Proposed regulations relating to flat rate supplemental wage withholding: April 11, 2005.

On April 11, 2005, TEI submitted comments to the Internal Revenue Service on proposed regulations relating to flat rate withholding on supplemental wages. The comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Neil D. Traubenberg of Storage Technology Corporation. Contributing substantially to the development of TEI's comments was David E. Sherwood of Microsoft Corporation. Also contributing to the development of TEI's comments was Michael J. Nesbitt of Paychex, Inc., chair of TEI's Subcommittee on Employee Benefits and Payroll Taxes.

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On January 4, 2005, the Internal Revenue Service issued proposed regulations amending the optional flat rate income tax withholding rules applicable to supplemental wages paid by an employer to employees. The proposed regulations also address the new, mandatory maximum flat rate income tax withholding requirement set forth in section 904 of the American Jobs Creation Act of 2004 for supplemental wages in excess of $1 million dollars paid to an employee during a calendar year. The regulations were published in the January 5, 2005, issue of the Federal Register (70 FED. REG. 767) and in the February 7, 2005, issue of the Internal Revenue Bulletin (2005-6 I.R.B. 484). No hearing is scheduled on the proposed regulations.

Background

Tax Executives Institute is the preeminent worldwide association of business tax executives. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, Europe, and Asia. TEI represents a crosssection of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises, including the employment tax and income tax withholding rules applicable to employee wages. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations governing the optional and mandatory maximum flat rate income tax withholding rules applicable to supplemental wage payments.

Summary of Comments

TEI commends the Treasury Department and Internal Revenue Service for issuing prompt guidance on the flat rate supplemental wage withholding rules. Subject to clarification for the issues described below, the proposed regulations provide a workable framework for determining the income tax withholding applicable to supplemental wages. In order to afford taxpayers sufficient time to implement the new rules, we recommend that the effective date of the regulations be deferred until the later of January 1, 2006, or six months following release of final regulations. In addition, to temper the burdens the rules would impose on employers, we recommend that the IRS adopt the rules of administrative convenience that are proposed below.

Legal Background

To the extent total supplemental wage payments to an employee within a calendar year exceed $1 million, section 904(b) of the American Jobs Creation Act of 2004 (Pub. L. 108-357) (hereinafter "the AJCA") requires employers to withhold federal income taxes at the maximum tax rate imposed by I.R.C. [section] 1(i)(2). For purposes of this provision, the term "employer" includes any related entity in the employer's controlled group of corporations or commonly controlled trades or businesses (e.g., partnerships and proprietorships) that are treated as a single employer under I.R.C. [section] 52(a) or (b). (1) The provision is effective with respect to supplemental wage payments made after December 31, 2004. Thus, for 2005 the optional flat rate for supplemental wages of $1 million or less is 25 percent; for supplemental wages in excess of $1 million, the higher, 35-percent rate applies.

The proposal to add the higher, mandatory flat rate withholding was originally part of the National Employee Savings and Trust Equity Guarantee Act (2) (NESTEG) and was subsequently incorporated in the AJCA. According to an explanation of the NESTEG bill, the provision is based on the presumption that the rate will produce income tax withholding that more accurately reflects an employee's actual tax liability:

   The committee believes that,
   because most employees who
   receive annual supplemental
   wage payments in excess of
   $1 million will ultimately be
   taxed at the highest marginal
   rate, it is appropriate
   to raise the withholding rate
   on such payments so that
   withholding more closely approximates
   the ultimate tax
   liability with respect to these
   payments. (3)

In addition, the Conference Report to the AJCA explains that, once the $1 million threshold for supplemental wages is exceeded, the maximum flat rate of income tax withholding applies to all additional supplemental wages paid during the year regardless of other withholding rules and the employee's W-4. (4)

The proposed regulations clarify which wages are considered "regular" or "supplemental," and thus potentially subject to the new provision on supplemental annual wages in excess of $1 million. "Supplemental" wages are defined as any amounts that are not "regular" wages; (5) "regular" wages are amounts paid by an employer for a payroll period either at a regular hourly, daily, or similar periodic rate for a payroll period or in a predetermined, fixed amount for the payroll period. (6) Where the only amounts received by an employee during a calendar year would otherwise be considered supplemental wages (e.g., commissions, tips, bonuses) if paid in addition to regular wages, the payments are considered "regular" wages.

