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: For a lump-sum severance payment paid at the same time as regular pay, which method should be used to compute the withholding--the aggregate method or the supplemental flat rate method?
Answer: The optional 22% flat-rate method may not be used unless an employer withheld tax from an employee’s regular pay at least once during the current or preceding year. Otherwise, the employer may choose the withholding method as long as the 37% mandatory flat-rate method does not apply. The 37% mandatory flat rate only applies if the employee’s cumulative supplemental pay for the current year exceeds $1 million.
For a lump-sum severance payment, depending on the employee’s usual withholding bracket, the optional flat rate may withhold an amount closer to the employee’s actual tax liability. The aggregate method would treat the entire lump-sum payment as paid during a single pay period and may withhold more than necessary.
For example, an employee who was paid $3,000 semimonthly is terminated June 30. A lump-sum severance of $36,000 is paid, which equals half his annual salary. The employee’s Form W-4, Employee’s Withholding Allowance Certificate, claims married with three allowances. The lump sum is paid during the same period as the last regular pay. As of June 30, the employee’s year-to-date earnings would total $72,000.
Withholding on regular pay is $221.80 a pay period and the June 15 year-to-date withholding would be $2,439.80 ($221.80 x 11 pay periods). The June 30 payment would be $39,000: 12 pay periods of severance at $3,000, totaling $36,000, plus the June 30 regular salary of $3,000.
Withholding on the aggregate amount of $39,000 (married, semimonthly, three allowances) is $11,476.37. The $221.80 regular pay withholding is subtracted from that total and the withholding on the severance is $11,254.57. Total withholding as of June 30 is $2,439.80 for the year-to-date amount through June 15, plus $11,254.57 for June 30, for a total of $13,694.37 withheld on total earnings of $72,000.
Withholding on the $36,000 severance at the 22% optional flat rate is $7,920. Total withholding as of June 30 is $2,439.80 for the year-to-date withholding through June 15, plus $221.80 for June 30 regular-pay withholding, and $7,920 withheld on the severance. Total withholding: $10,581.60.
For comparison purposes, the semiannual table can be used to compute withholding on the $72,000 that is paid semiannually, totaling $9,014.50. This amount may still seem to be too much to the employee because it assumes the worker would make the same amount during the second half of the year. Having extra withholding may be financially advantageous if the employee also is going to receive income in the second half of the year, such as unemployment benefits, that may not have enough withheld otherwise.
There is an alternative method that the employer may choose to use if the employee requests the option in writing. However, the method is still the employer’s choice even if the employee makes the request. This cumulative-wage method is described in IRS Publication 15-A, “Employer’s Supplemental Tax Guide.”
Under the cumulative-wage method, the current payment is added to all previous payments during the year, in this case $39,000 + $33,000 = $72,000. The average wage for each period is determined by dividing the total wages by the by the number of pay periods for the year to date including the current period. In this case, the $72,000 in wages is divided by 12 the semimonthly pay periods through June 30 to get $6,000 for each pay period.
The withholding on $6,000 paid semimonthly (married, three allowances) is $751.20 withholding for each period. The $751.20 is multiplied by 12 pay periods for total required withholding through June 30 of $9,014.40. The $2,439.80 withheld through June 15 is subtracted from the total required amount, leaving $6,574.60 to withhold from the $39,000 payment on June 30.
If the severance had been paid over the remaining 12 pay periods during the year, rather than in a lump sum, the total required withholding for the year would have been $5,323.50. Using the annual table, the required withholding on $72,000 for the year is $5,324.00. This is not an allowable method to determine the amount to withhold from a lump sum payment.
The employer has the choice as to which method to use. The optional flat rate is the easiest to apply. For lump sum distributions, the optional flat rate method is reasonably accurate for employees with earnings falling in or around the 22% tax bracket. However, for lower income employees, it generally withholds too much and for higher income employees, it does not withhold enough.
The aggregate method generally causes too much withholding for most employees, except those in the highest tax brackets. The cumulative wage method, while probably the most accurate from the employee’s standpoint, involves more work for payroll, requires employee consent and uniform pay periods during the year. The method used is up to the employer so long as the conditions for the chosen method are met.
Question: Some former employees are receiving back pay. Are these payments subject to the supplemental pay rules?
Answer: Payment of back wages to former employees is considered supplemental pay because it is not regular compensation for the current pay period.
If the back wages were paid to employees who had income tax withheld from regular wages this year or last year, you may have the option to use the optional 22% flat-rate method to compute withholding. The flat rate is applied to the gross supplemental wages.
If no income tax was withheld for an employee within the two-year period, the aggregate method must be used to determine income tax withholding. This could occur because the employee did not work for the employer during that time or the employee had no regular wages. An example of this is where an employee was paid on a commission only basis.
Under the aggregate method, use information from the former employee’s last valid Form W-4, Wage and Tax Statement, and the pay period from when the employee worked for the company. Any regular pay for the current period, which is probably zero, would be added to the supplemental pay to determine the withholding.
For example, a former employee is awarded $5,000 in back pay, has no current wages, claimed married with three allowances on the last valid Form W-4, and had been paid using a biweekly payroll period. Combine the regular pay of zero for the current period with back pay of $5,000 for total pay for the pay period of $5,000. Compute the withholding based on married with three allowances using the biweekly payroll tables.
If the cumulative supplemental pay for the current year for an employee exceeds $1 million, then the mandatory flat-rate method would apply to the amount exceeding $1 million for that employee. If that is the case, the optional flat-rate method or aggregate method may be used for the first $1 million of supplemental wages the employee received during the year and the mandatory flat-rate method of 37% must be withheld from any excess cumulative supplemental pay exceeding $1 million.
By Patrick Haggerty
Do you have a question for Payroll in Practice? Send it to firstname.lastname@example.org.