Payroll in Practice: 11.7.2022

Question: A foreign consulate in the US deducts part of the cost of an employee’s health insurance from the employee’s salary. Instead of providing a Form W-2, the consulate gives the employee a letter showing the salary paid for the year and the amount deducted for health insurance. The employee is a US person. Should the employee report the full salary or the salary minus the health insurance cost?

Answer: The employee should report the full salary on their income tax return. Providing the letter instead of a Form W-2 is consistent with tax rules for foreign governments. Foreign governments are not subject to US tax rules including payroll withholding and reporting requirements.

The full salary includes the amount deducted for the employee’s share of the health insurance. The general rule that employer-provided health care paid for by the employer is excluded from gross wages still applies and the foreign government’s share of the health insurance premium is not included in the employee’s income.

Special tax rules apply for employees working for a foreign government or specified international organizations located in the US. The compensation paid for their services is not considered wages for either income tax or Social Security and Medicare tax purposes.

The employee is to follow special rules for reporting their compensation and paying taxes. The rules vary depending on whether the employee is a US citizen, a dual citizen, a lawful permanent resident with a green card, or a foreign citizen without a green card.

US citizens working in the US report compensation for work performed in the US as wages on Form 1040, US Individual Income Tax Return. They also pay self-employment tax on the compensation. This tax is computed on Schedule SE, Self-Employment Tax, and is reported on Form 1040.

Although these employees are subject to self-employment tax, the employees are not considered self-employed for any other federal tax purpose. For example, they may not deduct unreimbursed expenses as business expenses and are not qualified to establish Simplified Employee Pension plans.

If these employees owe taxes at the end of the year, estimated tax payments may be made using Form 1040-ES, Estimated Tax for Individuals, or through the IRS website. Failure to make required estimated tax payments may lead to penalties. Payments should be adequate to cover the income tax and self-employment tax amounts.

Dual citizens are generally subject to the same rules as US citizens. However, dual citizens working for a foreign government are exempt from US social security taxes if they are also a citizen of a country with which the US has a bilateral social security agreement, other than Canada or Italy.

Green-card holders generally are subject to the same tax rules as US citizens but are not subject to the self-employment tax and may not voluntarily pay self-employment tax on their earnings. Estimated tax payments need only cover the income tax obligation.

Foreign citizens without a green card who are working in the US for a foreign government or international organization are generally exempt from US income tax and self-employment tax on compensation. Exemptions can be found in Section 893 of the Internal Revenue Code, tax treaties, consular agreements, or international agreements. Such workers should check with their embassy to determine if exemptions apply.

This tax exemption does not apply to a foreign citizen’s US-sourced income from any other US source, and they are generally subject to US income tax on such income. However, other tax treaty exemptions may apply to some types of income, which may include interest, dividends, rents, and royalties. Income subject to US income tax is reported on Form 1040-NR, US Nonresident Alien Income Tax Return, and estimated payments may be required.

Question: In the case of a $1,000 salary reduction for a SIMPLE plan contribution, is the contribution amount $1,000 or the net amount of $923.50 after FICA taxes are withheld?

Answer: The deposit to the plan must be the full amount of the salary reduction, in this case $1,000.

SIMPLE stands for Savings Incentive Match Plan for Employees. Under a SIMPLE plan, employees can choose to make salary reduction contributions to the plan while the employer contributes matching or nonelective contributions.

Employer contributions may be deducted as business expenses by the employer and are not included in employees’ gross income. Employee salary-reduction contributions are not subject to income tax withholding but are subject to Social Security, Medicare, and federal unemployment taxes.

When an employee makes a salary reduction of $1,000, the amount deposited into the plan must be $1,000. Otherwise, the contribution is reduced by the tax withheld, and the employee contribution becomes $923.50. The other $76.50 was used to pay the tax rather than being contributed to the plan. It remains taxable for income tax purposes and is not part of the exempt salary reduction.

Social Security and Medicare tax are assessed on the employee’s gross pay before the salary-reduction contributions are made. For example, it is not possible for an employee to defer 100% of a bonus payment because FICA tax must be withheld before the contribution can be deposited in the plan. SIMPLE contributions reduce taxable income for income tax purposes and net pay, while FICA deductions only affect net pay.

For example, an employee is paid $3,000 and contributes $1,000 to a SIMPLE plan. Assume the only deductions are the SIMPLE contribution and FICA taxes. FICA tax is based on $3,000 for a deduction of $229.50 ($3,000 x 7.65%). Taxable pay for income tax purposes is $2,000 ($3,000 - $1,000). Net pay will be $1,770.50 ($2,000 - $229.50) minus any income tax on $2,000.

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, N.C., 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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