. What is her FIT withholding?  Annualize salary $3,000 x 12 = $36,000  Biweekly gross $36,000/26 = $1,384.62  Can use wage bracket tables to look up single, biweekly and 2 allowances  FIT withholding = $137 LO-3

21. Example #5 Calculating FIT Withholding FACTS: Ferhart’s annual salary is $485,000 – he is paid semimonthly. His W-4 says “Married with 4”. What is his FIT withholding?  Semimonthly gross is $485,000/24 = $20,208.33  Must use percentage method  To Do:  Subtract amount of allowance (semimonthly allowance for 4) from gross  $20,208.33 – ($154.17 x 4) = $19,591.65  FIT equals $4,273.91 + (.35)($19,591.65 – $16,127.00) = $5,486.54 LO-3

22. Supplemental Wages Withholding  Examples include  Vacation pay (treated differently than other supplemental wages)  Severance pay, bonuses and commissions  Exercised nonqualified stock options  How to withhold  With regular pay (treat as one paycheck and withhold accordingly) or  Paid Separately  Method A – Add supplemental and regular wages from recent payroll; calculate FIT as if it were single regular payroll payment  Method B - 25% flat supplemental withholding (35% for amounts in excess of $1,000,000) LO-3

23. 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 – (.25 +.062 +.0145)] = $1,039.35 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

24. Wages and Tax Statement (W-2)  Form W-2 informs employees of wages and withholding taxes  Hard copy to employee on or before 1/31 or  Can post on secure web site so employee can access individual W-2  If issuing 250+ W-2s must use magnetic media - have until 3/31 to electronically file  Can request extension of time via FIRE at http://fire.irs.gov http://fire.irs.gov  W-3 is transmittal form and 941s must tie to W-3  Various penalties for filing incorrect or late W-2s  Must file W-2c and W-3c (if correcting) LO-4

25. Returns – Quarterly & Informational  Quarterly reports of taxable wages required (see Figure 4-11 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

26. 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