In addition, the proposed rules set forth the following new withholding requirements:

* Payments by Agents. Any payment made to an employee by a third party acting as an agent for the employer (regardless of whether such person is designated as an agent pursuant to I.R.C. [section] 3504) are considered as made by the employer. (7)

* Split Withholding Rates. The mandatory withholding rate on supplemental wages can apply to a full payment or only a portion of a payment. The maximum 35 percent flat rate withholding applies only to the excess of the supplemental wages over $1 million received by an employee from an employer, taking into account all payments of supplemental wages during the year. (8) All payments of supplemental wages are considered in determining whether the threshold is exceeded regardless of whether the optional flat rate or regular withholding rates applied to supplemental wages of less than $1 million. Where a supplemental wage payment causes an employee's aggregate supplemental wages for the year to exceed the threshold, the regular withholding rates or the optional flat rates apply to the supplemental wages up to the $1 million amount and the maximum 35 percent flat rate applies to the portion of the payment exceeding $1 million (as well as to all subsequent supplemental wages paid during the calendar year).

The proposed rules will become effective on the date published as final regulations in the Federal Register. Failure to comply with the new rules may subject the employer to liability for the amount of tax that is not properly withheld, interest on the withholding tax, and penalties (and interest on the penalties) for failure to timely withhold, deposit, and report the withholding taxes. (9)

Proposed Regulations Should be Clarified; Effective Date Deferred

Although the proposed regulations provide a generally workable framework for complying with the amended flat rate withholding provisions, employers require additional time to design, develop, test, and implement integrated payroll systems that will satisfy the rules relating to the new maximum flat rate withholding on supplemental wages in excess of $1 million. Before the adoption of section 904 of the AJCA, there was no legal requirement that employers coordinate and track cumulative, year-to-date payment amounts for various components of compensation that are classified by the proposed regulations as "supplemental" wages. To be sure, most employers track many components of compensation on a cumulative year-to-date basis (10) and all track aggregate cumulative wages from most sources, i.e., "regular" wages plus most forms of "supplemental" wages. But employers have not been required to (1) track all "supplemental" wages--as that term is defined by the proposed regulations--and, more important, (2) test the cumulative "supplemental" wages paid year-to-date on a continuing basis against a fixed-dollar threshold for purposes of applying the withholding tax rules. (11)

Moreover, many, if not most, large employers maintain multiple payroll systems, especially where, as a result of mergers and acquisitions, it is more cost-efficient to maintain a legacy payroll system than to convert an acquired employee workforce to a different payroll system. In addition, employers often maintain separate payroll systems in order to address the business needs of specific departments or divisions (e.g., sales commissions or other incentives) or to address the unique administrative burdens and challenges that specific forms of compensation can pose (e.g., stock options or other forms of equity pay; bonuses or other incentive payments; sick, disability, or vacation pay; and other forms of benefit payments). Indeed, many large employers could have dozens of--perhaps as many as a hundred--categories of compensation that must now be coded as "regular" or "supplemental" wages as prescribed by the proposed rules and cumulated on a year-to-date basis. Thus, under the proposed regulations, employers must substantially redesign, develop, and test their administrative processes and information systems in order to implement an updated, integrated payroll system that complies with the proposed rules.

The challenge of implementing a payroll reporting and information system that complies with the statute and the proposed rules is exacerbated by (1) the expanded scope of the term "supplemental" wages; (2) the likely existence of multiple payroll systems within a controlled group; (3) the requirement to track payments made by third-party agents; and (4) the application of split withholding rates to a single wage payment. We offer the following comments on each of these issues.

