HRMN 408 Assignment 1

Tax Considerations

• Deductibility of Wages and Benefits

• Limitations on Deductibility

• Independent Contractors

• Federal Withholding Requirements

• Tips

• Other Taxable Payments

• State Withholding Requirements

• Earned Income Tax Credit

• Deposit and Reporting Requirements

CHAPTER 7

C o p y r i g h t 2 0 1 7 . S o c i e t y F o r H u m a n R e s o u r c e M a n a g e m e n t .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Book: The SHRM Essential Guide to Employment Law : A Handbook for HR Professionals, Managers, Businesses, and Organizations. Author: Charles Fleischer Date: 2017

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The SHRM Essential Guide to Employment Law122

Tax considerations drive, or at least help shape, any number of transactions in the business world. The same is true for the employer-employee relationship. With combined federal and state income tax rates at or above 40 percent, the deductibility of employer expenditures becomes a critical factor in a business’s survival. At the same time, employees look to limit or defer tax on their employment-related benefits. The result is a complex web of employer opportunities and requirements.

DEDUCTIBILITY OF WAGES AND BENEFITS Wages and benefits paid to employees are deductible from the employer’s gross income for purposes of computing the employ- er’s federal and state income tax, so long as the amounts are rea- sonable, ordinary, and necessary. This means, for example, that for a corporate employer that is in the 39 percent marginal federal tax bracket and the 7 percent state tax bracket, 46 cents of each addi- tional dollar in wages and benefits are effectively paid by federal and state governments in the form of reduced tax liabilities.

QUICK TIP As an alternative to taking a deduction for wages, an employer may claim a work oppor-

tunity tax credit (WOTC) against its income tax for a portion of the first- and second-year

wages paid to targeted groups of hard-to-employ individuals, such as those receiving

benefits under the Temporary Aid for Needy Families (TANF) program or the Supplemental

Nutrition Assistance Program (SNAP), long-term unemployed individuals, summer youth

employees, and certain veterans and ex-offenders. The individuals must be certified as

qualified for the credit through the employer’s State Workforce Agency. The amount of the

credit varies, depending on which targeted group the specific individual is a member of

and the number of hours the individual was employed during the year for which the credit

is being claimed. See Internal Revenue Service (IRS) Forms 8850 and 5884 and instruc-

tions. As of this writing, the WOTC is scheduled to expire in December 2019.

As a general rule, whenever the employer takes a deduction for a wage or benefits payment, the employee who receives the payment

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Tax Considerations 123

must include it in his or her own gross income for federal and state tax purposes. The IRS keeps track of these shifting tax burdens by requiring employers to report employee payments on Form W-2 and payments to independent contractors on Form 1099.

However, the general rule has important exceptions. One excep- tion is for items of deferred compensation—compensation that the employee cannot immediately enjoy, such as qualified retirement plan contributions. It may make little difference to an employer whether compensation to employees is in the form of wages or partly in wages and partly in the form of a qualified retirement plan con- tribution, since both are fully deductible if they are within the limits imposed by law. But it can make a big difference to the employee because of the time value of money.

Take, for example, an employee whose marginal tax bracket for federal and state tax purposes is 40 percent. For each additional dollar received in wages, 40 cents is paid to the government, and only 60 cents is left to save or spend. (The employee’s portion of FICA and Medicare reduce even more the amount left to save or spend.) And if that 60 cents is invested, any investment income is subject to additional taxation.

In contrast, a dollar of deferred compensation is not subject to immediate tax, so the full dollar can be invested without reduc- tion for taxes. In addition, earnings on that dollar—called inside build-up—are not subject to immediate tax either. In the end, the employee should have a greater nest egg than if he or she had received and invested after-tax wages. Of course, that nest egg is subject to income tax as it is withdrawn during retirement, but in most cases, the employee is still better off, particularly since his or her tax bracket in retirement is probably lower than when actively working.

There are other important exceptions to the general rule that whatever the employer deducts, the employee must report. For example, employer contributions to group health insurance, health savings accounts, and group term life insurance up to $50,000 in

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coverage (all discussed in Chapter 10) are generally deductible by the employer but not includable in the employee’s income.

