Payroll in Practice: 4.17.2023

Question: An employee who normally has no withholding from regular pay receives a profit-sharing bonus every quarter. The normal procedures for calculating withholding from supplemental pay have us withholding far more than the employee is expected to owe. Is there any way to withhold less on the bonus payments?

Answer: There is a special rule that lowers the high rates of withholding on supplemental pay for employees who do not qualify for an exemption from withholding but have no tax withheld from their regular pay. Regulation 26 CFR 31.3402(g)-1(b) describes this special rule, which provides relief when the aggregate withholding exemption exceeds wages paid.

IRS Publication 15, (Circular E) Employer’s Tax Guide, summarizes the three primary methods of computing withholding from supplemental wages described in regulation 31.3402(G)-1(a). The three methods are the mandatory flat rate method, the aggregate method, and the optional flat-rate method.

The mandatory flat rate withholds 37% of cumulative gross supplemental wages to the extent the cumulative supplemental wages paid to the employee during the calendar year exceed $1 million. No other withholding method may be used with respect to wages for which this method applies. The mandatory flat rate applies regardless of any claims on the employee’s Form W-4, Employee’s Withholding Certificate, including a claim of exemption from withholding.

The aggregate method combines the employee’s supplemental and regular wages for that pay period, or the immediately preceding pay period, and computes the withholding on the combined amount as if it were a single payment. The amount to withhold from the supplemental wages is the difference between the withholding for the total pay period wages and the amount withheld from the regular pay. The aggregate method is the default method for supplemental pay unless the mandatory flat rate applies to the wages.

The optional flat rate method may be used only if the supplemental wages are paid or recorded separately from regular wages and income tax has been withheld from regular pay at some time during the current or immediately preceding calendar year. The amount to withhold under this method is 22% of the gross supplemental pay. No other percentage may be used. Like the aggregate method, this method may not be used if the mandatory flat rate applies to the supplemental wages.

The special rule described in 26 CFR 31.3402(g)-1(b) has not been described in Publication 15 even for years prior to the suspension of tax and withholding exemptions under the Tax Cuts and Jobs Act of 2018. This special rule may be elected when an employee’s “aggregate withholding exemption exceeds the wages paid.” This occurs when the employee’s regular pay for the pay period is less than the threshold for the first tax bracket for the employee’s filing status.

The employer may elect to use the special rule when the supplemental pay covers two or more consecutive pay periods, the pay period is not less than one week, the employee receives other wages during the pay periods, and no income tax is withheld from the regular pay because the threshold for the lowest tax bracket exceeds the adjusted regular pay.

To determine the amount to withhold, the employer must first determine the average wage for each pay period by adding together the regular pay and supplemental pay for the pay periods and dividing that sum by the number of pay periods. Next, the employer must determine the withholding amount based on the average wage per pay period, multiplying the withholding amount by the number of applicable pay periods. The amount to withhold from the supplemental wages is the amount of tax remaining, if any, after tax is withheld from the regular pay.

For example, on Form W-4, Employer’s Withholding Certificate, an employee selects “married filing jointly” in Step 1 and claims a credit of $500 for “other dependent” in Step 3, amounting to $20.83 per semimonthly pay period. During a particular quarter, the employee receives a semimonthly salary of $1,200 during each of the six pay periods in the quarter for a total of $7,200 in regular wages. The employee also receives a $3,000 quarterly bonus, raising the aggregate income for the quarter to $10,200. The average bonus is $500 per semimonthly pay period. The semimonthly and married table in Section 4 of Publication 15-T, Federal Income Tax Withholding Methods, was used for all computations.

Using the Percentage Method Tables for Manual Payroll Systems With Forms W-4 from 2020 or Later found in 2023 Publication 15-T, Federal Income Tax Withholding Methods, the standard withholding for a semimonthly salary of $1,200 is 10% of the amount in excess of $1,154. For the employee in this example, that leaves $46 subject to the 10% tax rate, which is $4.60 per pay period. Since the employee claims a $20.83 semimonthly dependent credit, that amount must be subtracted from $4.60, resulting in $0.00 being withheld from regular pay.

Because no income tax is withheld from regular pay, the employer can use the special rule under 26 CFR 31.3402(g)-1(b). Since the employee’s total amount of earnings for the quarter is $10,200 and there are six pay periods in the quarter, the average wage per pay period is $1,700 ($10,200 ÷ 6). Based on the same tax table used in the above paragraph, the amount to withhold on the $1,700 per pay period is 10% of the amount exceeding $1,154, or $54.60. Subtracting the $20.83 dependent credit from $54.60 results in $33.77 in withholding for each pay period, or $202.62 for the quarter.

In comparison, the employer would have to withhold $660 from the quarterly bonus using the 22% flat rate ($3,000 × 0.22) and $326.35 using the aggregate method. The aggregate method calculation is based on the same tax table used in the above paragraphs.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, 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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