Employment tax and reporting treatment of differential payments to active duty reservists.

In the category of "no good deed goes unpunished," civilian employers seeking to ease the financial strain for employees recently called to active military duty are faced with having to determine the correct federal employment tax and reporting treatment of "differential" or "supplemental" payments made to these employees without the benefit of updated and concise guidance. Calculated to make up the difference between the employee's regular civilian pay and his or her active duty wages while serving in the U.S. Armed Forces, these voluntary employer payments have resulted in disagreements with the very employees (and their families) that these payments were designed to help.

The Internal Revenue Service first ruled on the issue of differential payments more than 60 years ago. Differential payments clearly constitute income under section 61 of the Internal Revenue Code and would appear to be "wages" for purposes of federal income tax withholding (FITW), Federal Insurance Contributions Act (FICA) taxes, and Federal Unemployment Tax Act (FUTA) taxes, because the benefits are being provided based on the employee's past employment relationship with the civilian employer. Even IRS regulations describe differential payments to military personnel as "compensation paid by other employers." (1)

There is no indication, however, that the IRS intends to retreat from its historic ruling position that differential payments to former employees called to active duty by the Federal government or into federal service as a member of the National Guard are not wages for employment tax purposes because the employment relationship was "interrupted." Since the most recent iteration of the guidance nearly 35 years ago, there has been no additional guidance addressing whether the conclusion that the employment relationship was "interrupted" still holds true today. It simply is not clear whether the relationship has in fact been interrupted when civilian employers are more generous than what appears to have been contemplated by IRS rulings or by federal law guaranteeing reemployment and the protection of certain health and pension benefits to veterans. In other words, employers are struggling to be fully compliant with federal tax laws while doing "the right thing" by their employees, but without the benefit of updated IRS guidance and, therefore, they are potentially exposed to liabilities for the failure to subject the differential payments to federal employment taxes.

Until the IRS issues updated guidance, the IRS will not likely challenge a civilian employer's treatment of differential payments as not constituting "wages" for employment tax purposes. Moreover, even if the IRS were to challenge the employer's reliance on its outdated rulings, it will likely be precluded from arguing against the public guidance articulated in an outstanding revenue ruling. (2) In addition, if the employer decides not to treat the payments as "wages," there is an argument in support of entering into a voluntary income tax withholding agreement with the employee called to active duty, so that the latter is not greeted with a big tax liability when he or she returns from active duty. Furthermore, even if voluntary withholding is not elected by the military member, the employer may report the differential payments on Forms W-2 in Box 1 as opposed to reporting the payments on Forms 1099-MISC.

I. Historical Treatment of Differential Payments to Reservists: Rev. Rul. 69-136

The most recent formal guidance from the Internal Revenue Service on the employment tax treatment of differential payments came in 1969. Rev. Rul. 69-136 (3) concludes, in two hypothetical situations, that differential payments made by civilian employers to "former" employees who have been called to active duty in the U.S. Armed Forces or for service with the National Guard are "not 'wages' for services performed in 'employment' for the companies." In Situation 1 of the ruling, the differential payments were made to a reservist by a civilian employer who had also committed to making every effort to reemploy the veteran, but had not guaranteed such reemployment. The fact pattern of Situation 2, involving differential payments made to employees called for indefinite service in the National Guard, is silent on the issue of reemployment.

Rev. Rul. 69-136 was issued on the heels of Rev. Rul. 68-238. (4) The earlier ruling had concluded that differential payments made to employees on temporary duty (such as training) with the National Guard constituted "wages" for payroll tax purposes, because the employment relationship was not disturbed during this time. (5) In distinguishing Rev. Rul. 68-238, the 1969 ruling focuses on the employees' being called for active military service and concludes that the employment relationship had in fact "terminated" during the period of active duty service. (6) Therefore, the differential payments were held not to constitute "wages" for payroll tax purposes.

Rev. Rul. 69-136 does not specifically state that the payments are income for reporting purposes, although that is clearly the conclusion based on the ruling's focus on wage treatment. (7) The validity of Rev. Rul. 69-136 with respect to the "wages" issue, however, may be challenged on two fronts. First, there is no statutory exclusion for differential pay in the employment tax provisions. Unless specifically excluded by statute, the term "wages" generally means all remuneration for employment, including remuneration received after the employment relationship has terminated, if the payment relates to the past employment relationship. (8) Thus, it is difficult to comprehend the support for the ruling's conclusion in 1969 of "no wages" under the then-existing statutory scheme, since no explanation is offered in the ruling.

At the time Rev. Rul. 69-136 was issued, there was in fact a limited exemption for FICA and FUTA tax purposes for stand-by payments made to employees who had attained age 62, if the employee did not work for the employer during the period, if the employment relationship continued to exist, and if the pay was other than vacation or sick pay. (9) This limited exemption from employment taxation for standby pay was never available with respect to employees young enough to be called to active duty, so it could not have been the basis for the conclusions drawn by Rev. Rul. 69-136. In any event, this limited exemption was eliminated from the Code in 1983.

