We noticed an uptick in employment tax issues, so thought a primer on employment taxation basics would be helpful. While this may be of general interest to in-house counsel and human resources professionals, it is probably more useful to payroll professionals (so feel free to forward this to your favorite payroll department employee!).
To be clear, when we reference “employment taxes,” we refer to the taxes other than income taxes that an employer must withhold and remit to the IRS, normally reporting them quarterly on an IRS Form 940. These taxes are sometimes referenced as “FICA,” “Social Security,” and “Medicare,” and there is a portion that gets withheld from employee incomes to be remitted to the IRS and another portion that the employer pays out of its general assets. When mistakes are made, the IRS reserves the right to collect the full amount from the employer.
Instructions to the IRS Form 940 can be helpful, as can IRS publications 15, 15A, and 15B, but following is a brief rundown of some basic situations, in no particular order. Keep in mind that these are general guidelines, and exceptions may apply.
Payments to an employee related to medical bills, medical insurance, and medical treatment are generally not subject to employment taxes. This includes payments an employer makes to offset employee medical insurance premiums and amounts an employee receives to offset medical expenses.
Medical insurance premiums paid by employees through payroll deduction are subject to income and employment taxes unless the employer maintains a document complying with IRC § 125 (“cafeteria plans”). Sometimes medical insurance companies provide a document for employers to use, but if the employer also offers dental and vision policies and the document does not provide for those, then the dental and vision policy premiums are taxable.
Payments related to sick pay and other leave due to illness are generally subject to income and employment taxes in the same manner as regular pay.
Long-term and short-term disability payments are almost a “hybrid” between payments for medical bills and sick leave. When, as is usually the case, these are payments of a set amount (normally a percentage of someone’s salary or average earnings) for a period of time while the employee they cannot work without regard to actual medical bills or expenses, then these are more like sick leave and benefits are taxable. However, there is an exception that if the related insurance premiums are paid with after-tax dollars, then the benefits may be received tax-free. Premiums can be paid by the employee with after-tax dollars if employee incomes are subjected to income and employment tax before being reduced by the premium payments. To the extent the employer pays the premiums, it would need to “attribute” (or gross up) employee incomes by the value of the premium payments before subjecting them to taxation.
You can hire a third party to handle some of these payments and the related taxation, but that does not automatically make them liable to the IRS for addressing the taxes improperly. An example of how errors can arise is when a third-party insurer is paying long-term or short-term disability benefits with an incorrect assumption about whether benefits are taxable. An employer might assume the third party is properly withholding, but IRS publications go into detail about when the IRS will hold a third party responsible and when it will not. As explained in a prior paragraph, short- and long-term disability payments can be structured to be taxable or nontaxable, so if you are using a third party, make sure they understand whether there is a withholding obligation. We have seen circumstances when the third party thought the payments were to be tax-free, but they should have been subject to taxation.
With tax-qualified 1 and 403(b) retirement plans, employer contributions are not subject to employment taxes, and they will only be subject to income taxes when distributed. If distributed early, they may also be subject to early distribution penalties, but no employment taxes. Employee voluntary salary deferrals are subject to employment taxes when contributed to the plan, but income tax is deferred until distribution.
With 457(b) plans, the income tax treatment depends on whether the employer is a nonprofit or a governmental entity, but the employment tax treatment is the same. 457(b) plan assets are subject to employment taxation when they are no longer subject to a substantial risk of forfeiture. A 457(b) plan that follows the common structure of being funded with salary deferrals to which employees have firm rights upon termination of employment should subject those deferrals to employment taxation when contributed, as it would with a 401(k) or 403(b) deferral. For income tax purposes, nonprofit 457(b) plan assets are subject to taxation when “made available” to participants. That is, whenever the participant first has a right to receive those funds. Governmental 457(b) plans must subject plan assets to income taxation when assets are actually distributed.
With nonqualified plans, a term commonly applied to all other retirement plans not described or referenced above, amounts are subject to employment taxes at the same time that they are subject to income taxes, which is normally upon vesting, distribution, or when amounts are no longer subject to a substantial risk of forfeiture, depending on which of the numerous tax provisions (including IRC §§ 451, 457(f), and 409A) apply. This means that a company may need to withhold and report employment taxes on amounts paid to former employees many years after their termination of employment.
Business expense reimbursements are generally excludable from both income and employment taxes. Sometimes payroll programs require separate coding for this, and we have seen an employer accidentally subject these reimbursements to employment taxation while excluding it from income taxation.
The standard correction for employment tax errors is to prepare corrected returns. If an error is made and discovered early in the year, future withholding can sometimes be adjusted to offset the error. If the error arose with respect to retirement plan contributions or because an employer characterized some workers as independent contractors and realizes they are really employees, special correction programs may be available. There is little flexibility if the situation does not involve one of those three. Hence, the importance of getting it right the first time!
 “Tax-qualified plans” refers to retirement plans intending to comply with IRC § 401(a), which includes arrangements commonly called “defined benefit plans,” “defined contribution plans,” “profit-sharing plans,” “401(k) plans,” and “money purchase pension plans.”
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