1. Payroll Accounting 2013 Bernard J. Bieg and Judith A. Toland CHAPTER 4 INCOME TAX WITHHOLDING Developed by Lisa Swallow, CPA CMA MS

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 critical quarterly and year-end information returns and impact of state/local income taxes on payroll accounting process

3. Coverage Under FIT Withholding Laws • Employee-employer relationship must exist for FIT withholding laws to apply • See Chapter 3 for guidance on determining status • Statutory nonemployees (direct sellers and qualified real estate agents) have no federal taxes withheld • Taxable wages for FIT withholding purposes – gross amount of following items are taxable • Wages/Salaries • Vacation pay • Supplemental payments • Bonuses/Commissions • Taxable fringe benefits (see next slide) • Tips • Cash awards • See Figure 4-1 on page 4-3 for other types of taxable payments LO-1

4. FringeBenefits • 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 • De minimis fringe benefits (like personal use of corporate cell phone) • Complete list found on page 4-4 or consult Circular E, Employer’s Tax Guide 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 (except if use special period rule) • Value and add to regular pay - treat as one paycheck and withhold accordingly • Flexible reporting – option of treating benefits as being paid on one or more dates in the same calendar year, even if benefit received at one time • For example, can add entire $2,000 value of country club membership or add $500 on each of 4 paychecks – then calculate withholding accordingly Note: Employer can choose not to withhold FIT on employee’s personal use of corporate car LO-1

6. FITWithholding 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 allocatedtips - onlyreportedtips • 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 South Lake Tahoe reports tips = $2,000 for one week; her FIT/FICA withholding will exceed her gross 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 • Business connected • Adequate accounting within reasonable time period • Employee returns advanced cash in excess of substantiated expenses • 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 $125/month value See Figure 4-2 on 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 of potential benefits found 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 a 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 are monies set aside from current paychecks that will be paid out to employee upon retirement • 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) • In 2013, depending upon certain conditions, an employee can contribute lesser of $5,000 or 100% of earned income pretax to a retirement account • If made through payroll deductions, generally employer does not need to comply with ERISA • Roth IRAs are used for nondeductible contributions LO-1

12. Problems • 4 – 1 A, 4 – 7 A, 4 – 11 A

13. How Much 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 (page 4-11) • The W-4 identifies number of withholding allowances; employee can take: • One allowance for self (if not claimed by other person) and one allowance for each dependent • Special allowances such as itemized deductions, other compensation, tax credits, etc. - use worksheet on back of W-4 to calculate • Employer must retain W-4 as long as its in effect and for four years thereafter See IRS Publication 919 How Do I Adjust My Tax Withholding if an employee needs to calculate his/her FIT withholding www.irs.gov/pub/irs-pdf/p919.pdf LO-2

14. 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

15. 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 • If there’s an increase in # of allowances, can change or leave in effect • Additional/voluntary withholding agreements • Can effect additional FIT withholding by either reducing number of withholding allowances or request specific additional amount be withheld on line 6 • Employer can establish electronic W-4 system, but must provide paper option if employee requests • Unauthorized changes/additions invalidate W-4 • Employers should submit W-4s to IRS only when requested; penalties imposed for willfully filing false Form W-4s LO-2

16. FIT Withholding on Other Income Sources • Pensions (W-4P) in excess of $19,680 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 benefits, by completing a W-4V • This request is voluntary LO-2

17. Employer Calculates FIT Withholding • Textbook used 2012 tax tables for FIT rates • 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 • Need to know • Single/married, how often paid, gross pay and # of allowances Note: also other methods, rarely used, for withholding (see pages 4-17 - 4-18) LO-3

18. 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 = $65 LO-3

19. 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 Steps to percentage method: Subtract allowance amount * (biweekly allowance for1) from gross $3,246.15 - $146.15* = $3,100.00 FIT equals $374.40 + (.25)($3,100.00 - $3,031.00) = $391.65 *From Table of Allowances found in Appendix LO-3

20. 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 Steps: Subtract allowance amount (monthly allowance for 2) from gross $28,000 - $633.34 = $27,366.66 FIT equals $4055.42 + (.33)($27,366.66 - $18,796.00) = $6,883.74 LO-3

21. 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 = $136 LO-3

22. 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 Steps: Subtract allowance amounts (semimonthly allowance for 4) from gross $20,208.33 – $633.32 = $19,575.01 FIT equals $4,377.63 + (.35)($19,575.01 - $16,519.00) = $5,447.23 LO-3

23. SupplementalWages Withholding • Examples include • Vacation pay (treated differently than other supplemental wages) • Severance pay, bonuses and commissions • How to withhold • With regular pay (treat as one paycheck and withhold accordingly) • Except if amount indicated separately (then use flat rates – see below) 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

24. Gross-Up Supplemental Wages • If want to give an employee the intended amount of supplemental check, must “gross up” this amount • For example, an employer wants Dov, an employee, to receive a $700 net bonus check • To do: Must divide desired net check by [1.00 – tax rates] • FIT tax rate = .25 • OASDI tax rate = .042 • HI tax rate = .0145 • $700/[1.00 – (.25 + .042 + .0145)] = $1,009.37 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

25. Problem • 4 – 3A, 4 – 4 A, 4 – 8 A , 4 – 9 A, 4 – 10 A

26. Wages and Tax Statement (W-2) • Employers required to furnish Form W-2 to employees (and also must send copies to federal and state/local governments • Reports wages and withholding taxes • Instructions for completing in Figure 4-8 (pages 4-22 and 4-23) • 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 and have until 3/31 • Can request extension of time via FIRE at 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

27. Returns – Quarterly & Informational • Quarterly reports of taxable wages required (see Figure 4-11 (pages 4-27 and 4-28) for major required returns) • Payroll income tax withholdings reported on Form 941 • Employers must file information returns for compensation paid to independent contractors (IC) • 1099-MISC with 1096 as transmittal - See Figure 4-13 (page 4-29) • 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 this is not done, then hiring agent must withhold federal income tax = 28% of payments made • Nonpayrollitems (like withholding on independent contractors, pensions, IRAs, etc. ) reported on Form 945 LO-4

28. 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 withheld • Issue information returns to report payments to individuals not subject to withholding • Three different methods of withholding SIT – full taxation, leftover taxation and reciprocity • Most states require employers to withhold tax from both nonresidents and residents, unless a reciprocal agreement is in place LO-4

29. Problems • 4 – 12 A, 4 – 13 A