1. Supplemental Wages. The proposed regulations provide a clear demarcation between "regular" and "supplemental" wages, but the application of the rules to many forms of compensation is unclear. To assist employers in complying with the rules, we urge the IRS to provide guidance on the following:

a. Whether a shift differential paid to employees paid on an hourly basis constitutes regular or supplemental wages; (12) and

b. Whether payments to retirees are treated as supplemental or regular wages. (13)

2. Multiple Payroll Systems within a Controlled Group. Many employers have decentralized payroll systems and prior to the AJCA there was generally no legal requirement to coordinate payroll systems among entities within the controlled group. Indeed, separate lines of businesses or divisions within a controlled group may use different third-party payroll service providers or employ a different combination of in-house systems and third-party payroll service providers. Moreover, if an employee transfers from one employer to another within the controlled group, most employers treat the transferred employee as a new hire with a new wage base for FICA and FUTA purposes. For purposes of the $1 million threshold, however, amounts paid by the two employers within the controlled group must be aggregated. Since payroll data is highly sensitive, employers will require time to develop an integrated system to accumulate payroll totals from various companies within the controlled group.

3. Payments by Agents. The proposed regulations require employers to coordinate their payroll system with payments made by third-party payers, including sick or disability pay, supplemental retirement pay, various types of stock compensation, and relocation benefits. It will be extremely challenging for employers to track and incorporate year-to-date totals for such supplemental wages on a real-time basis with company-paid or other third-party supplemental wages because such amounts are generally paid outside of the employer's core payroll system. In addition, because of the time lag between the date such amounts are paid to the employee (or former employee) by the third party and the date the information is reported to the employer, it is possible--even likely--that the supplemental wages will, when cumulated with other supplemental wages paid to the employee by the employer (and other third parties), exceed the $1 million threshold before the employer has notice that the higher mandatory flat rate withholding tax applies. Assuming that such system limitations can be addressed and the employer's and third-party agent's information systems coordinated, the regulations should address the following issues:

a. Sick or Disability Pay. Which sick or disability pay amounts are counted for purposes of determining supplemental or regular wages? For example, are only the payments made by a third party that has no insurance risk considered supplemental wages paid by the employer? If the sick or disability payments are made under an insured plan, the employer likely will receive no information about the cumulative payments until after year end.

b. Stock Options. What is the proper characterization of compensation arising from the exercise of nonqualified stock options, especially where a broker handles the income tax withholding on behalf of the employer and employee? In most cases, it would likely be expedient to treat all option income amounts as supplemental wages subject to the flat rate withholding of either 25 or 35 percent, especially if TEI's proposed rules of administrative convenience are adopted. Where an option is exercised by a former employee (or retiree) who receives no regular wages during the year, however, will the $1 million supplemental wage threshold ever apply? The default in such a case under the proposed regulations is seemingly to regular wages.

What is the proper treatment of the compensation element of an option exercise where a former employee also receives pension payments or other supplemental wages during the year or subsequently becomes re-employed by the employer within the same year as the option exercise? At a minimum, in the case of a re-hired employee, subsequent payments of supplemental wages following the rehiring of the employee should not cause a violation of the maximum flat rate withholding rules in respect of the payments made prior to re-hiring the employee.

4. Application of Split Rates to a Single Payment: Where an employer makes a payment of supplemental wages that produces a cumulative year-to-date total exceeding $1 million, the employer must apply either the regular rates or the lower flat 25-percent withholding rate on the supplemental wage amounts up to the $1 million threshold and then apply the 35-percent mandatory fiat rate to the excess. Regrettably, most payroll systems are not currently designed to apply multiple fixed rates to a single payment. Moreover, the systems are not designed to calculate the portion of a payment that causes the year-to-date total to exceed a threshold amount.

We believe that the IRS and Treasury Department have ample authority to issue administrative regulations tempering the requirements of section 904 of the AJCA. Indeed, there are a number of precedents where the government has afforded taxpayers the opportunity to comply with withholding tax obligations based on a reasonable, good faith interpretation of a statute. See, e.g., Notice 94-96, 1994-2 C.B. 564 (reasonable good faith standard applied to FICA tax on nonqualified deferred compensation) and Announcement 85-113, 1985-31 I.R.B. 31 (rules of administrative convenience for non-cash fringe benefits). We urge the IRS and Treasury Department to recognize the administrative burdens and compliance challenges that a literal application of section 904(b) of the AJCA--combined with the revised definitions in the proposed regulations --might impose. Moreover, because of the need for the IRS to clarify the definition of supplemental wages and to address the issues and questions raised by commenters, employers should be afforded time following the release of the final regulations to make information system changes. Hence, we recommend that the effective date of the regulations be no earlier than six months following their publication in the Federal Register. Accordingly, we recommend that the effective date of the regulations be deferred until the later of January 1, 2006, or six months following the release of final regulations. Finally, the IRS should announce interim relief permitting employers (and other payers) to use a reasonable, good faith effort to comply with their withholding obligations. Such relief should include a waiver of reporting and withholding penalties (and interest) as well as a waiver of the employer's (or third-party payer's) potential withholding tax liability.

