Payroll in Practice: 11.18.2024

Question: A company pays sales personnel commissions with occasional bonuses. The company also makes periodic severance payments to certain terminated employees. The company uses the 22% flat rate withholding method for bonus payments but prefers to withhold from commissions and severance pay using the regular Form W-4 method rather than the supplemental methods. Is this allowable?

Answer: There are three methods for computing the amount to withhold from supplemental wages, the aggregate method, the 22% flat rate method, and the mandatory flat rate method. The method preferred by the company refers to the percentage or wage bracket methods described in Internal Revenue Service Publication 15-T, Federal Income Tax Withholding Methods.

The percentage method is allowable for such supplemental payments because it is effectively the aggregate method. If, for example, the employee receives only the commission during the pay period, the aggregate compensation during the period is the commission amount, since there is no regular pay.

Supplemental pay is any taxable compensation that does not qualify as regular pay. Regular pay is paid at a regular hourly rate or another periodic rate such as a day rate or a salary paid on a weekly or other regular period. IRS Publication 15 (Circular E), Employer’s Tax Guide, includes examples of supplemental wages, such as commissions, severance pay, bonuses, fringe benefits, overtime pay, and similar items.

Before the mandatory flat rate was introduced, if no regular pay was paid during a pay period, then any commission, bonus, or severance payments for that period did not meet the definition of supplemental wages and were treated as regular pay. In other words, the supplemental pay rules did not apply if there was no regular pay.

For example, if a bonus was the only compensation paid to the employee during a given pay period, the bonus was treated as regular pay for withholding. The optional flat rate method could not be used to compute withholding for the bonus unless there was also regular pay from which tax was withheld during the pay period the bonus was paid.

With passage of the American Jobs Creation Act of 2004, the definition of supplemental pay changed and employers had to begin tracking supplemental payments more closely. When the cumulative supplemental amount paid to an employee during the calendar year reached $1 million, the mandatory flat rate withholding was triggered for the pay amounts exceeding $1 million.

This rate is currently 37%. This mandatory flat rate applies regardless of any regular pay and regardless of any Form W-4 factors, including a claim of exemption from withholding.

The aggregate method uses the employee’s Form W-4, Employee’s Withholding Certificate, to compute withholding. It is called the aggregate method because all payments to the employee during the pay period are combined as if they were a single payment for purposes of determining the amount of income tax to withhold.

A supplemental payment may be treated as a separate payment with the taxes computed separately from regular wages under two conditions. Either the optional 22% flat rate is allowed and the employer elects to use it, or the mandatory flat rate applies. If the mandatory flat rate applies, it must be used to compute the withholding on the supplemental wages to which it applies.

Several alternative withholding methods are described in Publication 15-T. These methods are based on the employee’s Form W-4 and are compatible with the aggregate method.

Under current rules, in a week in which an employee receives supplemental pay and no regular pay, an employer can aggregate the supplemental pay with $0 regular pay to determine the total wages for the pay period, unless the mandatory rate applies.

For example, suppose an employee is paid severance pay of $2,000 per semimonthly pay period. The employee receives no other pay. The employee claims single filing status on a 2022 Form W-4 with no dependents or other deductions. Severance pay is supplemental pay by definition.

If the employer uses the aggregate method, the amount of income tax to withhold is $157.36, computed by adding the $2,000 severance pay to $0 regular pay and applying the percentage method tax table to the $2,000 total pay for the pay period. The $0 withholding for regular pay is subtracted from the $157.36 withholding on the aggregate gross pay, leaving $157.36 to be withheld from the $2,000 severance payment.

If taxes were withheld from the employee’s regular pay during the current or immediately preceding calendar year, the employer may elect to use the 22% optional flat rate to compute the amount to withhold. The amount to withhold is 22% of $2,000, which is $440.

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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