ot all payments to employees from employers are wages. If remuneration is not wages, an employer may be able to withhold less income tax, pay reduced employment taxes and accrue fewer retirement benefits. Thus, it is important for CPAs to understand the situations in which payments to workers may not be wages and such payments’ effect on these obligations and benefits.
DEFINING THE ISSUE
Generally, wages are treated similarly for purposes of income tax withholding and employment tax obligations. IRC sections 3121(a) and 3306(b) broadly define wages for employment tax purposes as “all remuneration for employment.” The definition under IRC section 3401(a) is essentially identical for income-tax-withholding purposes. The question is: Which payments fall outside the definition of wages? If payments are not wages, the employer incurs no legal obligation to withhold or pay employment taxes.
IS IT WAGES?
For payments to be wages, they must be remuneration for services the employee provided to his or her employer and therefore subject to FICA (for example, Social Security and Medicare) taxes. What remuneration for services is actually called and the basis on which it is paid are immaterial to classification as wages. Further, the employment relationship need not exist at the time it is paid.
The following are examples of the types of payments that may or may not be wages: payments made to involuntarily dismissed employees, settlements involving more than a single claim for damages, claims released in a termination agreement, attorney’s fees and reimbursements of employee business expenses.
Relief from the employer’s secondary obligation to withhold taxes on wages may occur even though an employer remains liable under its primary obligation to pay employment taxes. An employer’s withholding obligation may be reduced based on a reasonable expectation that no obligation to withhold existed or on the employer’s lack of adequate notice of his or her duty to withhold. The focus is on whether the expense was ordinary and necessary to the employer’s business rather than whether it was deductible by the employee.
If a qualified defined benefit or defined contribution plan defines compensation using the safe harbors in regulations section 1.415-2(d)(11)(i), compensation will equal the wages used for employment tax purposes. Severance pay classified as wages for employment tax purposes will require a corresponding increase in funding for retirement plan benefits.
If payments are not wages, the employer’s obligations to withhold, pay employment taxes and accrue retirement benefits are reduced. Given these potential liabilities, CPAs helping clients plan in this area should know how to determine whether payments are wages.
For more information see the article, “Is It Wages?” by Nancy Stara, in the March 2003 issue of The Tax Adviser.
—Lesli Laffie, editor
The Tax Adviser
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