Some noncash fringe benefits may be deductible for the employer but, subject to specified limits and conditions, not includable in the employee’s gross income (see IRS Publication 15-B). These include the following:

• no-additional-cost service, which is a service to an employee that the employer normally provides to its customers, as long as doing so is without substantial additional cost to the employer

• employee discounts on goods (provided that the discount does not exceed the employer’s profit margin) and on services (pro- vided that the discount does not exceed 20 percent of the retail price)

• working condition benefits, such as upscale office appointments and use of a company car for business purposes

• de minimis benefits, such as use of the copying machine or office supplies for personal purposes and such as eating facilities at or near the employer’s premises (so long as the facility is operated on at least a break-even basis and the employer does not discriminate in favor of highly compensated employees)

• transportation benefits, including a transit pass, parking, bicycle expenses, or cash reimbursements for those items (up to specified statutory limits)

• cellphones provided primarily for business reasons, even though employees may use their phones for personal purposes as well

Federal tax law allows companies to deduct all ordinary and neces- sary expenses of carrying on a trade or business. These include reim- bursements to employees who have incurred expenses on behalf of their employers. But special rules apply to transportation and travel expenses. For example, while companies can reimburse their employees for, and then deduct, actual expenses incurred in operat- ing an automobile for business, IRS regulations have long allowed use of standard mileage rates in lieu of providing substantiation for

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Tax Considerations 125

actual expenses. (For 2017, the standard rate for business use of an automobile is 53.5 cents per mile.)

The IRS takes a similar approach to per diem business travel expenses (meals, lodging, and incidental expenses), allowing stan- dard reimbursement/deduction rates instead of requiring substan- tiation of actual expenses. Employers may use one of two methods to reimburse employees, either of which satisfies the substantia- tion requirement. One, called the high-low method (available only for travel within the continental U.S.), allows a deduction of $282 per day for specified high-cost areas, and $189 for all other areas for 2017. See Internal Revenue Bulletin 2016-41, available on the IRS’s website. Alternatively, employers may use the federal per diem rates method, based on location-specific rates established by the fed- eral government for cities within the continental U.S. (the CONUS rates) and outside the continental U.S. (the OCONUS rates). The U.S. Government Services Administration (GSA) establishes and publishes these rates.

The deduction for food, beverages, and entertainment (but not lodging) is limited to 50 percent of the otherwise deductible amount, subject to a number of exceptions. Amounts paid to employees in excess of deductible amounts constitute income to the employees and are subject to withholding requirements and payroll taxes.

LIMITATIONS ON DEDUCTIBILITY Most business corporations are classified as C corporations (C corps) for federal income tax purposes. C corps are separate taxable enti- ties whose taxable income is determined by starting with the cor- poration’s gross revenue and deducting the cost of goods sold, salaries, rent, and other expenses. After paying tax on the resulting net income, the corporation may choose to distribute some or all of what is left to its shareholders in the form of a dividend. Dividends represent taxable income to the shareholders.

Because a C corp is a taxable entity, income is taxed twice on its way through the corporation to its shareholders: one tax is paid at the

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corporate level, and a second tax is paid at the individual shareholder level. Particularly in the case of small, closely held corporations, in which the shareholder-owners are also the directors, officers, and employees, this double taxation burden is problematic.

One way to avoid double taxation is to accumulate earnings inside the corporation and not pay dividends. But if the corporation accu- mulates earnings beyond its reasonable business needs, the corpora- tion may end up owing an accumulated earnings tax that is designed to stop that very practice.

Another way to avoid double taxation is to elect S corporation (S corp) status. (This is discussed in more depth in Chapter 1.) Although S corps are generally not subject to tax as separate entities, there are restrictions on who may elect S status. There may also be undesirable tax consequences to S corp owners.

Yet another way is to pay year-end bonuses to owner-employ- ees. Through careful calculation, the bonuses can be set so that the corporation has virtually zero taxable income, and it pays almost no tax. (It is usually not possible to reach exactly zero, since some cash expenditures during the year, such as equipment purchases and meals, may not be fully deductible, but they reduce the amount of cash available to pay bonuses.) The owner-employees, of course, will owe tax on the bonuses along with whatever other compensation they receive, but that is still just one tax, not two.

