February 2007

Welcome to the Inaugural Issue
of Payroll Insights

Payroll Insights is a publication from KPMG LLP’s Employment Tax Practice. It is designed to provide you with current developments in the payroll and employment tax arena and will be published periodically throughout the year as developments warrant.

In This Issue

• IRS Releases 409A Withholding Guidance
• IRS Issues Per Diem Expense Reimbursement Guidance
• Federal Legislation Introduced to Address Nonresident State Personal Income Tax Issues
• New York Acts on the Tax Treatment of Stock Options, Restricted Stock, and Stock Appreciation Rights by Nonresidents and Part-Year Residents
• Social Security Changes for 2007

IRS Releases 409A Withholding Guidance

Notice 2006-100 provides guidance to employers and payers on the reporting and withholding obligations for the 2005 and 2006 calendar years with respect to deferrals of compensation and amounts includible in gross income under section 409A.

Under the notice, employers and other payers do not need to report annual deferrals of compensation that are not includible in income under section 409A on Form W-2 or Form 1099-MISC for 2005 or 2006. However, amounts that are includible in income under section 409A for those years must be reported on Form W-2 or Form 1099-MISC, as appropriate. (When the IRS previously issued guidance under Notice 2005-94, it alerted employers and payers that amended information returns may be required to report amounts includible for 2005.)

The new guidance provides information on how to meet the income tax withholding requirements for amounts includible in income under section 409A for 2006, as well as guidance for service providers on their income tax reporting and tax payment requirements for amounts includible in gross income under section 409A for both 2005 and 2006.

Finally, the notice provides interim rules for 2005 and 2006 on how to calculate amounts includible in gross income under section 409A. These interim rules apply to service providers who must include amounts in income pursuant to section 409A and to employers (or other payers) who must report and withhold on the amount to be included in income under section 409A.

This guidance provides information employers, service providers, and other payers have been waiting for, so they may now update their payroll systems in order to bring their withholding and reporting processes into compliance with the requirements of
section 409A.

IRS Issues Per Diem Expense
Reimbursement Guidance

Under Rev. Rul. 2006-56, the IRS, for the first time, is setting forth the tax treatment when per diem expense arrangements don’t track allowances paid and routinely pay amounts in excess of the federal per diem rates. The ruling addresses an arrangement under which the taxpayer reimburses long-haul truck drivers for meals and incidental expenses on a cents/mile basis. The rate of reimbursement is based on an expectation of the daily expenses that would be paid or incurred and the average number of daily miles driven during the payroll period.

In this ruling, drivers received per diem allowances in excess of federal per diem rates (which allow for deemed substantiation) and were not required to substantiate their expenses (although they were required to substantiate their travel). The drivers were not required to return the portion of the per diem amounts that were in excess of the amounts needed for deemed substantiation, but were required to return per diem allowances for days they did not travel. Neither the taxpayer’s policies nor its practices included a process for tracking the amount of cents-per-mile allowance paid to each driver on a per diem basis, nor was there a mechanism for determining when allowances exceeded the amount that can be deemed substantiated under IRS administrative guidance. Excess amounts were not treated as wages for withholding or employment tax purposes, and the taxpayer did not report the amounts on the drivers’ Forms W-2.

The IRS ruled that when an expense allowance arrangement does not have a process for determining when an allowance exceeds the amount that may be deemed substantiated, and the arrangement routinely pays allowances in excess of the amount that may be deemed substantiated without requiring actual substantiation of all expenses or repayment of the excess amount, the failure of the arrangement to treat the excess allowance as wages for employment tax purposes causes the arrangement to fail the requirements of an accountable plan. Thus, all payments made under the arrangement are treated as being made under a nonaccountable plan — all amounts paid under the arrangement for reimbursement of the drivers’ meals and incidental expenses, not just the excess allowances, must be included in the drivers wages on Forms W-2, and the amounts must be treated as wages for withholding and the payment of employment taxes. Employers may wish to consider reviewing their expense reimbursement policies to determine whether they are in compliance with this new guidance.

Federal Legislation Introduced to Address Nonresident State Personal Income Tax Issues

H.R. 6167, the Mobile Workforce State Income Tax Fairness and Simplification Act (the Act), would limit state or local taxation of the compensation of any employee who performs duties in more than one state or locality to: (1) the state or locality of the employee's residence; and (2) the state or locality in which the employee is physically present performing duties for more than 60 days.

Under the Act, introduced by Rep. Christopher Cannon (R-UT) during the previous Congress, wages or other remuneration paid during any calendar year would not be subject to state or locality income tax withholding and reporting unless the employee is subject to the provisions mentioned above. Further, employers would be able to rely on an employee’s own determination of the time expected to be spent in the states or localities where the employee’s duties will be performed (except in cases of fraud by the employee in making the estimate and collusion between the employer and the employee to evade tax). Employer records regarding the location of the employee for other business purposes would not preclude the employer’s use of the employee’s information. This legislation did not advance during the final days of the last Congress. However, Rep. Cannon was reelected to office, and may reintroduce the bill during the 110th Congress.

