Payroll in Practice: 9.11.2023

Question: An employer is making a lump-sum payment from a supplemental executive retirement plan to a retired former employee. Should the payment be treated as ordinary income or supplemental wages for tax and withholding purposes?

Answer: Payments from a supplemental executive retirement plan (SERP) are a form of nonqualified deferred compensation and are wages for income and employment tax purposes. Because deferred compensation payments are usually made after the employee has retired, the payments are considered “trailing compensation” for state income tax and withholding purposes.

Trailing compensation is generally taxable in the state in which it was earned instead of the state where the employee resides at the time of payment. However, certain payments of deferred compensation paid out over at least 10 years are treated as payments like those made under a qualified plan and are not considered trailing compensation. A lump-sum payment does not qualify for this 10-year exception.

The term supplemental pay covers three wage categories: regular wages, supplemental wages, and wages that are neither regular wages nor supplemental wages. The latter category includes wages that are exempt from income tax withholding and wages that are exempt from income tax. “Ordinary income” is not a payroll withholding concept.

Ordinary income is a category of income that is subject to income tax on the taxpayer’s personal tax return at ordinary income tax rates instead of certain special rates, such as capital gains rates. Examples of ordinary income include wages, self-employment income, interest, gambling winnings, rent payments and retirement distributions.

Because SERP payments are essentially wages, the recipient cannot apply the more favorable capital gains rates to the distribution, even though the SERP may have been invested in securities that are held for more than a year.

Deferred compensation is also considered a supplemental wage. Payments are subject to the supplemental pay withholding rules even in the absence of regular pay during the payment period. The optional flat rate of 22% of the gross supplemental payment may be used only if the payee had income tax withheld from regular wages at some point during the year of the payment or the preceding year.

For example, consider an employee who retired in 2021. For a 2023 distribution, there could not have been any withholding from regular pay during 2022 or 2023, and the employer may not elect to use the 22% flat rate.

Where the optional flat rate is not allowed or is not chosen by the employer, the aggregate method applies. Under the aggregate method, the lump-sum payment is combined with any other payments made during the payroll period and withholding is computed for the combined amount using the employer’s usual withholding method or one of the allowable alternative methods.

The employer should use the latest effective Form W-4, Employee’s Withholding Certificate, provided by the employee. There is nothing that prevents an employee from providing a new W-4 in anticipation of the SERP payment.

If the SERP distribution is the only amount paid during the pay period, the aggregate amount is the amount of the lump sum payment. The employer may use either the payroll period that was used for the employee while they were employed or the payroll period currently being used for regular wage payments. For example, if the employee was paid on a semimonthly basis, the payroll period for computing withholding from the lump sum payment is semimonthly.

However, there is nothing that prevents the employer from electing to use an alternative withholding method, such the cumulative wage method, to compute the withholding for the lump-sum payment.

If the payee’s cumulative supplemental pay for the current year exceeds $1 million, the mandatory flat rate of 37% applies to the cumulative gross supplemental pay exceeding $1 million. Either the aggregate method or the optional 22% flat rate, if allowed, may be used for the amount under the $1 million threshold. Neither of those methods may be used to compute withholding on amounts over the $1 million threshold.

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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