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Payroll in Practice: 11.5.19

Nov. 5, 2019, 2:49 PM

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: Several employees who are eligible to participate in our 401(k) plan did not make contributions, although the retirement plan check box in Box 13 of their W-2 was checked. One of the employees asked that we correct the form. Are we required to make a correction?

Answer: You may be required to correct the check box if the employees were not active participants in a retirement plan. However, it is possible that they were active participants even though they did not make contributions. If funds are added to an employee’s account during the year, such as by the employer, the employee is an active participant.

If an account received additional fund during the year, the Forms W-2, Wage and Tax Statement, are correct with the box checked. If not, then the W-2 should be corrected.

An inaccurate check-box entry may affect the employee’s ability to prepare a correct individual income tax return. If the box is checked for an employee who was not an active participant, the amounts of contributions and tax deductions may be limited or denied in error for the employee or employee’s spouse.

If the box is not checked and the employee was an active participant, the employee or spouse may have made disallowed contributions to an individual retirement account or claimed excess deductions.

A Section 401(k) plan is a defined-contribution plan. Form W-2 instructions state: “Generally, an employee is an active participant if covered by (a) a defined benefit plan for any tax year that he or she is eligible to participate in or (b) a defined contribution plan (for example, a section 401(k) plan) for any tax year that employer or employee contributions (or forfeitures) are added to his or her account.”

If an employee did not make any contributions in a particular plan year, the box still needs to be checked if the employer made any contributions or if forfeitures were added to the employee’s account.

Generally, forfeitures are funds left in the employer’s 401(k) plan after an employee leaves a company and unvested funds are forfeited to the worker. Noninvested funds come from employer contributions, not from employee salary deferrals.

For example, many employers make employer contributions, matching or otherwise, to their 401(k) plans. Such contributions, when added to an employee’s account, make the employee an active participant. Although employee contributions are vested immediately, employer funds may have a vesting period, which precluded the employee from owning the funds for a period of time. In many cases, such a policy is intended as an incentive for the employee to remain with the company.

In leaving the company, the employee may withdraw or rollover vested funds. However, funds that are not vested are removed from the employee’s account but remain in the employer’s plan. Generally, subject to the plan provisions, forfeited funds must be used up by the end of the plan year or the following plan year. The plan may provide that they be used to pay allowable plan expenses or reduce employer contributions, or they could reduce or add to employer contributions to worker accounts.

For example, an employer might decide to make a profit-sharing contribution. This contribution is allocated to all eligible employees, even if they did not have deferrals that year. In one case, an employer plans a $50,000 profit-sharing contribution and has $10,000 of forfeitures in the plan. The employer may make a contribution, and take a corresponding tax deduction of $50,000 to the plan and add the forfeitures to the allocation, bringing the total to $60,000 allocated to employee accounts.

Alternatively, the employer could make a contribution and take a corresponding tax deduction of $40,000 and use the forfeitures to bring the total allocation to $50,000. Note that the $10,000 was previously deducted by the employer as plan contributions and is not an additional employer contribution. It is simply a reallocation, but that reallocation increases the accounts of the employees remaining in the plan.

In either case, employees who did not make salary deferral contributions are considered to be participating in the plan because of employer contributions or reallocations.

The plan administrator or trustee should be able to provide information as to whether additions were applied to specific employee accounts.

Another reason the employer should make sure the Forms W-2 are correct is that an employer may be penalized for failure to furnish a correct W-2 to the employee. The employer also may be penalized for filing an incorrect W-2 with the Social Security Administration. The full penalty of $270 for each incorrect form may apply for each of the two penalties.

Although there are several exceptions to the penalty, only two--the reasonable cause exception and first-time abatement--have potential to meet the requirements for abatement or waiver. The inconsequential error or omission and the de minimis dollar exceptions would not apply for a check-box error. The de minimis number of incorrect statements exception would not apply for 2019 because the corrections must have been made before August.

Question: Our company uses the 22% flat rate to withhold tax on supplemental pay. Some of our employees, in response to reduced refunds under the new tax law, are electing to have additional tax withheld from their paychecks. We are soon to start paying annual bonuses. Should we withhold this additional tax on the bonus payment in addition to the 22% flat rate?

Answer: When applying the optional 22% flat-rate method, do not withhold the additional amount from supplemental wage payments. The correct amount to withhold is 22% of the gross supplemental income tax wages.

Under the optional 22% flat-rate method, the only W-4 condition that applies is claim of exemption from withholding. In that case, do not withhold anything from the bonus.

Regulation 31.3402(g)-1(a)(7)(ii) states that withholding under the optional flat-rate method is made without reference to regular wages, the number of withholding allowances claimed by the employee, and whether additional withholding was claimed on Form W-4, Employee’s Withholding Allowance Certificate.

A similar rule applies if the supplemental payment is subject to the mandatory flat rate.

The mandatory flat rate applies when a payment causes the employee’s cumulative supplemental wages for the year to exceed $1 million. The employer is to withhold 37% of the gross supplemental pay that exceed $1 million without regard to any claims on Form W-4, including exempt status.

If an employee claimed exempt status on Form W-4, the exemption applies and no tax is withheld from supplemental pay unless supplemental pay for the year exceeds $1 million. Then the employer must withhold 37% of the cumulative gross supplemental pay that exceeds $1 million.

The additional amount generally is withheld from regular pay for the pay period and not from any supplemental payment made during the same period. When the employer uses the aggregate method, the amount to withhold is the total computed amount, including the additional withholding, less any amount previously withheld during the pay period, including the additional withholding.

The only time the additional amount might be withheld from supplemental pay is when the employer uses the aggregate method and the supplemental pay is the only amount paid during the pay period.

For example, an employee is paid commissions on a monthly basis, which is the only compensation the worker receives. No other compensation was received during the current and previous years, so the employer must use the aggregate method. In this case, the commission is the aggregate pay for the compensation period. The amount to withhold from the aggregate pay is the table amount plus the additional withholding.

By Patrick Haggerty

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

To contact the reporter on this story: Patrick Haggerty at phaggerty@prodigy.net
To contact the editor on this story: Michael Trimarchi in Washington at mtrimarchi@bloombergtax.com