Second, Rev. Rul. 69-136 does not answer the question whether a guarantee of reemployment (either by the employer or by law) or the provision of more protections and rights than required by law changes the ruling's conclusion that the differential payments are not subject to Federal payroll taxes. The ruling implies that such a guaranteed right could be significant, because it is stated as a fact in Situation 1 that reemployment had not been guaranteed by the civilian employer. With respect to the issue that the provision of benefits by the employer, in addition to differential pay, would be contrary to the ruling's conclusion that the employment relationship terminated when the employee entered military service, the ruling is entirely silent.

II. USERRA and the Reaffirmation of Rev. Rul. 69-136 in Informal IRS Guidance

Federal reemployment rights provisions for veterans, which safeguard employment and reemployment rights in civilian employment of members of the uniformed services, have been in effect for more than six decades. (10) Subsequent to the issuance of Rev. Rul. 69-136, the Uniformed Services Employment and Reemployment Rights Act of 1994, 38 U.S.C. [subsection] 4301-4333 (USERRA), was enacted to consolidate the rules and strengthen the guarantees of certain reemployment and benefits protections to veterans returning to civilian employment. (11) Although the IRS has issued guidance regarding the protection of benefits rights under USERRA, it has never formally addressed whether the statutory requirement to reemploy a veteran and to provide certain benefits protections during the period of military duty vitiates the IRS's conclusions in Rev. Rul. 69-136 that the employment relationship "terminated" during that time. The IRS also has never issued any private letter rulings or other legal memoranda discussing or applying Rev. Rul. 69-136.

In informal discussions, IRS personnel have reaffirmed the IRS's reliance on Rev. Rul. 69-136, but it is not clear whether the agency has fully considered the effect of the guaranteed reemployment rights set forth in USERRA or the provision of more generous benefits on the ruling's conclusion that the employment relationship is "interrupted" when the employee departs for active duty. The only "official" guidance from the IRS appears in the "Newsroom" of the IRS website in a short discussion entitled "Employer's Frequently Asked Questions for Employees in Combat Zone." In Q&As 38 and 39, the IRS cites Rev. Rul. 69-136 and the conclusion that differential payments to active duty military members do not constitute wages for payroll tax purposes. (12) Notably, the Q&A neither addresses the possible effect of USERRA or the provision of additional benefits to the absent employee or his family on the ruling's conclusion, nor the appropriate information return for reporting these differential payments. In relying on the information posted on the IRS website, employers must be cognizant of the fact that it does not constitute authority.

Certainly, if reemployment is guaranteed, either by the employer or by statute, it would be more logical to conclude that the employment relationship never terminated. The employment tax regulations deem an employment relationship for wage withholding purpose to exist even in situations where the employment relationship has been terminated if the post-employment payment relates to past services. This is most evident in the area of severance pay, where an employer's payments to a former employee continue to be treated as wages. Moreover, the employer delivers benefits to the absent employee and his or her family that are more generous than dictated by federal law, it defies logic to argue that the employment relationship has bee interrupted.

Nevertheless, the IRS has seemingly made an institutional decision to rely on Rev. Rul. 69-136, even though there is no statutory authority for its rationale. It may be that the IRS has chosen this course of action, because of the political and public relations problems it would now face if it concluded for payroll tax purposes either (a) that the employment relationship does not actually terminate during the period of military service or (b) that the guarantee of reemployment required by USERRA or the actual provision of benefits during the employee's absence from civilian employment makes the differential payments subject to payroll taxation. From a legal perspective, however, Rev. Rul. 69-136 certainly challenges established employment tax principles. Thus, the IRS should consider issuing updated guidance along the lines of Notice 2001-69, (12a) which essentially suspended the principles of constructive receipt and assignment of income following September 11 to permit charitable donations of annual leave. Alternatively, employers may want to consider asking the IRS for a ruling to confirm the agency's decision to continue its reliance on Rev. Rul. 69-136.

Not only has the lack of published, updated guidance in this area produced inconsistencies in the payroll tax and reporting treatment of differential payments by employers, but it has generated debate among lawmakers. This confusion is evidenced in the May 11, 2004, attachment of a Manager's Amendment to S.1637 (Jumpstart Our Business Strength (JOBS) Act). The amendment provides an employer wage credit for an employer that continues to "pay wages" to an employee-reservist who has been called to active duty. Accordingly, there appears to be a difference in opinion between the IRS and Congress about the characterization of these payments.

