Payroll in Practice: 4.8.2024

Question: A company is implementing an automated payroll system. What is the order in which deductions are made from employee pay when cash wages are insufficient to cover all the deductions?

Answer: Occasionally, the required deductions from an employee’s pay might exceed the amount of wages being paid, and the employer might not be able to cover all the deductions applicable to a particular wage payment. The order of precedence will vary depending on the type of employer, deductions applicable to the employer, and other factors such as legal requirements, timing, and employer policy.

The US Commerce Department provides an example of the order of precedence from gross pay through its Office of Human Resources Management. The policy includes deductions specific to the federal agency that might not apply to private employers, but the basic format is based on four levels of deductions.

In order of priority the four levels are taxes, court ordered collections, optional benefits, and other optional deductions. The taxes category includes Social Security, Medicare, federal income tax, state taxes, and local taxes.

Specific tax agency rules might further determine the order of precedence. For example, the Internal Revenue Service provides a procedure for employers to use when ranking tax deductions for tipped employees when the taxes on the tips exceed employee the cash wages. In that situation, all taxes on wages, including additional Medicare tax, are deducted before those for tips. Service charges added to a bill or fixed by the employer are not tips.

Social Security and Medicare taxes on the tips are deducted next, followed by federal, state, and local income taxes in that order. If the employer cannot collect all of an employee’s Social Security and Medicare taxes on the tips by the 10th of the month following the month the employee reported the tips, the employer does not have to collect the tax and instead reports the uncollected amounts as an adjustment on the employment tax return and in the appropriate box on employee’s Form W-2, Wage and Tax Statement.

The employer can withhold uncollected federal income tax and additional Medicare tax from future wage payments, when funds are available, until the end of the calendar year. Any uncollected additional Medicare tax is not reported on Form W-2. This procedure applies only to tipped wages.

A similar procedure might apply at the state level for uncollected tax from tipped employees. In California, if an employer is unable to collect personal income tax and state disability insurance from reported tips by the end of the calendar year, the employer reports the uncollected amounts on Form DE 370, Statement of Amount Due From Worker.

When more than one state is involved, it is important to look at state rules for guidance. For example, in the case of a Connecticut resident working in New York, the employer is required to withhold New York tax because it is the state where the employee is performing services.

Connecticut requires employers who are registered for payroll purposes in Connecticut to withhold tax for Connecticut residents who work in other states. However, the employer is required to withhold tax only to the extent that Connecticut income tax withholding exceeds the amount required to be withheld for the state where services are performed. To avoid double taxation on wages earned in other states, Connecticut offers a tax credit for income taxes paid on wages earned while performing services out of state.

Withholding is not always required by the resident state. For example, North Carolina rules say that “to prevent double withholding and to anticipate any allowable tax credit, North Carolina withholding is not required from wages paid to a resident for services performed in another state if that state requires the employer to withhold.”

Court ordered or involuntary collections are generally debts to others that are not controlled by the employer or the employee. These deductions may be limited by an amount allowable under law and precedence may be set by law, in the order received, or as established by the court as in the case of bankruptcy.

This category may include such things as tax levies, child support, alimony, federal student loans and commercial garnishment.

Optional benefits as a group do not have a general order of precedence. However, the employer may set a policy or have compliance requirements specified in plan documents. This category includes such things as insurance premiums including those for health care, dental care, vision care, long term care, and optional life insurance, contributions to qualified retirement plans such as 401(k), 403(b), and pensions, and contributions to heath savings accounts, flexible spending arrangements for health and dependent care, and thrift savings plans.

Other optional deductions generally are last in line. The order within the group is usually a matter of employer policy. This group includes deductions for such things as company loans and advances, union dues, savings bonds, and charity contributions.

This listing is not hard and fast or complete. Certain items in one category might be better placed in a different category. For example, an employer might decide that certain advances or amounts due from employees should be assigned a higher precedence. Under such a policy, travel advance refunds and wage overpayments might head the list of deductions.

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, 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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