The taxpayer corporation has the burden of proving that its com- pensation payments are reasonable under Internal Revenue Code §162. And particularly when the taxpayer corporation is controlled by the employees receiving the compensation, the payments are subject to careful scrutiny by the IRS to be sure that they truly represent (deductible) compensation for services rendered, rather than disguised (nondeductible) dividends. In determining whether compensation is reasonable, the courts look at a number of factors, including the following:

• the employee’s qualifications • the nature, extent, and scope of the employee’s work

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Tax Considerations 127

• the size and complexity of the employer’s business • a comparison of salaries paid with the employer’s income • prevailing rates of compensation for comparable positions in com- parable companies

• the amount of compensation paid to the employee in previous years

• whether the employer offers pension and profit-sharing plans to its employees

These factors are applied on an individual employee basis, rather than in the aggregate to a group of employees. In other words, that the company’s overall deduction for compensation is reasonable does not matter; each individual employee’s compensation must be reasonable as well.

QUICK TIP Payments to partners in a partnership and to members of a limited liability company are

generally treated as nondeductible distributions rather than deductible wages and sala-

ries. This occurs even when the partner or member works for the partnership or limited

liability company.

Public Companies Under Internal Revenue Code §162(m), publicly held corporations also face limits on the amount they can deduct. In general, the code places a $1 million-per-year cap on deductions for remuneration paid to covered employees—defined as the chief executive officer and the four highest-paid officers other than the CEO—unless the board of directors takes special steps to authorize higher compensation.

Closely related to these income tax caps are several execu- tive compensation disclosure requirements. The Securities and Exchange Commission (SEC) requires each publicly held company to disclose in its annual proxy statement the amount of compen- sation paid to its high-level executives—its chief executive officer, chief financial officer, and its three other most highly compensat-

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ed executive officers. The company also must disclose the criteria used in reaching executive compensation decisions and the rela- tionship between the company’s executive compensation practices and corporate performance.

And a 2010 amendment to the Dodd-Frank Act, known as the say-on-pay rule, requires public companies periodically to disclose in its proxy statements, and give shareholders a vote on, executive compensation and any golden parachute payments, although the vote in not binding on the company.

Dodd-Frank also requires the SEC to issue a pay-ratio rule, under which most public companies would have to disclose the following:

• the median of the total annual compensation of all employees (except the CEO)

• the CEO’s total annual compensation • the ratio of the above two numbers

In 2015 the SEC issued final rules as required by Dodd-Frank, and in September 2017, the SEC issued further interpretive guid- ance on the rules.

INDEPENDENT CONTRACTORS As pointed out in Chapter 1, employers sometimes try to classify their workers as independent contractors to avoid the laws and reg- ulations that apply to employees. When a worker is misclassified as an independent contractor, the results can be financially ruinous for the employer. For example, employees (but not independent con- tractors) are subject to federal and state income tax withholding, they are entitled to have employer FICA contributions made on their behalf, they are covered by workers’ compensation and unem- ployment insurance for which the employer must pay premiums, and they are entitled to participate in the employer’s various ben- efit plans. So if an employer wrongly treats a group of employees as independent contractors over a period of years, the total cost of remedying the error can be substantial.

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Tax Considerations 129

Traditionally, the question whether a worker is an employee or an independent contractor turns on whether the employer has a right to control the manner in which the worker does his or her job. This is sometimes known as the common-law test. To determine whether there is a right of control, a number of subsidiary factors are consid- ered, such as who sets the worker’s hours, whether the worker works for one or several employers, whether the worker or the employ- er provides necessary tools and workspace, whether the worker has specialized knowledge or requires a license or a professional degree to do the job, and so on. The problem with the common-law test is its lack of certainty. If the employer guesses wrong, disaster can strike.

