Wages, Salary, And Other Compensation
Wages, salary, and most other forms of compensation, including some fringe benefits, for work are the most heavily taxed form of income, subject to both flat employment taxes and a progressive marginal tax that increases with income. Only a few specific types of compensation for work is nontaxable, such as certain tax-free fringe benefits, certain foreign earned income, and tax-free Armed Forces and veterans' benefits, regardless of the form of compensation, be it in cash, property, or services. Employers report taxable compensation paid to employees on Form W-2, Wage and Tax Statement. Earnings from self-employment or from a sole proprietorship business are reported on Schedule C, Profit or Loss from Business, and self-employment taxes are reported on Schedule SE, Self-Employment Tax. Certain retirement benefits are reported on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. There are certain payments by an employer for an employee that are tax-free but are limited by IRS rules, such as per diem payments or mileage allowances. Reimbursements that are greater than what the IRS allows are generally taxable as income, especially reimbursements from a non-accountable plan, which is an account that does not satisfy IRS rules. Certain withholdings for retirement plans may allow the deferral of marginal tax — but not employement tax — on the contributions, such as contributions to a traditional IRA.
Compensation is includable in the gross income of the taxpayer in the year when it is actually or constructively received. Constructive receipt means that the employee had access to the money or the check even if it was not actually received, such as because the employee was on vacation. However, if the employer asked the employee not to cash a check until later because the employer was short of funds, then the payment is considered received when the employee is able to cash the check.
If compensation is paid with property, then the value of the compensation = the fair market value of the property when it is received. Company stock, for instance, is often used to pay compensation. If the stock is unrestricted, then it is fully taxable when received by the employee. However, if the stock is restricted as to transferability or if there is a substantial risk of forfeiture, then the restricted stock does not have to be reported as income until the restrictions are removed.
Generally, when assigning pay to another party, the assignor is still generally liable for taxes on the income. Although gifts are generally tax-free, any income received from employers is almost never considered a gift, unless the gift was given for affection, admiration, or charity. Any payment associated with past or future services is not considered a gift even if the employer is not obligated to make the payment.
Commissions are taxable when they are credited to the employee's account, whether the employee withdraws the amount or not. However, if the commissions cannot be calculated accurately or if it will take time to collect the commissions, then the commissions do not have to be reported as income until the uncertainties or problems are resolved. Advances against unearned commissions are generally taxable when the employee has full access to the funds, since most companies generally do not require repayment of unearned commissions.
However, if unearned commissions must be repaid in a future tax year, then the employee can deduct the repayment in the year of the repayment. If the repayment was to repay income subject to self-employment tax, then the repayment can be written off as a business expense on Schedule C, Profit or Loss from Business. A repayment by an employee may be deducted from income. If the repayment amount is at least a $3000, then the taxpayer can claim the repayment as a credit, equal to the difference between the tax that was paid in the prior year and what the tax would have been if the commission was not paid then. For repayment amounts of at least $3000, the taxpayer can choose either the deduction or the tax credit, whichever method yields the greatest benefit.
If the employee paid employment taxes on the previously paid commission, then he can either ask for a refund from his employer, or if the employer refuses, file Form 843, Claim for Refund and Request for Abatement. If the employee also paid the Additional Medicare Tax on the repaid commission, then the only way to claim a refund of that tax is by filing an amended return.
Any kickbacks of commissions that are illegal under state law are not deductible. The salesperson must report the full amount as income, such as when a real estate agent pays part of his commission to the buyers or sellers.
Commissions received by personal representatives of estates and trustees are generally taxable. However, the commissions can be waived by giving the principal beneficiaries a formal waiver of the right to commissions within 6 months after 1st being appointed or by not claiming the commission when the 1st accountings of the estate or the trust is given to the probate court or to the beneficiaries.
Tips are also taxable and if the employee receives tips directly from customers, then the tips must be reported to the employer, so that FICA and income taxes can be withheld.
Golden parachute payments, which are additional payments to key employees when there has been a change in company control, are taxable as income, and the IRS has certain rules to determine if the payments are excessive — excessive payments are subject to an additional 20% excise tax penalty. Golden parachutes generally take the form of severance pay, stock options, or bonuses and are generally given to top executives when the company is taken over by another firm.
