Payroll in Practice: 10.3.19

Practitioners’ questions are answered by a payroll and tax consultant who also is an enrolled agent licensed to practice before the Internal Revenue Service.

Question: Our company is a semiweekly depositor. We received a penalty notice for late deposit of payroll taxes for the fourth quarter of last year. This was because deposits for several off-cycle payments, including bonuses and termination checks, were held until the regular due dates. Is there anything we can do to minimize or eliminate the penalty, which is sizable?

Answer: There are some ways to possibly mitigate the penalty. The first is to consider establishing reasonable cause. The Internal Revenue Service may waive the penalty if the error was because of reasonable cause. If that does not apply, your company may qualify for a first-time abatement. You also may be able to reduce the amount of the penalty by designating the periods to apply the deposits.

The amount of a late deposit penalty depends on how soon the late funds are deposited. The penalty is 2% of the late amount for deposits one to five days late, 5% for deposits six to 15 days late, and 10% for deposits late by 16 days or more. However, the deposit must be made before the 10th day after first IRS notice asking for the tax deposit. The penalty is 15% for amounts unpaid more than 10 days after the first notice or, if earlier, the day that a notice and demand for payment is received.

First, request a penalty waiver when claiming a reasonable-cause defense. In this case, the worst that can happen is a waiver denial from the IRS. The penalties do not apply if the failure to make a proper and timely deposit stemmed from reasonable cause and not willful neglect. The IRS also may waive penalties if the taxpayer inadvertently failed to deposit in the first quarter as required or in the first quarter that the taxpayer’s frequency of deposits changed, as long as the taxpayer timely filed the employment tax return.

In requesting the waiver, describe what happened, including any unusual circumstances. A good record of compliance helps, so mention that if it applies. Additionally, note efforts that are underway to ensure deposit compliance.

The request can be made in a written response to the notice or by calling the IRS. Use the address and phone number listed on the notice, along with the notice’s reference number.

Ensure that the person calling the IRS has the appropriate authorization to discuss the matter with the agency. The caller may need to be an officer authorized under Form 2848, Power of Attorney and Declaration of Representative. Part 2 of the form requires an authorization code, such as “d” for corporate officer or “e” for full-time employee. Be prepared to fax the form to the IRS at the time of the call.

If reasonable cause cannot be established, the company may qualify for administrative relief under the IRS first-time penalty abatement policy. This can be requested if the company did not previously have to file a return, such as Form 941, or had no penalties for the three years before the tax year that the penalty was received, the company has filed all required returns or timely extensions, and any tax due has been paid, or an arrangement to pay has been made.

If penalties still apply, IRS Revenue Procedure 2001-58 describes how to designate the periods to apply tax deposits to minimize late-deposit penalties. The procedure is intended to prevent cascading penalties when a single deposit is underpaid, but it might prove helpful for the situation you describe. This designation must be made within 90 days of the penalty notice date. Instructions for this procedure accompany the notice.

The IRS usually applies a deposit to the most current liability, however, when a deposit is made before a liability due date, it may be applied to the most recent earlier unpaid liability. This can cause the liability the deposit was intended to cover to become unpaid and cascading penalties on several liabilities not limited to the single underpayment.

Question: An employee was given a bonus while on unpaid leave. Her pretax medical account was in arrears and our payroll software program deducted the liability from the bonus. The program applied the optional flat rate to the gross amount of the bonus after subtracting the pretax deduction. IRS Publication 15 does not mention pretax deductions in the section on supplemental-pay withholding and we want to make sure the subtraction is allowed. Is this subtraction allowed or should the withholding be on the entire bonus?

Answer: Based on your question, it appears the deduction for medical was a qualified pretax deduction under a cafeteria plan. That is, that under the plan, the deduction for the medical may be withheld from the bonus as well as regular pay and there is no other requirement that the employee payments for medical, while the employee is on leave, must be made with after-tax dollars.

While IRS Publication 15, (Circular E), Employer’s Tax Guide, does not specifically mention pretax deductions, the regulations cover the subject. Under the supplemental wage rules, there are three types of wages: regular wages, supplemental wages, and wages that are neither regular wages nor supplemental wages.

The wages that are neither regular nor supplemental include two types:

--those that are subject to tax but are not subject to withholding, for example, excess group-term life insurance coverage, and

--those that are not subject to tax, for example, pretax medical and Section 401(k) plan salary reduction contributions.

The Code of Federal Regulations discusses salary reduction deferrals with regard to the determination whether an employee has been paid $1 million in supplemental wages, which would trigger the application of mandatory flat-rate withholding. The regulations require that employers allocate deferral amounts to the type of deferred compensation. For example, when regular wages and bonuses are subject to deferral under the employer’s plan, the deferral must be allocated appropriately between the regular wages and the bonus, according to the plan provisions.

Because pretax medical is not subject to income tax because it is a fringe benefit that qualifies for exclusion from wages, it is not subject to income tax withholding. This includes supplemental wage withholding even though it was deducted from what are otherwise supplemental wages. That is, there should not be any income tax withheld for the amount deducted for medical expenses.

The expense also is not subject to withholding when mandatory flat-rate withholding applies to the supplemental wages. This is different from the rule that the mandatory flat rate applies even if the employee has claimed exempt from withholding on Form W-4, Employee’s Withholding Allowance Certificate. That exemption is mentioned as not effective with regard to supplemental wages subject to the mandatory flat rate.

For more information, see the Federal Code of Regulations, Title 26, Section 31.3402(g)-1(a)(1)(iii), supplemental wage payments.

By Patrick Haggerty

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.