In an effort to resolve this uncertainty, Congress enacted legisla- tion to provide a safe harbor for employers. Under these safe harbor provisions, an employer’s treatment of a worker as an independent contractor is relatively safe from IRS challenge if the employer meets the following criteria:

• It has never treated the worker as an employee. • It filed all required tax reports and returns relating to the worker on a timely and consistent basis.

• It had a reasonable basis for treating the worker as an independent contractor.

The employer will be considered to have a reasonable basis for treating the worker as an independent contractor if the employer relied on a court decision involving facts similar to the employer’s own or if the employer relied on rulings or technical advice from the IRS. The employer can also demonstrate a reasonable basis if a signif- icant segment of the industry in which the worker is engaged has a long-standing recognized practice of treating such workers as indepen- dent contractors. A significant segment of the industry is 25 percent. However, the employer will not have a reasonable basis for treating a particular worker as an independent contractor if the employer has other workers doing similar jobs who are treated as employees.

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While the IRS can still challenge a safe harbor classification, the burden of proving that the classification is wrong falls on the IRS. To ensure that the safe harbor provisions are fully effective, the IRS must provide the employer with a written notice of the provisions when it audits an employer in connec- tion with a worker classification issue. The IRS is also prohib- ited from issuing regulations or rulings dealing with the safe harbor provisions.

CASE STUDY: SAFE HARBOR PROVISION APPLIED A company licensed as a residential service agency wants to provide nonskilled, home health aides for the elderly in the Washington, D.C., area. Before opening for business, the company conducts a survey of some 20 to 30 local competitors. It finds that approximately 80 percent of the agencies surveyed treat their aides as independent contractors, while only 10 percent treat them as employees. (The other 10 percent did not respond.) Upon opening additional offices in Baltimore and Richmond, the company conducts similar surveys in those areas and obtains similar results. Based on these surveys, the company classifies its workers as independent contractors. The company’s reliance on its surveys is reasonable, and the company’s classification of its aides is accepted by the court.

Another approach to resolving the employee/independent con- tractor issue for federal tax and withholding purposes is to ask the IRS to decide. Upon filing Form SS-8 (either by the employer or by the worker whose status is in doubt), the IRS will determine whether the worker is an employee or an independent contractor. The determination can then be relied on for safe harbor pur- poses. It is probably fair to assume that the IRS resolves close questions by concluding that the worker is an employee, not an independent contractor. So as a practical matter, the SS-8 route may not be very helpful to employers.

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Tax Considerations 131

Yet another solution is to participate in the IRS’s Voluntary Clas- sification Settlement Program. Employers that want to voluntarily change the prospective classification of a worker or group of work- ers from independent contractors to employees file IRS Form 8952 and enter into a closing agreement with the IRS. Under the closing agreement, the employer agrees to treat the workers as employees for future tax periods. The IRS in turn limits the employer’s pre- vious tax liability to 10 percent of what would have been due on compensation paid to the workers for the most recent tax year. In addition, the IRS waives penalties and interest, and it agrees not to conduct an employment tax audit with respect to those workers.

Suppose an employer incorrectly classifies a worker as an inde- pendent contractor when, in reality, the worker should have been treated as an employee. As an independent contractor, for 2017 the worker pays a self-employment tax equal to 15.3 per- cent of earnings up to $127,200 (which equals $19,461.60), plus an additional Medicare tax of 2.9 percent on any earnings above $127,200. Had the worker been properly classified as an employee, however, the employee would have paid only half the $19,461.60 as the employee’s share of FICA, and the employer would have paid the other half. So the question arises wheth- er, as a result of misclassification, the worker has a claim against the employer for the $9,730.80 that the employer should have matched but did not.

In a case from the U.S. 11th Circuit Court of Appeals (headquar- tered in Atlanta), the court ruled that FICA is a tax statute that only the federal government can enforce and that it does not create a private right of action. In other words, so far as FICA is concerned, an employer may be liable to the government for misclassification, but the employer is not liable to the misclassified employee.

FEDERAL WITHHOLDING REQUIREMENTS We are all used to seeing a long list of deductions and with- holdings on our pay stubs. Some of them are voluntary, like the

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employee portions of retirement plan contributions and health insurance premiums. Others are required by law.

