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Stay Compliant by Following IRS’ Methods to Compute Taxes

BY: Manoucheka "Monica" Joseph, CPP | 09/26/19

The employer-employee relationship comes with many responsibilities. Though most employment arrangements are at will, other aspects are mandated by the government. U.S.-based businesses must operate in accordance with federal regulations. The same is true for multinational companies with assignees working abroad since guidance related to treaties, presence, and other metrics must be upheld. To be compliant with statutes found in the IRS’s internal revenue code, employers are directed to withhold and remit employment taxes from wages, among other things.

The IRS is a bureau of the United States Department of the Treasury that oversees and administers federal tax laws. Because of the broad nature of employment tax and the litigious implications it places on payroll (not to mention that remuneration for employment or service can have different provisions regarding withholding and reporting), stakeholders in the industry must leverage resources from all credible areas to avoid compliance pitfalls.

IRS Tax Withholding

Arguably, tax withholding may be the least favorite topic for many tax payers. The angst among the majority is usually the stark contrast from what they start out with, their gross earnings, and what they end up with. In some cases, this means disposable earnings (gross minus statutory deductions). In others, it means net pay or take-home pay. The phrase, “the more you make, the more taxes you pay” may sound like a cliché, but it’s a reality as tax brackets fluctuate—plus or minus—in the direction of the wages.

Tax withholding isn’t the only concern for tax payers. For some, the idea of a huge tax bill is also daunting. Payroll professionals are prohibited from giving employees tax advice despite any concerns of an overpayment or underpayment of taxes. Employees should be advised to speak to a tax preparer or anyone authorized to do so. Thankfully, there are tools to refer to in the event of a major discrepancy impacting all employees. The IRS provides a couple of methods to compute taxes from eligible wages.

The two most common methods are the percentage and wage bracket methods—found in IRS Publication 15, Circular E, Employer’s Tax Guide.  The former is built into many payroll software, as it is more accurate. First, any pretax benefits, which will be discussed later in this article, should be deducted from gross wages. Next, the percentage method deducts the value of the employee’s allowance(s), if any, found on their Form W-4 from their taxable wage. At this point, the pay frequency and marital status dictates the applicable table to follow.  While it would be impractical for payroll professionals to manually calculate an employee’s federal tax, it is important to understand the mechanism of doing so in the event of a software disruption or change in the tax law as with the incoming Form W-4 slated for 2020. Federal withholding encompasses other areas that employees are often subject to.

Federal Taxes

Federal taxes consist of U.S. income withholding, also known as federal income tax, in addition to social security and Medicare taxes. The latter two represent a form of insurance that becomes available for use once the taxpayer meets the age requirement. Social security, otherwise known as Old Age, Survivors, and Disability Insurance (OASDI) imposes a tax of 6.2% of the employee’s taxable wages. The employer is also subject to a 6.2% matching on each employees’ behalf. For individuals who are self-employed, they pay both the employee and employer share of the tax for a total of 12.4%. The social security wage base for 2019 is $132,900 with a tax limit of $8,239.80, indexed annually for inflation.

Historically, social security tax stops once the employee reaches the annual threshold. Keep in mind, however, if an employee works for two or more companies in a given year and meets the wage and tax limit with the first employer, all employers thereafter are required (regardless of protest from the employee) to withhold as if the employee earned and paid zero wages and taxes to social security.  The employee on the other hand, is entitled to a refund of the overpayment on Form 1040, Individual Income Tax Return, when filing his or her personal tax return.

Likewise, Medicare tax follow the same guidance as social security tax with some differences.  Medicare, also known as Health Insurance (HI), is the component of FICA (social security + Medicare) tax. The Medicare impound is 1.45% of taxable wages for both the employer and employee. Unlike social security, Medicare tax does not have a wage base, so the tax is calculated indefinitely despite the earned income amount. In fact, employees earning in excess of $200,000 in a given year are subject to an additional .9% tax, for a total of 2.35%. It’s important to note, employers aren’t subject to the same. The additional Medicare tax applies only to employees. The employer and employees’ share of these taxes are reported on Form 941, Employer’s Quarterly Federal Tax Return, and other tax statements. There are other deductions from pay that aren’t taxable. Let’s look at those next.

Pre-Tax Benefits

Despite popular belief, not all employer provided benefits are taxable. A cafeteria plan under Section 125 of the Internal Revenue Code “provides participants an opportunity to receive certain benefits on a pretax basis.” Under this plan, an employee can pay for benefits in cash or by salary reduction. With the salary reduction option, only the wages remaining are subject to withholding. In effect, by choosing to participate in a Section 125 plan, the employee lowers their tax liability. For instance, if an employee earns $1,000 on a biweekly basis and has $200 of pretax benefits, only $800 are taxable for federal, FICA, and state, if applicable. Specifically, “salary reduction contributions are not actually or constructively received by the participant.  Therefore, those contributions are not considered wages for federal income tax purposes. In addition, those sums generally are not subject to FICA and FUTA.” As a result, these contributions are excludable from the employee’s Form W-2 Boxes one, three, and five, federal, social security, and Medicare taxable wages. But they do generally appear in Box 14 of the Form W-2—Wage and Tax statement.

Tax laws are subject to change. These changes may be temporary, perpetual, or modified. As fiduciaries, there’s an obligation to understand the scope of withholding, existing and any nuances, to optimize compliance and better serve our base.

Manoucheka “Monica” Joseph, CPP, is Payroll Supervisor for a law firm. She is a member of the APA’s Government Relations Task Force (GRTF) IRS Issues, Retirement Accounts, and State and Local Topics Subcommittees, as well as the Social Networking Committee.