Rules of Administrative Convenience

In addition to delaying the effective date of the regulations and clarifying the application of the rules, TEI recommends that the following rules be adopted in order to facilitate employers' ongoing compliance with the maximum mandatory flat rate withholding rule:

1. Apply the 35-Percent Rate After Total Compensation Exceeds $1 Million. Because of the difficulty of distinguishing "regular" wages from "supplemental" wages, employers should, at their discretion, be permitted to apply the 35-percent withholding rate when the cumulative total of all wages--regular and supplemental--to an employee exceeds $1 million. We believe this recommendation is consistent with congressional intent that the maximum rate of tax apply where it will more accurately reflect the employee's ultimate tax liability.

2. Apply the 35-Percent Rate to the Entire Payment. Because of the difficulty of developing a system to apply split withholding rates to a single payment of supplemental wages, employers should be permitted to apply the 35-percent withholding rate to the entire supplemental wage amount where the payment causes the employee's cumulative supplemental wages to exceed the $1 million threshold. Permitting employers to elect this rule would temper the burden of applying a split withholding rate to a single payment and, again, is consistent with congressional intent to match the withholding tax with the employee's ultimate tax liability.

3. Apply the 35-Percent Rate to Additional Supplemental Wage Payments once the $1 Million Threshold is Exceeded. As an alternative to the second rule, employers should be permitted to elect to apply the 35percent withholding rate to the first payment of additional supplemental wages made after a payment that causes the employee's annual supplemental wages to exceed the $1 million threshold. This rule would temper the burden of applying a split withholding rate to a single payment. As important, the proposal reflects the literal language in the Conference Report, which states:

   Once annual supplemental
   wage payments to an employee
   exceed $1 million,
   any additional supplemental
   wage payments to the
   employee in that year are
   subject to withholding at the
   highest rate.... (14)

4. Regulations Should Permit Third-Party Payers to Apply the Maximum Withholding Rate to Cumulative Supplemental Wages Measured on a Stand-Alone Basis. The statute enacted by Congress does not address withholding on payments made by third-party payers. We do not believe that the regulations should require the coordination of withholding on supplemental wages paid by third parties, such as stock brokers or insurance companies, with supplemental wages paid by the employer for purposes of determining whether the $1 million threshold is exceeded and applying the maximum 35-percent withholding rate to the third parties' payments. Employers have adopted third-party pay arrangements for sick pay, stock option exercises, and other forms of compensation because they promote administrative efficiency and enhance compliance with the withholding rules. We believe it would be excessively burdensome to require employers to bring such systems back in house or to compel integration with the employer's payroll systems. Thus, we recommend that third-party agents be permitted to treat all payments to employees as supplemental wages subject to the optional flat withholding rate (currently, 25 percent), unless the cumulative supplemental wage payments by the third-party agent to the employee will, standing alone, exceed the $1 million threshold.

No Penalties or Withholding Tax Obligations for Reasonable, Good Faith Employer Compliance