How does the employer know how much to withhold? And what is done with the money? The first step in the process is for the employer to obtain an Employer Identification Number (EIN). The number has nine digits, as do Social Security num- bers, but instead of being in the format 123-45-6789, an EIN is formatted 12-3456789. EINs are obtained by filing Form SS-4 with the IRS and may also be obtained by phone or fax or by completing an online application.

The next step is for the employee to submit IRS Form W-4 and the applicable state equivalent to the employer. This must be done at hiring time and whenever the employee’s tax withholdings need to be changed. Form W-4 calls for basic information, such as the employ- ee’s name, address, Social Security number, and marital status. It also contains a worksheet for figuring the number of exemptions to be claimed on the employee’s tax return and various other factors that affect the employee’s tax liability. These factors, known as allowances, are then totaled and entered on the form. Finally, Form W-4 permits the employee to claim a complete exemption from federal income tax withholding under certain conditions.

ALERT! While an employer cannot challenge the allowances claimed by the employee, the IRS cer-

tainly can. The IRS may request an employer to provide copies of Forms W-4 for specific

employees. If the IRS concludes that an employee is not entitled to claim married status

or is not entitled to the allowances he or she claimed on the W-4, the IRS will instruct the

employer (by what is commonly known called a lock-in letter) as to how to withhold for

the future.

When is an employee considered married? According to the IRS’s Publication 15 (also known as Circular E), a marriage of two individu- als is recognized for federal tax purposes if the marriage is recognized by the state, possession, or territory of the United States in which the

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Tax Considerations 133

marriage is entered into. As a result of the Supreme Court’s 2015 decision in Obergefell v. Hodges, states no longer have a choice about recognizing same-sex marriages.

The employer has four basic federal tax obligations relating to employees:

• federal income tax • Social Security tax (FICA) • Medicare tax • unemployment insurance contributions

The first three are discussed below. Unemployment insurance is covered in Chapter 12.

Federal Income Tax With Form W-4 in hand, the employer turns to a set of tables issued by the IRS in Publication 15 to determine how much to withhold from each paycheck. The tables are based on four variables:

• the frequency of paydays (for example, weekly, biweekly) • the employee’s marital status as shown on Form W-4 • the amount of the wage payment • the number of allowances claimed by the employee

Publication 15 (updated annually) is really the employer’s bible when it comes to federal employment tax matters. It can be viewed and downloaded from the IRS’s website.

Social Security (FICA) Tax The tax rate for an employee is 6.2 percent on a maximum wage base of $128,400 for calendar year 2018, which translates to a maximum with- holding of $7,960.80. The employer must match whatever amount is withheld from the employee. So for an employee whose annual salary is at least $128,400, the total payment on account of Social Security is $15,921.60, half of which is withheld from the employee and half of which is the employer’s own matching contribution. The amount

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to be withheld from each paycheck is simply 6.2 percent of the gross payment until the maximum amount $7,960.80 has been withheld. These rates and the wage base are subject to periodic change.

Medicare Tax The Medicare tax rate is 1.45 percent of all wages for the employee and a matching amount of 1.45 percent for the employer. There is no wage base cap—the Medicare tax applies to all wages. The amount to be withheld from each paycheck is 1.45 percent of the gross payment.

ALERT! Owner-employees of S corporations engaged in personal services (for example, doctors,

lawyers, accountants) may try to reduce their payroll tax obligations by paying themselves

unreasonably small salaries (which are subject to payroll taxes) and treating the remaining

corporate profits as shareholder income (which is not subject to payroll taxes). When this

scheme comes to the IRS’s attention, it will recharacterize all or most of the corporate

profits as salary.

Exceptions In general, all employees who are U.S. citizens or resident aliens are subject to withholding for federal income tax, FICA, and Medicare. Publication 15 contains a list of situations in which special rules apply, including the following:

• nonresident aliens • household employees • clergy • disabled workers • deceased workers

Independent contractors are also exempt from withholding requirements. However, a few, limited types of workers called stat- utory employees are required by law to be treated as employees, even though they might otherwise qualify as independent contractors. (See Chapter 1 for more information.)

