Payroll in Practice: 12.19.2022

Question: An employer wishes to gross up the taxes on holiday bonus checks. How is the gross-up tax rate determined under the supplemental pay rules?

Answer: Assuming the 37% mandatory flat supplemental rate does not apply to the holiday bonus, two methods are prescribed for computing withholding on supplemental wages: the aggregate method and the optional 22% flat rate method. Of the two, the optional 22% flat rate is easier to use but is not always an option.

The aggregate method uses the graduated tax tables and factors from the employee’s Form W-4, Employee’s Withholding Certificate. When using the aggregate method, graduated income tax rates make it difficult to determine the rate to use in a gross-up formula. The employer must determine the marginal tax rate or rates to be applied to the bonus, and this may involve computing the gross-up in steps if the gross-up crosses a tax bracket threshold.

Using the optional flat-rate method, the gross up formula is:

Gross Pay / [1 – (federal income tax rate + Social Security tax rate + Medicare tax rate + state income tax rate)] = Grossed-Up Pay

For example, assume an employer wants to gross up taxes for a $500 bonus for an employee whose pay does not exceed the Social Security wage base. Using the optional federal flat rate of 22%, a state income tax rate of 5%, and a FICA tax rate of 7.65%, the filled-in formula is $500 / [1 – (0.22 + 0.0765 + 0.05)] = $765.11.

To check the math, subtract the taxes from the grossed-up pay. The $765.11 gross bonus minus $168.32 (22% federal income tax rate), $58.53 (7.65% FICA), and $38.26 (5% state income tax rate) leaves $500 in net pay.

The optional flat rate may not be used for a given employee unless income tax has been withheld from the employee’s regular pay sometime during the current year or the preceding year.

The optional flat rate also may not be used if an employee did not have any regular pay during the applicable years, such as a sales representative compensated solely by commissions.

Determining each employee’s federal income tax rate to use in the gross up formula is more difficult under the aggregate method because of the graduated income tax rates. This is also an issue for states with graduated income tax rates. The problem is compounded in this case because only part of the aggregated payment, the bonus, is being grossed up.

If not grossing up the bonuses, the aggregate method could be used to compute the amount of tax required to be withheld on the combined amount by adding the bonus to the regular pay for either the current pay period or the immediately preceding pay period . The amount of tax attributable to the bonus is the difference between the withholding for the combined amount and the withholding for the regular pay.

However, if taxes were not withheld from the bonus, under this method the taxes for the bonus would have to be withheld from the regular payment for the pay period. Late penalties might apply if the two payments do not have the same deposit due date. The tax attributable to the bonus must be deposited on the deposit due date for the date the bonuses are distributed. This might be different from the deposit due date for the regular payroll.

For example, assuming a semimonthly pay cycle and a biweekly deposit schedule, the regular December pay dates might be Dec. 15 and 30. If the bonuses are to be distributed on Thursday, Dec. 22, the deposit due date for the bonus would be Wednesday Dec. 28. Waiting to withhold and deposit the taxes on the regular pay schedule would cause a late deposit. The employer could deposit the tax on Dec. 28 and withhold the tax from the Dec. 30 wages on a catch-up basis.

Question: An employer offers both a dependent care flexible spending arrangement and occasional free on-site dependent care services for employees. An employee elected a $4,500 salary reduction contribution to the FSA. The administrator accidentally paid $4,700 in reimbursement to the employee. In addition, the employee used $1,500 worth of services from the on-site dependent care facility. How is the value of dependent care reported on Form W-2?

Answer: A dependent care FSA is a written plan offered to employees through a cafeteria plan. Under such plans, employees elect to have their salary reduced to fund the plans and then withdraw funds from the plans to pay for qualifying benefits.

The limit for exclusion from income for employer-provided dependent-care assistance is $5,000, or $2,500 for employees who are married and filing separately.

Any dependent-care assistance provided exceeding the limit is included in the employee’s gross income. Employees may elect to reduce their salary up to $5,000 ($2,500 for married filing separate) under an FSA in a cafeteria plan. The amount would count as employer-provided dependent-care assistance.

An employer also may help in addition to the spending arrangement. For example, the employer might contribute to the FSA or provide free or discounted childcare. If the value of the employer-provided dependent care exceeds $5,000, the excess is included in the employee’s gross income.

The employer reports the total amount of employer-provided benefits in Box 10 of Form W-2, Wage and Tax Statement. In the case referenced in the question, the employer would report $6,200, which includes the $4,700 reimbursement plus the $1,500 fair market value of the on-site care. The employer will include the $1,200 excess over $5,000 on Form W-2 Line 1 – Wages tips and other compensation, Line 3 – Social Security wages, and Line 5 – Medicare wages and tips.

The $200 excess payment over the $4,500 employee contributions to the flex spending arrangement is considered an employer-provided benefits. The onsite care is valued at the fair market value of the services minus any amount the employee pays for the service.

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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