Payroll in Practice: 2.26.19

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: What is the best supplemental pay method to use for lump-sum payments, such as bonuses and awards? Is a different method appropriate for stock exercises?

Answer: There is no best method for all circumstances. For example, the optional flat-rate method often is the easiest for payroll to apply when there are multiple payments in a pay period. However, for employees in lower tax brackets, the flat-rate method often withholds too much. For high earners, the method may not withhold enough.

The aggregate method may be easier to use when regular and supplemental pay are combined in the same paycheck. This usually works pretty well with smaller supplemental payments, such as awards or the value of taxable use of employer facilities, or with regular supplemental payments, such as commissions.

For larger amounts, such as a bonuses or stock exercises, the aggregate method treats the total payments for the period as if the employee receives that amount every period during the year and may withhold too much. Using the aggregate method in that situation may lead to an employee’s changing the W-4 in anticipation of the bonus and then back again after the bonus.

The IRS has provided employers with options. The employer may use different methods in different circumstances for different payments and for different employees depending upon the circumstances. In some cases, however, use of a particular method may be restricted or required.

If cumulative supplemental wages paid to an employee exceed $1 million for the current year, the employer must use the mandatory flat-rate method and withhold 37 percent from the gross supplemental pay to the extent the cumulative supplemental wages exceed $1 million. When the mandatory flat-rate method applies, neither the aggregate method nor the optional flat-rate method may be used to compute withholding for any cumulative supplemental wages in excess of the $1 million threshold.

Employers may treat the entire payment that causes the cumulative supplemental pay to exceed $1 million as subject to the mandatory flat rate. For example, a professional athlete is paid a $3 million signing bonus before receiving other payments, regular or supplemental, from the employer, a party related to the employer, or an agent of the employer. The employer is not allowed to use the optional flat-rate method for any part of the payment amount because there no regular pay was withheld.

The default method for the first $1 million is the aggregate method; the mandatory flat-rate method must be used for the $2 million that exceeds the $1 million threshold. The employer has the option to apply the mandatory flat rate to the entire $3 million bonus because the payment caused cumulative supplemental pay for the year for that employee to exceed $1 million.

The aggregate method is the default method and may be used for payments not covered by the mandatory flat-rate method. Under this method, all payments made during the pay period are combined as if they were a single payment and the amount to withhold is computed on the aggregate pay. If there are separate payments, the withholding on the last payment is computed by subtracting any prior withholding for the pay period from the aggregate withholding amount.

There are alternative withholding calculation methods that the employer may choose to use, when otherwise allowed, that are compatible with the principles of the aggregate method, including the:

•percentage method;

•wage-bracket method;

•quarterly average-wage method;

•cumulative wage method, if requested by the employee in writing;

•part-year employment method, if requested by the employee in writing; and

•the special rule when total allowances exceed regular pay.

The optional flat-rate method may only be used if the supplemental pay is separately paid or separately stated in the employer’s records and income tax was withheld from the employee’s regular pay at some time during the current year or the immediately preceding year. The optional flat supplemental rate is 22 percent, which is applied to the gross amount of the supplemental payment. No other percentage is allowed under this method.

If the requirements for using the optional flat rate are not met for a particular employee, the optional flat-rate method is not allowed for that employee. The employer may elect to use the method for other employees. For example, the optional flat rate may not be used to compute withholding on a commission paid to an employee who has been paid on a commission-only basis during the current and immediately preceding calendar years. The withholding from regular pay requirement is not met and the aggregate method must be used unless the mandatory flat rate applies.

In determining which method to use for a particular payment to a particular employee, the employer should first determine that the method chosen is in compliance with the law and regulations. After that, the employer has flexibility to take into consideration which method works best for the employer, the employee, and the payroll department under the circumstances.

--Patrick Haggerty