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Tax Considerations 135

QUICK TIP Workers’ compensation benefits (discussed in Chapter 11) are exempt from income tax.

Irregular Pay Questions sometimes arise regarding withholding on back wages paid to an employee for some earlier year. Suppose, for example, that the employer and employee are in dispute over the exact amount due, and the dispute gets resolved in court, years after the employee did the work. Or suppose back pay is awarded in connection with a discrimi- nation suit or an unfair labor practice complaint. Should the employer treat the wages as paid when they were originally due or as paid in the year they were actually paid? (The answer can make a big difference if the tax rates or FICA cap changed.) The IRS has long taken the position that the wages should be treated as paid currently, and the Supreme Court affirmed that position in a 2001 case involving the Cleveland Indians baseball club.

Other taxable benefits subject to withholding include bonuses, commissions, expense reimbursements (unless the reimbursement is pursuant to an arrangement that requires the employee to verify expenses), payments in kind, meals, and lodging (unless provided for the employer’s convenience on the employer’s premises).

TIPS In addition to withholding for wages, the employer must withhold on account of tips. Employees are required to report tips to their employer no later than the 10th of the month after the month the tips are received, unless tips for the month are less than $20. The report should include not only cash tips the employee receives directly from customers but also tips received in a sharing arrangement with other employees and tips paid by credit card. Employees may use Form 4070 (contained in IRS Publication 1244) or a similar statement to report tips to their employers.

The employer then must figure tax withholdings, payroll taxes, and garnishments just as if the tips were wages paid by the employer.

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However, the employer is not liable to taxing authorities or garnish- ers for more money than actually comes into the employer’s hands. Employers that operate large food and beverage establishments (defined as employing more than 10 people who work more than 80 hours per week in the aggregate) must file Form 8027 annually with the IRS showing total tips.

The IRS has developed a Tip Rate Determination and Education Program in which employers may participate. The program primar- ily consists of two voluntary agreements developed to improve tip income reporting: the Tip Rate Determination Agreement and the Tip Reporting Alternative Commitment. For more information, see IRS Publication 3144.

OTHER TAXABLE PAYMENTS Suppose an employee is laid off under circumstances that could give rise to a claim of abusive discharge. Fearing a claim, the employer obtains a written release of claims from the employee and, as consider- ation for the release, makes a lump sum payment to the employee. Or suppose the employee refuses to sign a release and instead files a law- suit that results in a money judgment against the employer. Are those payments deductible by the employer and taxable to the employee? Are they subject to withholding and reporting requirements? To pay- roll taxes?

It has long been the rule that the proceeds of a personal injury action (a suit claiming injury to the body or person of the suing party) are excluded from taxation and from any withholding or reporting requirements. In the past, the parties to an employment dispute often characterized payments in settlement of the dispute as damages for emotional distress, injury to reputation, and so on to avoid tax obligations.

In 1996, the Internal Revenue Code was amended to narrow the exclusion. The code now states that gross income does not include damages received on account of personal physical injuries or physical sickness. A private letter ruling by the IRS defines personal physical

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Tax Considerations 137

injuries as “direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding.”

As a result of the 1996 amendment, most payments in employment dispute situations will be includable in the recipient’s gross income for federal income tax purposes. At the same time, the payments will be deductible by the employer. In addition, since damages in an employ- ment dispute are usually based on lost wages, the payments are gener- ally viewed as the equivalent of employee compensation and therefore subject to wage withholding and FICA requirements.

When an employer and employee settle an employment dispute, they may agree to treat only a portion of the settlement payment as wages and allocate the remainder to emotional distress. The IRS will respect such an allocation for wage withholding and FICA purposes, so long as the allocation is reasonable, but the IRS will nevertheless view the entire payment as taxable income to the employee. There- fore, the employer should report the portion allocated to wages as Form W-2 income subject to withholding and payroll taxes, and the portion allocated to emotional distress as Form 1099 income not sub- ject to withholding or payroll taxes.