III. Reporting Differential Payments

Rev. Rul. 69-136 does not tell former civilian employers how to report the payments--a fact often overlooked by commentators. Despite the assertions of some veterans' groups that differential payments must be reported on Forms 1099-MISC, the better approach is to report the payments in Box 1 of Form W-2. The issue of reporting was not addressed in Rev. Rul. 69-136 and no other guidance has ever been issued by the IRS addressing the reporting treatment of these payments. Even the recent Newsroom Q&A is silent on the issue, though the question is included in Q38.

Treas. Reg. [section] 1.6041-2(a)(1) provides that "all other payments of compensation" paid to an employee (or former employee) by his employer must be reported on Form W-2 if the total of the "other compensation" and the wage compensation aggregates $600 or more in a calendar year." (13) (Treas. Reg. [section] 1.112-1(a)(4) confirms that differential payments are in fact a form of "compensation.") Reporting the differential payments in Box 1 of Form W-2 does not automatically trigger the application of payroll taxes. The instructions to Form W-2 are most explicit in explaining that, in addition to "wages," Box 1 must be used for payments of "compensation not subject to withholding," which are made by an employer to an employee, a term defined by Treas. Reg. [section] 1.112-1(a)(4) to include a "former employee." (14)

Utilizing Form W-2 reporting is also likely to be administratively easier for both the employer and the military member. It is possible that a Form W-2 will be issued to the military member for other wages earned or compensation paid during the year that he or she is on active duty, so it is more practical to report the differential payments in Box 1 of the same return, rather than to issue a separate Form 1099-MISC for the differential payments. (15)

IV. Voluntary Withholding Agreements

Even if an employer takes the position that the differential payments are not wages for FITW, FICA tax, and FUTA tax purposes, it may still want to consider asking reservists whether they would like to elect voluntary withholding from the payments. Admittedly, the IRS has not been generous in permitting such agreements under the regulatory authority of section 3402(p)(3)(B) of the Code. The use of such an agreement in conjunction with differential pay, however, seemingly fits within the spirit of the statute and would run little risk of being perceived by the IRS as abusive. Specifically, section 3402(p)(3)(A) permits voluntary withholding "from remuneration for services performed by an employee ... which ... does not constitute wages...." For this purpose, Treas. Reg. [section] 31.3402(p)-1(a) cross-references Treas. Reg. [section] 31.3401(a)-3(b)(1), which includes in amounts deemed to be wages for purposes of a voluntary withholding agreement, "remuneration for services performed by an employee for an employer which ... does not constitute wages under section 3401(a)," provided the remuneration is not specifically excluded by Treas. Reg. [section] 31.3401(a)-3(b)(2). (16)

In other words, Treas. Reg. [section] 31.3401(a)3(b)(1) ensures that compensation for services that is statutorily excluded from "wages" under section 3401(a) may be the subject of a voluntary withholding agreement. Critically, this regulation does not preclude the use of such an agreement in a situation where the compensation is not specifically excluded under section 3401(a), but is determined not to be wages for another reason. Since Rev. Rul. 69-136 concludes that differential payments are not wages and the IRS appears to respect that ruling, arguably an employer that concludes that Rev. Rul. 69-136 can be extended to post-USERRA differential payments should also be permitted to rely on the ruling's conclusion for purposes of establishing a voluntary withholding agreement with the active-duty employee.

The use of voluntary withholding agreements has two practical advantages. First, it ameliorates the potential for a large income tax liability being presented to the veteran at the time he or she files an annual return. Second, in the unlikely event that the IRS were ever to challenge an employer's reliance on Rev. Rul. 69-136, the employer could receive abatement for the failure to withhold income taxes. (17) In other words, the only issue would be the failure to impose FICA and FUTA taxes on the payments. (18)

V. Conclusion

Employers would benefit from updated guidance from the IRS, clarifying the proper payroll tax and reporting procedures for differential payments. The deployment of reserve and National Guard personnel is at record levels, and employers providing differential payments to their employee-reservists should be commended. Hopefully, the IRS will provide additional assistance in the form of clear guidance. Alternatively, employers should consider asking for a statutory clarification in the pending FSC/ETI legislation.

(1) Treas. Reg. [section] 1.112-1(a)(4).

(2) Dover Corp. v. Commissioner, 122 T.C. No. 19 (May 5, 2004); and Rauenhorst v. Commissioner, 119 T.C. 157, 170-171 (2002). See also Chief Counsel Notice CC-2002-043 (Oct. 17, 2002) (instructing Chief Counsel attorneys not to argue contrary to formal guidance, which includes revenue rulings).

(3) 1969-1 C.B. 252.

(4) 1968-1 C.B. 420.

(5) Rev. Rul. 68-238 was a restatement of S.S.T. 49, XV-2 C.B. 420 (1936), in which the IRS concluded that voluntary differential payments made by a company to its employees while serving in the State National Guard were wages for purposes of the Social Security Act. In restating the conclusion of S.S.T. 49 as to the wage treatment of this type of payment, Rev. Rul. 68-238 emphasizes the employees' temporary absence from work and, therefore, "the employment relationship between the company and its employees is not disturbed by this service in the Guard."