The proposed regulations treat all wages other than fixed and determinable amounts as supplemental wages. If an employer (or a third party) makes an inadvertent error in the classification of a payment, the error may cause the employee's cumulative annual supplemental wages to exceed the $1 million threshold at a date earlier than otherwise believed. In such cases, the employer may be subject to penalties for failure to withhold at the maximum rate on all or a portion of supplemental wages subsequently paid. In addition, since employers must include payments of supplemental wages made by third-party payers in the determination of when the employee's annual $1 million threshold is exceeded, (15) delays by a third-party payer in reporting information to the employer may expose the employer to potential penalties (and withholding tax) for failure to withhold at the maximum withholding rate. TEI does not believe that employers should be subject to the secondary withholding tax obligation or to withholding and reporting penalties (and interest) for inadvertent misclassifications of payments as regular wages. Similarly, we do not believe that employers should be penalized for delays in information reporting by third-party agents. In either case, the employer has likely withheld tax on the supplemental wage payments, albeit at the regular rate or the lower flat rate applicable to supplemental wages of less than $1 million, and reported the wage and tax amounts to the government and to the employee. TEI recommends that the IRS adopt a reasonable cause and good faith exception to the imposition of penalties and withholding tax obligations so that employers may be assured that reasonable, good faith efforts to comply with the new maximum flat rate withholding rules will not result in penalties.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to flat rate supplemental wage withholding. If you have any questions, please do not hesitate to contact Neil D. Traubenberg, chair of TEI's Federal Tax Committee, at 303.673.3904, or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601.

(1) [section] 9041b)(2) of the Act.

(2) S. 2424, 108th Cong., 2nd. Sess. (2004).

(3) S. Rep. No. 108-266, 105 (2004).

(4) "[O]nce annual supplemental wage payments to an employee exceed $1 million, any additional supplemental wage payments to the employee in that year are subject to withholding at the highest income tax rate (35 percent for 2004 and 2005), regardless of any other withholding rules and regardless of the employee's Form W-4." See H.R. Rep. No. 108-755, 785-86 (2004).

(5) Prop. Reg. [section] 31.3402(g)-1(a)(1)(i).

(6) Prop. Reg. [section] 31.3402(g)-1(a)(1)(ii).

(7) Prop. Reg. [section] 31.3402(g)-1(a)(3)(ii).

(8) Preamble, 2005-6 I.R.B. 484, 486.

(9) See, e.g., I.R.C. [subsection] 3403, 3402(d), 6601(a), 6651, 6656, and 6662.

(10) Note, however, that many forms of thirdparty pay, such as sick and disability payments, are not cumulated throughout the year. Rather, the third-party payers report the amounts to the employer at year end so that the amounts can be aggregated with the employee's other wages and reported on the annual W-2 wage and tax statement.

(11) Under the current regulations governing supplemental wage payments, employers are permitted to aggregate all regular and supplemental wage payments and treat the amount as a single wage payment subject to the withholding tax rules applicable to regular wages.

(12) Employers may have adopted varying practices in respect of the treatment of shift differentials. The regulations should clarify whether the third lowest income tax rate (i.e., the 25-percent rate) or regular withholding applies to the shift differential amounts. If employers may adopt either withholding practice, the regulations should also confirm that. In addition, although it would be unlikely for employees compensated on an hourly basis to exceed the $1 million threshold, there may be unusual facts and circumstances where the treatment of the shift differential as regular or supplemental wages will be critical. For example, a software programmer may be paid regular wages on an hourly basis with a shift differential. If the employee also receives nonqualified stock options, annual wages may exceed the $1 million threshold during the years when the options are exercised. In such a case, if shift differential payments are treated as supplemental wages, the employee's total supplemental wages will exceed the threshold at an earlier date than if the shift differential amounts are treated as regular wages. In addition, subsequent shift differential payments would be subject to the higher, mandatory rate.

(13) In addition to payments from qualified plans and nonqualified deferred compensation arrangements, retirees often receive multiple forms of compensation payments prior to or in connection with retirement, including sick or disability pay, accrued vacation, severance pay (or settlement amounts), and option exercise income. Such amounts may be paid in a year in which the retiree receives regular wages from employment or in the subsequent calendar year where the retiree may not receive any regular wages. In a subsequent calendar year where the employee receives no fixed and determinable periodic income, are all the supplemental wages considered regular or supplemental pursuant to the default rule in Prop. Reg. [section] 31.3402(g)-1(a)(1)(ii)? We urge the IRS to consider issuing additional guidance on the treatment of payments received at or in connection with retirement.

(14) H.R. Rep. No. 108-755, 785-786 (2004) (emphasis added).

(15) Absent the adoption of TEI's recommended rule of administrative convenience to treat third-party supplemental wage payments on a stand-alone basis, the employer is also potentially subject to taxes and penalties for the third party's classification errors or for the third party's delays in recording information from the employer about the employee's cumulative annual supplemental wages.