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W-4 Exempt & Supplemental Taxes

I have a question regarding taxation on a bonus for an employee claiming exempt from taxation. Our Payroll group (across multiple regions) can not come to consensus on the IRS regulations. :x

From the IRS website provided to us:
This document contains amendments to 26 CFR part 31 under sections 3401 and 3402 of the Internal Revenue Code (Code). Section 904(b) of the American Jobs Creation Act of 2004 (Public Law 108-357, 118 Stat. 1418) (AJCA) provided for mandatory income tax withholding at the highest rate of income tax in effect under section 1 of the Code to the extent an employee’s total supplemental wages paid by the employer exceed $1,000,000 during the calendar year. The AJCA also provided that the supplemental wages paid by other businesses under common control would be taken into account in determining whether the employer has paid $1,000,000 of supplemental wages to an employee in the calendar year. In addition, section 904(a) of the AJCA provided that the rate for purposes of optional flat rate withholding on other supplemental wages (i.e., those supplemental wages not subject to mandatory flat rate withholding at the highest rate of income tax) would remain at 25 percent, but could change if income tax rates change.

My question: I am paying a bonus to an employee who is claiming exempt on his W-4. The bonus is normally taxed at the supplemental rate of 25% for federal. Should this employee pay the 25% supplemental taxes on this bonus, or should he not have any federal taxes withheld?


  • Has the employee in question earned more then one million dollars in supplemental wages this year? If not, the rule you cited is not applicable.

    You should look at IRS publication 15, the supplemental wage withholding rules (which could be better written). The key phrase is as follows:

    If you did not withhold income tax from the employee's regular wages in the current or immediately preceding calendar year, use method 1-b above. This would occur, for example, when the value of the employee's withholding allowances claimed on Form W-4 is more than the wages.

    You have to read through the entire section several times to get the context correct, but basically is the million dollar rule is not in effect, then an Exempt W-4 that was valid for the normal wages would also shut down the FIT withholding for the supplemental wage.
  • These employees have not earned more than 1 million this year.

    So, based on Pub 15 referance, we should be withholding FIT using the aggregate method on bonus payments to these employees? We don't have the resources to use a selective aggregate for these employees. Our bonus pay codes are set up at a standard 25%. These employees claiming exempt will either have to withhold FIT at 25% or no income tax at all.

    To tax, or not to tax...that is the question... :P
  • I am always very careful with this particular question, because for whatever reason, people seem to be very eager to change what I did say in the answer to something that I did not actually say. One of the mysteries of the universe. Example:

    Bob is going to make much less then one milliion dollars this year. Bob has had an Exempt W-4 in play for a while. Because the Exempt W-4 has in play for a while, when the normal paycheck is processed, no FIT is being withheld. Normal routine vanilla processing.

    For this pay period only, Bob receives a $1K bonus payment. Under the very long standing IRS supplemental pay rules that every payroll system that I have ever used since the late 1970s has supported, the 25% Flat Tax method cannot be because the IRS rules (for a very long time) says it cannot be used. This leaves the Aggregate system, which means add the bonus to the regular wages and then taxed using the W-4 instructions against the current pay period tax table. Since the W-4 instructions say no FIT is withheld, it is not.

    Based on what you have said, this is a very clear example of no FIT withheld on the bonus payment. The same as it would have been one year ago, ten years ago, or even thirty years ago.

    IRS during the law change you referenced added the 35% Flat Tax method, which you say does not apply (million dollar rule). IRS also changed the definition of supplemental wages (which also does not seem to effect your example).
  • Beyond that - even if the payment does qualify for the optional flat rate method - that is, income tax was withheld from regular wages sometime during the current or preceeding calendar year - if the employee claims exempt from income tax withholding (not income tax, but income tax withholding) the employee is exempt from withholding on all wages and compensation EXCEPT to wages subject to the mandatory flat rate which applies without regard to the W-4.

    The mandatory flat rate only applies when supplemental pay exceeds $1 million for the employee for that year - and then only on the excess (I know there is an exception to that too) - that is, the employee would be exempt from withholding on all pay except to the extent that supplemental wages exceed $1 million.

