Managing Payroll Earnings and Deductions Codes

Payroll professionals should use best practices and standardized procedures to effectively manage earnings and deductions codes in their payroll systems, two payroll experts said May 15.

Earnings codes identify the types of wage paid to employees and the taxability of those payments, including whether they constitute regular or supplemental wages, said Lori Carter, director of global payroll and timekeeping for Guidehouse. Deductions codes, on the other hand, note the benefits, taxes, and garnishments that are deducted from employees’ wages, and the codes distinguish between pre-tax and post-tax deductions.

Before using these codes, payroll professionals should test them in their payroll systems to ensure that their tax treatment is correct and that reporting on Form W-2, Wage and Tax Statement, is accurate, she said. Some should also consider creating a “master list,” a catalog of each code and its description, she added. These lists are especially useful for handling the payroll of multiple legal entities, each of which might require a different code setup, she said.

Failure to follow these practices can result in costly payroll mistakes for companies, added Jon Stone, employment tax principal for Ryan, LLC. For example, one of his clients did not set up their deduction codes correctly for employee 401(k) contributions, and the organization discovered the mistake four years after the fact, he said. The mistake caused an underreporting of 401(k) contributions, and the organization spent over $1 million to remedy the situation, which included paying both the employer and employee portion of the contributions owed, he said.

“When you start putting things into context about why this is so important, that’s a big story I always tell,” he said. “Just testing can save you money.”

Carter and Stone spoke at PayrollOrg’s 44th Payroll Congress in Nashville, Tennessee.

Payroll professionals should separately test codes for state and local taxes, since they can differ from the federal tax treatment of wages, Stone said. For example, employee 401(k) contributions are taxable wages in Pennsylvania, Section 125 benefits are taxable wages in New Jersey, and health savings account contributions are taxable wages in California and Philadelphia, even though these are all exempt from federal income taxes, he said.

Visa holders might require unique earnings and deductions codes, Stone said. For example, F-1 student visa holders are exempt from paying FICA tax in the US for the five calendar years from the date of the visa, he said. Businesses hiring F-1 visa holders need to track the FICA exemption, and Stone suggests that they obtain a copy of the visa to know when to update the earnings and deductions codes.

If an employee is working internationally, earnings and deductions code might need readjusting if the employee submits a Form 673, Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911, to the employer, Carter added. The form lets employees claim an exemption from US income tax withholding on wages earned abroad up to a certain annual threshold, she said.

“Managing what that amount is can be challenging because most systems are not set up to track it,” Carter said. “So, you can get creative and set up an accumulator for it.”

Earnings codes can include accumulators, which track an employee’s earnings over a certain period of time, Stone said. They are useful for monitoring items like supplemental wages, which are subject to 37% federal income tax withholding for amounts exceeding $1 million in a calendar year, he said.

Payroll professionals should also determine if any income tax treaties or totalization agreements apply to any international employees working in the US, Stone said. These international arrangements prevent double taxation on employee wages, but some states do not follow them, he warned.

“If you’re bringing somebody into the US, you are paying them, they are covered under an income tax treaty, and you have everything properly documented, look at the state they’re working in,” he said. “You may have to set up a unique earnings code just for them, to exempt them from federal [tax] and have them taxed for state purposes because the state does not follow the federal exemption.”