Sometimes employers use stock appreciation rights (SARs) to compensate employees. The compensation equals:
SAR Compensation = (Stock Price when Exercised – Stock Price when Granted) × Number of SARs
If the stock appreciation rights satisfy IRS tests, then the employee does not have to pay tax on the compensation until the rights are exercised.
Group life insurance premiums paid by the employer for the employees are tax-free if the coverage does not exceed $50,000. In the past, some employees tried to increase their tax-free life insurance coverage by using a split-dollar insurance arrangement, where the employer pays the premiums for the life insurance, but then receives all the contributions back when the employee dies, then distributing the remaining part of the life insurance proceeds to the beneficiaries of the employee. However, the IRS has issued new regulations to tax this arrangement. If the employer owns the policy, then the employee will be taxed on the benefit of the policy; if the employee owns the policy, then the premium payments will be treated as employer loans with imputed interest, taxable to the employee.
Unemployment benefits are fully taxable and are reported on Form 1099-G, Certain Government Payments. Supplemental unemployment benefits that are usually paid from a guaranteed annual wage plan based on union contracts are taxable as wages. If the employee made contributions to a private union fund, then only the unemployment benefits that exceed the contributions made by the employee are taxable, since part of the benefit is considered a return of capital. However, such contributions are not deductible.
Educational benefits for employees' children may be tax-free if the grant is based solely on the children's aptitude, need, or some other factor not related to the parent's employment. The primary purpose of the educational benefit must be to educate the children. In such cases, the grants would be considered scholarships or fellowships; otherwise the grants are taxable to the parents as compensation.
Strike and lockout benefits are taxable as wages. However, the employee can deduct contributions as a return of capital from the amount received. In rare cases, strike benefits can be considered tax-free gifts if the payments are unconditionally based on individual need and are available to both union and nonunion members. However, any requirements for the compensation, such as requiring the employee to participate in a strike, will indicate that the strike benefits are not a gift. Severance pay is also taxable.
Taxation of Sick Pay, Workers Compensation, and Disability Payments
Sick pay received from an employer is taxed as wages and is also subject to withholding, but can be tax-free if the sick pay was provided pursuant to a law or regulation.
Workers compensation is tax-free. If an employer pays the full compensation to the employee in exchange for receiving the workers compensation, then the difference between the compensation and the workers compensation will be taxable as wages. To be tax-free, workers compensation must be paid as a requirement under law or regulation for on-the-job injuries or illness. Payments may be taxable if they can be received for injuries or illness that are not job-related. Payments pursuant to a labor agreement are not tax-free, even if they serve the same purpose as workers compensation, since these payments are not required by law or regulation. Payments from plans based on age, length-of-service, or contributions, such as retirement or disability plans, are not tax-free, even if triggered by disability or illness. Workers compensation is treated as income in determining the taxability of Social Security or Railroad Retirement benefits, which may lead to higher taxes on those benefits.
Employer payments for certain serious permanent injuries and payments from accident or health plans are also tax-free, but not excessive reimbursements. Social Security disability benefits are treated like regular benefits, so they are taxable for higher income taxpayers.
Disability pensions provided by employers are taxed as wages, unless the payments are for severe permanent disability, until the worker really reaches retirement age; afterward, the disability pension is treated as a regular retirement pension. Low income taxpayers may be able to claim a tax credit if younger than 65 and permanently and totally disabled.
Short-term disability payments paid pursuant to state law are taxable under federal law to the extent that they are financed by the employer or they substitute for unemployment compensation.
Most military disability payments are taxable unless the taxpayer became entitled to the payments before September 25, 1975 and the amount of the payments is based on the degree of disability, in which case, those payments are tax-free; likewise, for disability pensions received from the Foreign Service, Public Health Service, or National Oceanic and Atmospheric Administration. Disability pensions from the Department of Veterans Affairs (VA) are tax-free; however, additional disability benefits from Social Security may be taxable, since these benefits are payable regardless of the reason for the disability. Also tax-free are disability pensions paid for combat related injuries or sickness, injuries incurred from training or maneuvers, or caused by an instrumentality of war, such as weapons.