    For example, you have a commission only sales person who has 10 kids, lots of medical expenses, and tithes to the church. Commissions are, by definition, supplemental pay. If the sales person has not been paid regular wages during the current or preceeding calendar year, the optional flat rate method is not allowed. If the employee claims exempt (had no tax liability the previous year and does not expect one this year), why would the employer withhold simply because commissions are supplemental?
  • If I understand this correctly, when an employee submits a W-4 for exempt mid-year, and then they receive supplemental wages, we can tax the supplemental wages at the flat rate (25% if not at 1million for the calendar year).

    We are having an issue in our new payroll system - employee has been taxed all year for his regular wages, has taxable tuition reimbursement for his grad school courses, we tax him at 25% on that income and separate it as supplemental on our payroll results.

    He doesn't like paying the taxes (through a series of emails to our payroll dept) and then sends in a W4 claiming exempt to our payroll system. The payroll system now excludes his regular wages AND supplemental taxable education imputed income from ANY and ALL federal withholding.
    I am trying to research this with our internal HR IT group, but my thoughts are that the tuition income SHOULD be taxed at 25% since he's had it withheld all year to date, and if he wants to claim exemption for the full year next year, he would not be taxed.
    Obviously, I am not sure our payroll system can automatically do this which is why all income is now exempted from tax withholding since his recent submission of the exempt W4.

  • mcypherCMU
    "If I understand this correctly, when an employee submits a W-4 for exempt mid-year, and then they receive supplemental wages, we can tax the supplemental wages at the flat rate (25% if not at 1million for the calendar year)."

    Why on Earth would you understand that?
    If the employee has submitted an exempt W-4 that is valid, you honor it and do not withhold tax on any payments made once the W-4 claiming exempt takes effect (except those that are subject to the mandatory flat rate for cumulative supplemental pay in excess of $ 1 million - BTW that rate is currently 39.6 % - the maximum tax rate in effect at the time of payment - it was 35% when the AJCA was passed).

    "The payroll system now excludes his regular wages AND supplemental taxable education imputed income from ANY and ALL federal withholding."

    That is exactly what it should be doing. Congratulate it. Unless - from "ANY and ALL" you include Social Security and Medicare withholding - it that is happening then you may have a coding error of some kind.

    Simply submitting an exempt W-4 mid-year when exemption was not claimed earlier in the year does not make it invalid - the employee would have had to make an unauthorized change to the W-4 wording or claimed a percentage or indicated to you at the time it was submitted that it contained a false statement) --- Saying when giving it to you that they only reason they are claiming exempt is to avoid withholding on the wage payments. It sounds like it is possible that the employee may have done that -- "He doesn't like paying the taxes (through a series of emails to our payroll dept)" depending upon what he said in the e-mails.

    You may want to gently remind him (without giving tax advice or accusing him of lying) that the W-4 is "signed" (even in the electronic system if it is set up properly) under penalties of perjury (possible fine, jail time or both) and he may want to claim additional allowances to get the correct amount of withholding for the remainder of the year rather than go for "exempt" status which has much narrower requirements - i.e. no tax liability for the previous tax year and none expected for the current tax year and would not have to otherwise file a tax return except to claim a refund.

    David - I am with you on wondering why it is so hard to understand that an "exempt from withholding" claim on the W-4 means exempt from federal income tax withholding (and only federal income tax withholding) on all compensation provided to the employee, except in the case of supplemental pay subject to the mandatory flat rate, on or after the date the W-4 takes effect until a subsequent W-4 takes effect or the exempt W-4 expires (Feb 15 of the tax year following the year the exempt W-4 was effective)

    An exempt W-4 submitted mid-year after there has been withholding does not result in a refund of the prior withholding - that is, the W-4 in that case does not achieve the result of the employee not having to file a tax return - the employee will have to file a return to get that money refunded. Also, if the employee is entitled to a refundable credit (EIC, AOTC, CTC/ACTC) then a return will have to be filed anyway.

  • Every time I answer this sort of question, I feel like I playing a three card Monte game. No matter what I do or do say, the other guy is going to reshuffle the answer into something I did not say.

    There are a bunch of little W-4 rules that Pat knows better then I do, but the big rule is that there is only one set off withholding instructions in play for each payroll. Pick one (and make sure it is legal). Any time someone wants to use more then one W-4 in one pay period, they are playing games.

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