New York Acts on the Tax Treatment of Stock Options, Restricted Stock, and Stock Appreciation Rights by Nonresidents and Part-Year Residents

On December 27, 2006, proposed regulations for sourcing stock options, stock appreciation rights, and restricted stock for New York nonresidents were formally adopted. The regulations are effective for tax years beginning on or after January 1, 2006.

Draft proposed regulations were issued on August 3, 2006. Subsequently, the New York Appeals Tribunal issued a decision, holding that current law requires an allocation of nonresident compensation based on the number of days worked in and out of the state in the year the compensation was federally recognized. State of New York Tax Appeals Tribunal, In the Matter of the Petition of E. Randall Stuckless and Jennifer Olson, Decision DTA No. 819319, August 17, 2006.

Following Stuckless, the language of the draft proposed regulations was further modified in an attempt to bring clarity to the sourcing issue. Under the revised draft proposed regulations (and ultimately the regulations that were formally adopted), the allocation periods discussed below apply to stock options, stock appreciation rights, and restricted stock, but only for tax years beginning in 2006:

• For statutory stock options, non-statutory stock options with no readily ascertainable fair market value, and stock appreciation rights, the allocation period is from the date of grant to the vesting date or, only for tax year 2006, the date of grant to the earliest of the date the option or right is exercised, the individual’s services terminate, or the compensation is recognized for federal income tax purposes.
• For (1) non-statutory stock options with a readily ascertainable fair market value, and (2) restricted stock for which an Internal Revenue Code (IRC) section 83(b) election has been made, the allocation period is the same period of time applicable to regular, non-stock based remuneration from the grantor during the tax year the option was granted or the restricted stock was received.
• For restricted stock for which an IRC section 83(b) election has not been made, the allocation period is from the date the stock is received to the earliest of the date the stock is substantially vested (transferable or not subject to a substantial risk of forfeiture), the individual’s services terminate, or the stock is sold. For the portion of the stock-related compensation attributable to dividends paid on the stock, the allocation period is the same as for regular, non-stock based remuneration from the grantor during the tax year the dividends were received.

The regulations also provide that determination of New York source income from stock-based compensation depends on the individual’s residency status at the time the compensation is recognized for federal income tax purposes. If the individual recognizes stock-based compensation during the residency period, the entire amount recognized for federal income tax purposes is includible in New York source income. For statutory stock options, the entire amount of gain or loss recognized for federal income tax purposes (both the compensation element and any appreciation in value after the exercise date) is includible in New York source income. If stock-based compensation is recognized during the non-residency period, the amount includible in New York source income is determined using the allocation methods described above.

In addition, the New York State Department of Taxation and Finance has issued a bulletin (TSB-M-06(7)I (the Bulletin)) setting forth new rules for determining the amount of compensation related to an option, restricted stock, or stock appreciation right that is includable in New York source income for tax year 2005, and any prior year where the statute of limitations is open.

The Bulletin provides that for statutory stock options, nonstatutory options that do not have a readily ascertainable fair market value at the time of grant, restricted stock plans where the IRC section 83(b) election has not been made (except for dividend income related to the stock) and stock appreciation rights:

• Generally, full-year nonresidents use the days-in-and-out allocation for the tax year the options or rights were executed or the restricted stock vested (or, if earlier, the year the stock was sold). The use of the grant-to-exercise method under TSB-M-95(3)I would also be accepted, as an alternative allocation method.
• Part-year residents who have compensation recognized in the nonresident period would be subject to the same rules as full-year nonresidents. The allocation for the tax year the options or rights were exercised or the restricted stock vested or, if earlier, was sold, is determined as if the individual were a nonresident for the entire year. If the compensation is recognized in the resident period, it must be included in New York source income, as provided under TSB-M-95(3)I.

For nonstatutory stock options that have a readily ascertainable market value at the time of grant, restricted stock (and dividends related to restricted stock) where the IRC section 83(b) election has been made, both full-year nonresidents and part-year residents would continue to apply the TSB-M-95(3)I allocation methods, including the alternative method.

Taxpayers who have previously filed tax returns for open years affected by this change may file amended returns.

Social Security Changes for 2007

The Social Security Administration has released its cost-of-living adjustments for 2007. The tax rate for employees remains at 7.65 percent. Similarly, the tax rate for self-employed individuals remains at 15.30 percent.

In 2007, the maximum taxable earning amount increases from $94,200 to $97,500. The Retirement Earnings Test exempt amount increases from $12,480 ($1,040/month) to $12,960 ($1,080/month), for individuals who have reached full retirement age. For individuals reaching retirement age during 2007, the exempt amount increases from $33,240 ($2,770/month) to $34,440 ($2,870/month). This test applies only to earnings for months prior to attaining full retirement age. One dollar in benefits will be withheld for every $3 in earnings over the limit.

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