Sometimes the employer agrees to pay the employee’s attorney’s fees as part of a settlement. Before the American Jobs Creation Act of 2004, most courts took the view that the attorney’s fee portion of the settlement was taxable income to the employee, even when the attorney’s fee portion was paid directly to the employee’s lawyer. The American Jobs Creation Act now provides that, in most employ- ment disputes, the attorney’s fee portion is not taxable income to the employee, although it is taxable, of course, to the lawyer.

When negotiating a settlement agreement, a prudent employer should insist that the agreement explicitly state how all payments are being allocated and how they will be reported for tax purposes. If the agreement attempts to characterize any portion of the payment as nontaxable (a risky arrangement), the agreement should at least con- tain a provision requiring the employee to indemnify the employer should the IRS later recharacterize the payment as taxable.

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QUICK TIP The settlement of an employment dispute should be in writing and include a provision

by which the employee, former employee, or applicant for employment clearly releases

all employment-related claims against the employer. If the release is intended to cover

an actual or potential age discrimination claim, the release must conform to special rules

contained in the Age Discrimination in Employment Act. (See Chapter 16 for specifics on

age discrimination.)

Garnishments When an employer satisfies a garnishment by paying a portion of the employee’s salary to the employee’s creditor, the employer is discharg- ing a debt the employee owes. Economically, it is as if the employer paid wages to the employee and the employee, in turn, paid down the debt. So for tax withholding and reporting purposes, a garnishment payment is treated just like a wage payment to the employee.

STATE WITHHOLDING REQUIREMENTS Most states impose their own taxes on income and require employ- ers to withhold against that tax. State withholding requirements can get confusing, particularly for employees who commute to work from out of state. For each employee, the first step is to determine the state or states in which the employee may have to file a state income tax return. If the employee both lives and works in the same state, then only that state’s withholding requirements apply. If the employee lives in one state but commutes to work in another state, then both states’ withholding requirements need to be considered, since the employee potentially has tax filing obliga- tions in both states. (Those few states that do not have any income tax at all can be ignored.)

Even though an employee may have a tax filing obligation in a particular state, the employer might not be required to withhold under that state’s law. This situation could occur if the employ- er itself is not subject to the jurisdiction of that particular state, because the employer has no office in that state and does not do

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Tax Considerations 139

business in that state. Take, for example, a Maryland company whose employees all work in Maryland, but some of whom live in Virginia. Virginia might like the company to withhold from its Virginia employees, but if the company is not subject to Virginia’s jurisdiction, Virginia has no power to compel the company to do so. At the same time, Maryland, where the company is subject to jurisdiction, has no interest in enforcing Virginia’s tax laws.

The company could withhold Maryland income tax from all its employees. But this would mean that its Virginia employees would face a big Virginia tax bill not covered by withholdings, plus they would need to deal with Maryland to get back some or all of their Maryland withholdings. To resolve this situation, Maryland and Virginia have entered into reciprocal agreements with each other. Under these agreements, the Maryland company in the example above withholds Maryland tax from its Maryland employees and Virginia tax from its Virginia employees.

Many other states that have common borders have entered into reciprocal agreements similar to those between Maryland and Vir- ginia. Contact your state employment tax office for details.

QUICK TIP At least one state (New Jersey) takes the view that a company that has no offices in the

state but that employs a teleworker there is subject to New Jersey’s jurisdiction for tax

and corporate purposes. (See Chapter 20 for details.)

EARNED INCOME TAX CREDIT The Earned Income Tax Credit (EITC) is a tax credit available to low- and moderate-income employees. The amount of the credit ranges from a few hundred dollars for an employee with no depen- dent children up to $6,318 for an employee with three or more dependent children. The credit is refundable, meaning that if the credit reduces the employee’s tax liability below zero, the employ- ee owes no tax and the government pays the amount of the nega- tive tax to the employee.

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The SHRM Essential Guide to Employment Law140

Employers must notify their employees who have no federal income tax withheld that they may be able to claim a tax refund because of the EITC. The back of copy B of Form W-2 contains the required notice.

