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Reminder: IRS Regulations on Income Tax Withholding on
Supplemental Wages Effective for Payments Made On or After January 1,
2007
The American Jobs Creation Act of 2004
(AJCA) changed the way employers withhold federal income tax on
supplemental wages (e.g., bonuses, commissions, etc.). The
optional flat rate for withholding on supplemental wages is generally 25
percent on amounts up to $1 million. Under the AJCA, supplemental
compensation amounts paid in the aggregate in excess of $1 million during
a calendar year are subject to mandatory income tax withholding at the
highest income tax rate (currently 35 percent).
In July 2006, the Internal Revenue Service issued final regulations
implementing the AJCA withholding provisions (71 Fed. Reg. 42049) that are
effective for wages paid on or after January 1, 2007. The regulations
address several issues:
Definitions of Regular Wages and Supplemental Wages
Supplemental wages include any wages paid by an employer that are not
regular wages. Regular wages are amounts paid by an employer for a payroll
period either at a regular hourly rate or in a predetermined, fixed
amount. Supplemental wages are wages that vary from payroll period to
payroll period based on factors other than the amount of time worked (such
as commissions, tips, and bonuses). Under the regulations, payments that
satisfy the basic definition of supplemental wages are considered to be
supplemental wages, even if the employee has not received any regular
wages in his or her working career with the employer. This last sentence
represents a change in the rules, effective January 1, 2007, but it is not
as much of a change as tax practitioners had hoped for. Although the
amounts are now always called "supplemental wages," if the employee has
not received regular compensation for the year of payment or the prior
calendar year, the employer still cannot use the supplemental
withholding rates for ad hoc supplemental payments made to former
employees (see the optional flat rate discussion below).
The regulations provide guidance and examples regarding the proper
classification of certain types of payments as regular or supplemental
wages, and options for the treatment of certain payments to simplify
employers’ compliance with the requirement that they separately track the
payment of supplemental wages prior to reaching the threshold for
mandatory flat rate withholding.
Employers may treat tips and/or overtime pay as regular wages, and they
are not required to apply the treatment of tips and overtime pay uniformly
to all employees of the employer. Employers must treat commissions,
third-party sick pay paid by agents of the employer, or taxable fringe
benefits as supplemental wages.
Procedures for Withholding on Supplemental Wages of $1
Million
or Less
If an employee has not received cumulatively more than $1 million of
supplemental wages during the calendar year, there are generally two
procedures available for withholding: (1) the aggregate procedure, under
which employers calculate the amount of withholding due by aggregating the
amount of supplemental wages with the regular wages paid for the current
payroll period or for the most recent payroll period of the year of the
payment, and treating the aggregate as if it were a single payment for the
regular payroll period; or (2) the optional flat rate procedure, under
which the employers can disregard the amount of regular wages paid to an
employee as well as the withholding allowances claimed by an employee on
Form W-4 and use a flat percentage rate (specified in the regulations) to
calculate the amount of withholding.
The optional flat rate procedure is available only if the employer has
withheld income tax from regular wages paid to the employee, and the
supplemental wages are either not paid concurrently with regular wages or
are separately stated on the payroll records of the employer. One change
from prior years is that optional flat rate withholding is available if
the employer has withheld income tax from regular wages in the current
year or the prior calendar year. Since most supplemental payments are made
while the employee is still working or within a year after termination,
this should support the use of supplemental withholding rates for many
payments to former employees. However, a stock option exercise made two
years after an individual retires may not satisfy this rule and thus the
regulations provide that the optional flat rate is not available, even
though the stock option is labeled as a "supplemental wage."
Procedures for Withholding on Supplemental Wages in Excess
of $1 Million Paid to One Employee in a Calendar Year
The regulations provide that if the sum of supplemental wage payments
and all other supplemental wage payments paid by an employer to an
employee during the calendar year exceeds $1 million, the withholding rate
on the amounts in excess of $1 million will be equal to the maximum tax
rate for that year (currently 35 percent).
Applicability of Mandatory Flat Rate Withholding
In the interest of making the rules administrable for employers, the
regulations provide that employers can treat amounts included in Box 1 of
Form W-2, "wages, tips, and other compensation," as supplemental wages in
determining whether an employee has received $1 million of supplemental
wages.
Mandatory flat rate withholding applies only to the excess of
supplemental wages over $1 million received by an employee from an
employer, taking into consideration all payments of supplemental wages
made by an employer to an employee. Thus, the mandatory flat rate
withholding on supplemental wages in excess of $1 million can apply to all
of a payment or to only a portion of the payment. The treatment may be
applied on an employee-by-employee basis.
Compensation payments that are not defined as "wages subject to income
tax withholding" are therefore not treated as "regular" or "supplemental"
payments and do not count toward the $1 million limit. For example,
disqualifying dispositions of ISOs are not subject to wage withholding
(though they are reported as compensation for the year). Likewise, salary
deferral payments do not count toward the limit.
In determining the amount of supplemental wages paid, salary deferral
amounts are allocated to the gross regular wage payments or to the gross
supplemental wage payments from which they are actually deducted. Thus,
under an example in the preamble to the regulations, Employee has an
automatic nonqualified deferred compensation salary deferral election in
place to withhold 10 percent of compensation from salary and from bonuses.
Employee is paid $1.5 million of regular salary and a $1 million bonus.
Ten percent of the salary and bonus are automatically deferred into the
plan. Employee is counted as having $150,000 of regular wages withheld and
$100,000 of bonus compensation withheld. Thus, Employee has only $900,000
of supplemental wages.
Payments by Agents of Employers in Determining
Applicability of Mandatory Flat Rate Withholding
Payments made by agents of the employer must be considered in
determining the applicability of mandatory flat rate withholding. However,
the regulations include a de minimis rule exception that is
optional for both employers and agents. An agent making total wage
payments, including regular and supplemental wages of less than $100,000
to an individual in any calendar year, may disregard other supplemental
wages from the common law employer or any other agent of the employer that
would subject the employee to mandatory flat rate withholding.
If an agent reaches the $100,000 threshold of wages paid to a single
employee in a calendar year, then the employer must take into account all
supplemental wages paid by the agent in determining whether mandatory flat
rate withholding applies to a wage payment made after the agent reaches
the $100,000 threshold. With the payment that reaches the $100,000
threshold, the agent who has made the $100,000 of wage payments to an
employee during a calendar year is required to take into account all wages
paid by the employer and any other agent of the employer who has reached
the $100,000 threshold in determining the applicability of mandatory flat
rate withholding.
This de minimis rule does not apply to the employer in
situations where the employer has created arrangement(s) with five or more
agents if a principal effect of the arrangements is to reduce applicable
mandatory flat rate withholding for an employee. An employer may take into
account all supplemental wages paid by agents, regardless of how small the
payments are from any particular agent. | 
