The Advisors' Blog

– Michael Album, Partner, Proskauer Rose

During the summer doldrums, what better topic to think about than withholding tax obligations. The IRS just issued an important Revenue Ruling concerning signing bonuses and severance payments. Revenue Ruling 2008-29 (June 16, 2008) provides much needed guidance on satisfying withholding payment obligations under I.R.C. § 3402 of the Code for certain types of “supplemental wages.” Two of the situations described determine the required withholding rate on signing bonuses and severance pay.

The first step in the analysis is determining whether the amount involved is a “regular wage” or a “supplemental wage.” The wage classification can have a significant impact in determining how much income tax must be withheld. Treas. Reg. § 31.3402(g)-1(a), as amended by T.D. 9276, 2006 C.B. 423, governs the classification of wages for this purpose.

The distinguishing feature of regular wages is they are paid within a particular payroll period. Two scenarios will satisfy the test for a regular wage: (1) when the amount is paid at a regular hourly, daily, or similar periodic rate (and not an overtime rate) for the current payroll period; or (2) when it is paid at a predetermined fixed determinable amount for the current payroll period. Treas. Reg. § 31.3402(g)-1(a)(1)(ii). For purposes of I.R.C. § 3402, an employee can only have one payroll period with respect to wages paid by any one employer. Treas. Reg. § 31.3401(b)-1(d).

Supplemental wages are all wages paid by an employer that are not regular wages. Treas. Reg. § 31.3402(g)-1(a)(1)(i). Supplemental wages include amounts paid without regard to an employee’s payroll period, but may also include payments made for a payroll period if the payments aren’t tied to a regular periodic rate or a predetermined fixed amount. Id. Sales commissions paid within a payroll period are an example of supplemental wages in the latter group. Id. The regulations provide many examples of supplemental wages, such as bonuses, non-qualified deferred compensation, commissions and back pay. Id. The supplemental nature of such wages remains the same regardless whether the employer paid the employee any regular wages during the calendar year of the payment or any prior calendar year. Id.

Once the wages are identified as supplemental, the method of determining the proper withholding depends on whether the total amount of supplemental wages paid by the employer to the employee during the calendar year exceeds $1,000,000. Treas. Reg. § 31.3402(g)-1(a)(2). If the amount paid for the calendar year exceeds $1,000,000 then mandatory flat rate withholding applies to the portion exceeding $1,000,000 for the calendar year. Id. Under mandatory flat rate withholding, the applicable rate on the excess amount equals the highest rate of tax under the Code for taxable years beginning in such calendar year.

Mandatory flat rate withholding applies to the excess amount without regard to: (1) whether income tax has been withheld from the employee’s regular wages; (2) the number of withholding allowances claimed by the employee on Form W-4, “Employee’s Withholding Allowance Certificate,”; (3) whether the employee requested additional withholding on Form W-4; or (4) the withholding method used by the employer. Id.

Two procedures may be used for withholding on amounts not exceeding $1 million during the calendar year: (1) the aggregate procedure (which keys to the tax rate applicable to the aggregated regular wages and supplemental wages up to first $1,000,000 of supplemental wages) or (2) the optional flat rate withholding (applying a flat rate without reference to regular wages). See Treas. Regs. § 31.3402(g)-1(a)(6) and (7). (The IRS regulations discuss both approaches in detail).

The IRS’ Examples

Here are two examples addressed in the Revenue Ruling:

1. Application to Signing Bonuses (Situation 5 of Rev. Rul. 2008-29):

Under an employment contract entered into on May 1 of Year 1, Employee F is scheduled to begin performing services for employer P on October 1 of Year 1. F will receive regular wages of $75,000 per month for his services as an employee of P, and will have a monthly payroll period. On June 1 of Year 1, P pays F $2,100,000 as a bonus for signing the employment contract. F has received no wage payments from P’s agents or any other person treated as the same employer as P under Treas. Reg. § 31.3402(g)-1(a)(3)(i).

The bonus payment on June 1 of Year 1 is a supplemental wage. See Rev. Rul. 2004-109, 2004-2 C.B. 958, and Treas. Reg. § 31.3402(g)-1(a)(1). P must apply mandatory flat rate withholding to the portion of the bonus exceeding $1,000,000 for the calendar year, or $1,100,000 in this example. Treas. Reg. § 31.3402(g)-1(a)(2).

P has the option of applying either the aggregate procedure or treating the payment as subject to mandatory flat rate withholding for the first $1,000,000 of the bonus. Treas. Reg. § 31.3402-(g)-1(a)(4)(iv). If P uses the aggregate procedure, the payroll period to be applied with respect to determining the amount of income tax on the first $1,000,000 of the bonus is the monthly payroll period, because the regular wage payments to be paid to F during the calendar year are scheduled to be paid on a monthly basis. P may not use the optional flat rate withholding to determine income tax withholding on F’s signing bonus because at the time the bonus is paid P has not withheld income tax from regular wages paid during Year 1 or the preceding year. Treas. Reg. § 31.3402(g)-1(a)(7)(C).

2. Application to Severance Pay (Situation 6 in Rev. Rul. 2008-09)

Employee G performs services for employer S, which has a severance pay plan for its employees. The plan generally provides that if an employee is involuntarily terminated, the employee receives weekly severance pay equal to his or her ending regular weekly pay. The severance pay continues after termination for the number of weeks equal to the number of full years the employee performed services as an employee for the employer multiplied by 3. G is involuntarily terminated by S on June 30 of Year 1, after G has performed services as an employee of S for 17 years. Thus, G will receive 51 weeks of severance pay, paid weekly starting in July of Year 1 and continuing into Year 2.

The severance payment is a supplemental wage because it is not a payment for services in the current payroll period. It is a payment made upon or after termination of employment. Thus, although the payments in this situation are for a fixed determinable amount for 51 weeks, they are not regular wages because they are not fixed payments for the current payroll period.

S may use the aggregate procedure to determine withholding on the payments or, if S has withheld income tax on regular wages paid to G in Year 1, S can use optional flat rate withholding to determine the withholding with respect to the supplemental wage payments in Year 1 and in Year 2.

Now, go to the beach, have a cold drink, enjoy Summer. Having read this you earned it!

(Katie Gerber, a third year law student at Temple University’s Beasley School of Law and a Summer Associate at Proskauer Rose LLP, assisted in the preparation of this blog posting. We also want to thank our tax partner, Mitchell Gaswirth, who provided his assistance on this blog.)