DEPOSIT AND REPORTING REQUIREMENTS All employment-related federal tax payments—taxes withheld from employees, and employers’ and employees’ Social Security and Medi- care taxes—must be deposited using electronic funds transfer (EFT). Deposits are made using either the IRS’s Electronic Federal Tax Pay- ment System (EFTPS) or by having a third party, such as the employ- er’s tax professional, financial institution or payroll service, make the deposit. Employers must enroll in EFTPS to use that system.

The frequency of deposits depends on the amount of taxes involved. In general, if the annual amount is less than $50,000, the deposits are made monthly, and if the amount is $50,000 or more, the deposits are made semiweekly. However, if an employer accumulates a tax liability of $100,000 or more on any day during a deposit period, the deposit must be made by the next banking day. An employer owing less than $2,500 in employment taxes per quarter may remit those taxes with its quarterly return, rather than depositing the taxes separately.

The rules governing employment taxes under the Federal Unem- ployment Tax Act (FUTA) are covered in Chapter 12.

Trust Fund Penalty Taxes withheld from employees are considered to be held by the employer in trust. Rather than just owing the money to the IRS, the employer is treated as having a fiduciary duty to ensure that deposits get made as required by law. If the employer fails to do so, the IRS may impose a trust fund penalty equal to the amount of the unde- posited tax in addition to collecting the tax itself.

The corporate shield offers no protection when it comes to the trust fund penalty, since any person responsible for collecting, accounting for, or depositing the tax will have personal liability for

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Tax Considerations 141

the penalty. Responsible persons can include corporate officers, employees, directors, anyone who signs checks or has authority for spending business funds, and even volunteers of nonprofit orga- nizations. (Volunteers of tax-exempt organizations are relieved of personal liability if they are serving in an honorary capacity, if they do not participate in the day-to-day or financial operations of the organization, and if they had no actual knowledge of the failure to withhold or make the required deposit—so long as there are at least some remaining responsible persons left to pay the taxes.) Liability for withholding taxes and for trust fund penalties is not discharge- able in bankruptcy.

QUICK TIP Even though a single-member limited liability company is considered a disregarded

entity so that its owner is treated as a sole proprietorship for federal income tax pur-

poses, under IRS regulations the owner of the LLC is not liable for the LLC’s share

of employment taxes (although he or she would be liable for taxes withheld from

employees).

W-2s, 1099s and K-1s No later than January 31 of each year, employers must issue IRS Form W-2 to each employee, reporting the employee’s compen- sation for the previous calendar year. Copies of the Forms W-2 are then transmitted to the Social Security Administration using IRS Form W-3. If an employee quits or is terminated during the year, the employer must, if so requested by the employee, issue a W-2 within 30 days. Forms W-2 may also be filed electronically.

Independent contractors that have been paid more than $600 during the previous calendar year are issued Form 1099-MISC by January 31. Although corporate independent contractors (including limited liability companies that have elected to be taxed as corpo- rations) do not have to be issued Forms 1099, payments to attor- neys, regardless of their corporate status, do have to be reported on Forms 1099.

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The SHRM Essential Guide to Employment Law142

Partners in general partnerships, members of LLCs that have not elected to be taxed as corporations, and shareholders of corpora- tions that have elected S corporation status are issued Schedule K-1 (Form 1065) at the time the partnership, LLC, or S corp files its own tax return. (See Chapter 1 for more information.)

Payroll Services For very modest charges, a commercial payroll service provides the following:

• calculates each employee’s deductions and withholdings • issues net checks to employees using the employer’s preprinted check stock (or makes deposits directly to the employees’ bank accounts)

• provides a paper or electronic check stub to each employee show- ing current and year-to-date earnings, deductions, withholdings, and leave accruals

• makes all required federal and state tax deposits • prepares all federal and state reports • prepares Forms W-2 and appropriate transmittal forms

Particularly for smaller employers, this service is difficult to beat. Be cautioned, however, that the employer will be held responsible if the payroll service fails to make required tax deposits. For that reason, it is a good idea to check with the IRS periodically to be sure no deficiencies exist. The address on file with the IRS for mailing deficiency notices should be the employer’s address, not that of the payroll service.

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