(6) The predecessor to Rev. Rul. 69-136 also concludes that the employment relationship was terminated when the employees were called for active military service. See S.S.T. 406, 1940-2 C.B. 264. See also Em. T. 432, 1942-1 C.B. 238 (federal unemployment taxes).

(7) A discussion of wage treatment in Rev. Rul. 69-136 would not have been necessary, unless the payments were income under section 61 of the Code. See, e.g., Anderson v. United States, 929 F.2d 648 (Fed. Cir. 1991); Redfield v. Insurance Co. of North America, 940 F.2d 542,548 (9th Cir. 1991); Dotson v. United States, 87 F.3d 682, 689 (5th Cir. 1996); Gerbec v. United States, 164 F.3d 1015, 1025-26 (6th Cir. 1999); and HB&R, Inc. v. United States, 229 F.3d 688 (8th Cir. 2000). Importantly, these differential payments are not exempt under section 112 of the Code, which provides an exemption from income for combat zone compensation. Moreover, Treas. Reg. [section] 1.112-1(a)(4) confirms that differential payments are in fact a form of "compensation." It provides in pertinent part that "compensation paid by other employers (whether private enterprises or governmental entities) to members of the Armed Forces cannot be excluded under section 112, even if the payment is made to supplement the member's military compensation or is labeled by the employer as compensation for active service in the Armed Forces of the United States."

(8) See I.R.C. [subsection] 3401(a) (FITW), 3121(a) (FICA taxes), and 3306(b) (FUTA taxes). See also Treas. Reg. [section] 31.3401(a)-l(a)(5), 31.3121(a)l(i), and 31.3306(b)-1(i) (each concluding that remuneration for services is subject to FITW, FICA taxes, and FUTA taxes, respectively, unless a specific statutory exception applies, even though the employee is no longer an employee when the remuneration is paid).

(9) Former section 3121(a)(9) of the Code was repealed by section 324(a)(3) of the Social Security Amendments Act of 1983, Pub. L. No. 98-21.

(10) See H.R. Rep. No. 103-65, at 18 (1994), reprinted in 1994 U.S.C.C.A.N. 2449, 2451.

(11) See 38 U.S.C. [subsection] 4312-4313 and 4316-4318. USERRA requires coverage under the employer's health plan to be made available under certain circumstances. In addition, on reemployment, an employee is entitled to receive certain pension, profit-sharing and similar benefits (under defined benefit or defined contribution plans) that would have been received but for the employee's absence during military service. See also I.R.C. [section] 414(u).

(12) See the IRS website at http://www.irs.gov/newsroom/article/ 0,,id=112695,00.html.

(12A) 2001-_C.B. 491.

(13) Reporting the differential payments in Box 1 of Form W-2 (without applying payroll taxation) is consistent with the IRS's conclusion in Private Letter Ruling 8315021 (Jan. 7, 1983) that a Form W-2 is the appropriate form for reporting income that is not wages to a former employee.

(14) Because differential payments are in fact compensation (as confirmed by Treas. Reg. [section] 1.112-1(a)(4)), arguably it would not be appropriate to report the payments in Box 3 (Other income) of Form 1099-MISC. The correct box would be Box 7 for nonemployee compensation, which in turn would trigger taxation under the Self-Employed Contributions Act (SECA). In any event, this issue is avoided entirely, if the differential payments are reported in Box 1 of Form W-2.

(15) The issuance of both a Form W-2 and Form 1099-MISC to an employee for the calendar year often triggers inquiries from the IRS during employment tax examinations. The matter could be easily resolved at that time, but the employer would be put to the inconvenience of having to explain it to the examining agents.

(16) Differential pay is not specifically excluded from the definition of "wages" under section 3401(a) of the Code.

(17) I.R.C. [section] 3401(d). The employer would be obligated to get a signed Form 4669 from each employee.

(18) Assuming the calendar year is still open, the employee's share of FICA taxes could be collected from the employee's remuneration when he returns from active duty. See generally Treas. Reg. [section] 31.6205-1(b). Given the confusing state of current guidance, it is unlikely that the IRS could successfully collect the employee-half of FICA taxes. See Central Illinois Public Service Co. v. United States, 435 U.S. 21 (1978). Also, as mentioned in note 2 and the accompanying text, the IRS will have a difficult time disavowing its own published revenue ruling, as supplemented by its informal reaffirmation of its conclusion.

MARIANNA G. DYSON and MARY B. HEVENER are partners in the District of Columbia office of Baker & McKenzie. They are frequent contributors to The Tax Executive and have made presentations at both local and national TEI meetings. The authors gratefully acknowledge the assistance of Thomas M. Cryan, Jr., in the preparation of this article.