Federal vs. state employee benefit plan and fringe benefit income tax withholding.

Over the past few years, Federal, state and local governments have passed or adopted several legislative changes for employee benefits and fringe benefits taxation. In many cases, these changes were first implemented at the Federal level and subsequently adopted by state and local jurisdictions.

While it may be true that a vast number of states and localities follow the Federal guidelines in calculating taxable wages, it is also true that there can be a timing factor as to the effective date of these changes. Many states first require local tax authorities to review and approve Federal changes before changing their statutes. Further, some Federal legislation has a retroactive effective date, yet states adopt the law when it is passed and do not include the retroactive period.

There are still some states and localities that follow only certain Federal provisions in calculating taxable wages. As a result, the state taxable wages may differ from the Federal wages. (Note: This discussion only addresses calculating taxable wages for income tax withholding. FICA, FUTA and state unemployment insurance taxable wages can (and do) have different rules.)

In September 1997, Pennsylvania passed legislative changes retroactive to Jan. 1, 1997, that reduced employees' state taxable income by their contributions to a cafeteria-style benefits plan for hospitalization, sickness, disability or death benefits. This change required employers to reduce the amount of Pennsylvania tax withheld from their employees' remaining payroll checks for 1997 or reflect the correct amount of taxable wages in the state wage box on their employees' Forms W-2 (which would enable the individuals to get a refund directly from the state). If the employer did not comply with either of these alternatives, a Form W-2c was issued to its Pennsylvania employees, if they were supposed to receive their state tax refund.

While this change brought Pennsylvania more in line with the rules on taxable wages that exist for Federal income tax withholding purposes, a number of differences still remain between the Federal and state treatment of fringe benefit and employee benefit plan taxation.

Adoption assistance. Federal rules allow for $5,000 per adoption ($6,000 for a special needs child) of tax-free employer-paid assistance. Alabama, California, Minnesota and New Jersey exempt these payments from income, provided they are part of a cafeteria-style plan; Pennsylvania, on the other hand, considers these payments taxable.

Education assistance. Federal rules allowing exempt tuition reimbursements have been extended for undergraduate courses until June 1, 2000, provided all the associated conditions are met. Arkansas, Hawaii, Minnesota, South Carolina, Wisconsin and the District of Columbia, however, subject these payments to state tax withholding.

Moving expenses. Under Federal rules, the costs of moving household goods and the costs of employee and family travel expenses from point A to point B are not taxable; all other employer-paid moving expenses are deemed nonqualified and should be included in an employee's Federal wages. Illinois, Kansas and Maryland do not consider these payments as taxable.

Dependent care and Sec. 401(k). Federal rules allow employees $5,000 of pre-tax dependent care benefits. In 1998, the Sec. 401(k) limit for Federal purposes is $10,000. Pennsylvania, however, still considers employee contributions to these benefits taxable, and New Jersey considers dependent care contributions taxable as well.

Local variations. Variations in calculating taxable income, along with others not mentioned (such as cafeteria plans), can and do exist at the local level as well. For example, Philadelphia, Pennsylvania and Cleveland, Ohio do not reduce taxable wages for employee contributions to cafeteria, dependent care or Sec. 401(k) plans.

Employers should review their payroll process to ensure that the correct taxing rules are in effect for the benefits listed. Noncompliance could result in employees or employers, or both, paying unnecessary taxes. In addition, penalties and interest could be incurred on wages improperly reported or taxed.

THOMAS R. SCHERER, CPA, J.D., AND PAUL L. CHEUNG, CPA, J.D., CHICAGO, IL