Disability payments for injuries resulting from a terrorist act, whether within or outside of the US, or from US military action responding to attacks against the US or its allies are tax-free for any US taxpayer so injured.
Nonqualified Deferred Compensation and Section 409A
Sometimes an employer provides a deferred compensation plan that is not qualified under IRS rules, in which the employee earns money in one year but is not paid until a later year. Whether taxes can be deferred on such deferred compensation is governed by IRC §409A, which applies to any compensation arrangement between an employer and an employee, a principal and an independent contractor, or a partnership and a partner, in which payment for services is deferred to a later year, but in which the payee has a binding right to the income even though it is not actually or constructively received. One of the most common types of such deferred compensation is when schoolteachers elect to be paid over a 12 month period rather than the 10 months in which they typically work. Some of the compensation is deferred because a teacher's work year typically begins in August and ends in May, so the teacher is paid over 12 months instead of 10 months, resulting in lower monthly payments and, therefore, less income received from August until the end of the year than would otherwise be the case if the teacher was receiving 1/10th of her annual salary for each month during the same time period. Section 409A does not apply if the school district pays all its teachers in the same way; it only applies if each can make an election as to how they are paid.
Section 409A does not apply to qualified retirement plans, such as 401(k)s or Individual Retirement Accounts — why it is called nonqualified deferred compensation — or for welfare benefit plans such as vacation, sick leave, or disability programs. For a plan to qualify under §409A, the employee must give written or electronic notice about how the employee wants the compensation to be paid — such as ratably over 12 months — before the work period, and the election must be irrevocable over the period; otherwise the contributions will not only be taxable but will also be subject to an additional 20% penalty when there is no risk of forfeiture, even if the employee did not receive the money. Once the election is made, the arrangement can continue until the employee makes a new election to be paid differently. The IRS does not require a particular form to make the election — it could be any kind of notification that the employer requires — and the IRS does not have to be notified.
If the plan requirements are not met, then the nonqualified deferred compensation will be includable in the income of plan participants as long as there is no risk of forfeiture, and the tax will be increased by interest and a 20% tax penalty on the deferred compensation. However, §409A does not apply to FICA (Social Security and Medicare) taxes.
An employer can deduct contributions to a nonqualified plan only if the contributions become includable in the income of the plan participant. However, no compensation is deferred if the contributions go to an offshore trust outside of the United States or if the plan becomes restricted or altered if the employer encounters financial difficulties.
Employer contributions to a domestic irrevocable Rabbi trust are not taxed until distributed. However, the assets of the trust must be subject to creditor claims against the employer if the employer becomes insolvent or bankrupt.
Certain permissible payments are allowed without incurring tax penalties if it is for an employee separating from employment, the employee dies or becomes disabled, or because of some other emergency, or because of a change in the ownership or control of the employer. However, distributions to key employees cannot be made until the earlier of 6 months after the employee departs or the employee dies.
Repayment of Wages, Benefits, or Expenses to the Employer
If an employee receives compensation based on contingent events, but then later must repay that income, then the employee can claim a deduction or credit depending on the amount. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), if the repayment was $3000 or less, then the expense was listed as an item in the Job Expenses and Certain Miscellaneous Deductions section of Schedule A, Itemized Deductions, as Other Expenses, where the deduction was limited to the 2% AGI floor, but the TCJA eliminated this deduction. However, if the repayment is over $3000, then the deduction can be claimed in the Other Miscellaneous Deductions section of Schedule A not subject to the 2% AGI floor. Another method of reducing taxes because of a repayment is provided in IRC §1341, which allows the employee to recompute taxes for the prior year but without the paid wages, then calculate the tax accordingly. The new tax result is then subtracted from the taxes that were actually paid in the prior year, then the difference can be applied as a credit, often called a §1341 credit, for the current tax year.
Section 1341 Credit = Prior Year Tax Paid – Prior Year Tax Liability Without Repaid Amount
Section 1341 also applies to repayment of supplemental unemployment benefits. However, the IRS has held that repayment of disallowed travel and entertainment expenses cannot be deducted under §1341, although an appeals court allowed a §1341 computation in at least 1 instance.