Payroll In Practice: 10.15.2024

Question: A company pays employees a monthly stipend of $3,000 for work on a project at a remote location. The assignment is expected to last more than a year. Management wants to keep the stipend separate as a situation-specific benefit and would like to gross up and pay the additional taxes for the employees. The employees have a weekly pay period and are concerned about the withholding impact of the monthly stipend when combined with their regular pay. Is there a way to reduce the amount of tax withheld for the stipend?

Answer: There are some options for mitigating the taxes. The stipends are considered supplemental pay, so the supplemental pay rules apply when determining the amount of taxes to withhold. Two basic methods that can be used for determining the amount to withhold from supplemental pay in this case are the aggregate method and the optional flat rate method.

The aggregate method combines the supplemental and regular pay for the pay period when the supplemental compensation is paid. It computes the required withholding on the total. The optional flat rate method computes income tax withholding on the supplemental pay separately by multiplying the gross supplemental payment by a flat 22%.

A gross-up formula is used to calculate the withholding required to cover the taxes on a net of tax payment, such as the $3,000 stipend. It computes the effective gross pay required to yield the desired after-tax payment. To calculate the gross pay required, the employer must divide the net pay by the difference between 1 and the applicable tax rates, including all applicable income and social taxes.

The following examples assume an employee receives $1,000 regular pay each week and a $3,000 stipend each month. The employee is based in Ohio, which has a supplemental income tax rate of 3.5%, and the employee’s W-4 claims single or married filing separately in Step 1 and has no entries in Steps 2, 3, or 4. A payroll calculator is used for the following computations.

The normal withholding on the regular pay, excluding any supplemental wages, using the percentage method is $182.50. This includes $81.82 in federal income tax, $62 for Social Security, $14.50 for Medicare, and $24.18 in state income tax. The net pay for the employee is $817.50.

On the last payday of the month, the employee receives the normal $1,000 in addition to the $3,000 monthly stipend. Since both wages are paid at the same time, the aggregate method can be used in this instance.

The aggregate method requires withholding as if the combined regular wages and stipend were a single payment. For a $4,000 total payment, the employer must withhold $760.98 for federal income tax, $248 for Social Security, $58 for Medicare, and $130.71 for state income tax. The total withholding is $1,197.69.

The amount of supplemental withholding is the total withholding minus the normal tax withholding for the regular wages, which is $182.50. Therefore, supplemental withholding for the $4,000 payment is $1,015.19, or $1,197.69 minus $182.50.

Using the aggregate method, the employee’s net pay for the last payday of the month is $2,802.31, or $4,000 minus $1,197.69 in tax withholding. If the employer wanted to gross up the amount, the gross pay in this case should be $6,182.49. Withholding would include $1,495.82 in federal income tax, $383.31 for Social Security, $89.65 for Medicare, and $213.64 for state income tax.

An easier method is to not combine the supplemental wages with the regular wages. The optional method can be used if the payments are identified separately and federal income tax was withheld from the employee’s wages in the current or immediately preceding calendar year.

The optional flat rate method is 22% of the supplemental pay. Additionally, the stipend is subject to 3.5% in Ohio supplemental withholding, 6.2% for Social Security, and 1.45% for Medicare.

In this case the gross-up formula would be $3,000 ÷ (1 – [22% + 3.5% + 6.2% + 1.45%]). This results in the gross-up pay for the stipend being $4,487.66, or $3,000 divided by 0.6685.

To verify that $4,487.66 is the correct gross-up amount for the stipend, the tax withholding on this amount should result in $3,000 in net pay to the employee. The required tax withholding on $4,487.66 is $987.29 in federal income tax (22%), $278.24 for Social Security (6.2%), $65.08 for Medicare (1.45%), and $157.07 for Ohio supplemental tax (3.5%). Subtracting these amounts from $4,487.66 results in $2,999.98 in net pay for the employee.

For a third alternative calculation, the employer could use the average quarterly wage method described in IRC §3402(h)(1), which would allow the withholding to be spread over all the pay periods in the quarter as if the monthly payment were paid evenly over the same pay periods.

The employer must first estimate the employee’s total pay for the quarter. Estimated quarterly wages for this case are comprised of $1,000 in weekly regular pay and $3,000 monthly stipends. However, the monthly stipend will have to be grossed up to cover the additional taxes. As shown in the previous example, the gross-up amount is $4,487.66.

The total estimated pay for the quarter is $26,462.98. This includes $13,000 in regular pay ($1,000 × 13 weeks) and $13,462.98 in stipends ($4,487.66 × three months). As shown in the previous example, withholding on the grossed-up monthly stipend payment is $987.29 in federal income tax, $278.24 for Social Security, $65.08 for Medicare, and $157.07 in Ohio supplemental tax. Multiply these amounts by three to get quarterly amounts of $2,961.87 for federal income tax, $834.72 for Social Security, $195.24 for Medicare, and $471.21 for Ohio income tax.

Similarly, multiplying the tax withholding amount of the weekly regular pay by 13 weeks results in the quarterly withholding amounts of $1,063.66 in federal income tax, $806 for Social Security, $188.50 for Medicare, and $314.34 for state income tax.

Required federal income tax withholding for the quarter is $4,025.53 ($2,961.87 + $1,063.66). For state income tax, the required withholding for the quarter is $785.55 ($471.21 + $314.34). Divide each by 13 weeks to get the average required withholding for each of the 13 weekly pay periods in the quarter. In this case, the average required withholding is $309.66 for federal income tax and $60.43 for state income tax.

Under the average quarterly wage method, the average federal income tax is withheld each pay period regardless of the actual gross pay for the period.

If the actual wage amount for the quarter is different from the estimated amount, the amount of withholding is adjusted for the last pay period of the quarter so that the total amount withheld for the quarter is correct for the actual wages paid during the quarter. Social Security and Medicare taxes are withheld for each pay period based on the actual wages paid during the pay period rather than the average wages paid.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information
Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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