Payroll in Practice: 7.5.2022

Question: During a particular workweek, an employee worked 40 hours on the first shift and eight hours on the second shift. The employer pays a shift differential for work performed on the second shift. How does the shift differential affect the regular rate of pay for the workweek?

Answer: A shift differential is extra pay for working during less-desirable hours. Because it is paid for something other than working overtime, it is included in the regular rate of pay for purposes of the overtime pay computation.

A shift differential also does not fall under any of the other statutory exemptions, such as additional pay for work performed on holidays or regular days of rest.

Generally, the regular rate of pay is computed by dividing the sum of all compensation paid for work performed during the workweek by the number of hours the employee worked during the workweek. Amounts of compensation that are excluded by statute from the regular rate of pay are not included in the computation.

For example, assume the employee’s first shift rate is $20 per hour and the shift differential for work performed during the second shift is $3 per hour. During the specified workweek, the employee worked 40 hours at $20 per hour and eight hours at $23 per hour. The employee’s regular pay for the workweek is $984. Under the general rule, the regular rate of pay is $20.50 per hour, which is computed by dividing $984 by the 48 hours worked during the week. The employee is entitled to an overtime (half-time) premium of $10.25 per hour for additional compensation of $82.00.

The use of the half-time method to compute overtime pay is preferable when the regular rate is a blended rate as in the example. A blended rate does not lend itself to a time-and-one-half computation for either of the actual rates paid. The blended rate is a weighted average rate, which is based on the number of hours worked at each rate. The average of the two hourly rates would be computed as half of $20 plus $23 for $21.50.

As an alternative, the employer and employee could agree to compute overtime based on the rate in effect when the overtime was worked. This agreement would have to be made before the work is performed. They would also have to agree on which hours constituted the overtime hours. For example, they could agree that the hours outside the employee’s regular shift comprised the overtime. Alternatively, they could agree that the overtime hours were the hours that exceeded the 40-hour threshold for the workweek.

The employer could also compute the overtime based on the highest regular rate paid during the period. This method would meet the statutory requirement for overtime compensation by providing overtime pay of at least time and one-half the regular rate of pay as computed using the blended rate.

State wage and hour or contract rules might also provide for an overtime premium for excess hours worked during a day or on a special day. For example, state law might entitle the employee to additional compensation for working more than eight hours during a workday or for working on a sixth day in a workweek. In that case, the additional compensation may be counted toward any overtime compensation required to be paid for the workweek.

Question: A tipped employee received tips to the extent that the required tax withholding exceeded the employee’s cash wages. How does the employer handle withholding, tax deposits, and reporting when the cash available to the employer is less than the amount of tax withholding required?

Answer: Withholding on tips can be complicated, in part, by when the employee reports gratuities to the employer. Generally, employees who receive tips of at least $20 during a month must report the total amount to the employer by the 10th of the following month. Sometimes, the reporting can cause a shortfall in the cash available to withhold for taxes.

An employer may require employees to report tips more frequently than once a month. For example, the employer may expect tips to be reported each pay period or each day. However, the periodic tip report may not cover a period of more than one month. The report may be filed using Form 4070, Employee’s Report of Tips to Employer; a substitute form; or an electronic reporting method.

The employer is required to withhold Social Security, Medicare, and federal, state, and local income taxes for both the tips reported during the pay period and the cash wages paid by the employer. The taxes related to the tips may be withheld from the employee’s regular wages or from other funds the employee makes available to the employer for withholding.

The withholding requirement is based on the total tips for the month. If employees are reporting tips by pay period and there are not enough funds available for the employer to cover the employee’s tax withholding for a particular pay period, the employer should not issue a negative paycheck. Instead, the amount of uncollected tax is carried forward to succeeding checks until the employer receives the monthly tip report from the employee by the 10th of the following month.

If at that time there is insufficient cash available to cover the employee taxes for the period, the employer is no longer obligated to collect the full amount.

The employer is to withhold taxes from the employee’s compensation in the following order:

• federal income tax, employee Social Security and Medicare taxes, and state and local taxes from regular wages and other nontip compensation;
• Social Security and Medicare taxes on tips; and
• income taxes on tips.

The employer is to report the total tips along with collected and uncollected Social Security and Medicare taxes on Lines 5b and 5c (and 5d if the additional Medicare tax applies) of Form 941, Employer’s Quarterly Federal Tax Return. The equivalent lines on Form 944, Employer’s Annual Federal Tax Return, are Lines 4b, c, and d. Show an adjustment on Form 941 Line 9 (Form 944 Line 6) for any of the Social Security and Medicare taxes that were not collected.

On the employee’s Form W-2, Wage and Tax Statement, the uncollected Social Security and Medicare taxes are reported in Box 12 with Codes A and B. The employee adds these amounts to the tax liability on Form 1040, U.S. Individual Income Tax Return. Uncollected additional Medicare tax should not be reported in Box 12.

The employer is responsible for the employer’s share of the Social Security tax until the total wages, including tips, exceeds the annual Social Security wage base. The employer is also responsible for the employer portion of Medicare tax on all wages and tips earned by the employee during the year.

The employee might be required to make estimated tax payments to cover the uncollected taxes reported on their income tax return. Also, the employee is responsible for reporting and paying their taxes on any tips that are not reported to the employer, including tips that were not required to be reported because they amounted to less than $20 for a month.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, 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.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.