Payroll in Practice 9.20.2021

Question: There are three withholding methods for supplemental pay: the optional flat rate, aggregate rate, and mandatory rate. My boss doesn’t want to use any of these when taxing commissions or severance but will for bonus payments. I told him the mandatory rate is mandatory when the employee’s supplemental pay reaches $1 million. But, otherwise, must we use either the aggregate or optional flat rate, or can we just use the employee’s Form W-4?

Answer: Reading between the lines, unless bonuses are also paid during the pay period, employees paid by commission or receiving severance pay do not receive other compensation during the pay period. Thus, to your boss, the commission or severance payment looks very much like regular pay so the aggregate method would not apply.

Before the mandatory flat rate was enacted, and in the absence of regular pay, commission payments and severance pay were not considered to be supplemental wages and were treated as regular pay. With passage of the American Jobs Creation Act of 2004, the definition of supplemental pay became very important. Employers had to know when the cumulative supplemental amount paid to an employee during the calendar year reached $1 million, triggering the mandatory flat rate of 37%.

The regulations define supplemental pay as commissions, severance pay, bonuses, fringe benefits, deferred compensation, overtime premiums, tips, and similar items.

Supplemental pay is any taxable compensation that does not qualify as regular pay. Regular pay is paid at a regular hourly rate or another periodic rate such as a day rate or a salary paid on a weekly or other regular period.

Also, before the mandatory flat rate was enacted, if there was no regular pay during a pay period, there could be no supplemental pay.

For example, if a bonus was the only compensation paid to the employee during a given pay period, the bonus was treated as regular pay for withholding. Furthermore, the optional flat rate method could not be used for the bonus unless there was also regular pay from which tax was withheld during the pay period the bonus was paid.

The aggregate method uses the employee’s W-4 factors to compute withholding. It is called the aggregate method because all payments during the pay period are combined as if they were a single payment for purposes of determining the amount of income tax to withhold.

A supplemental payment may be treated as a separate payment with the taxes computed separately under two conditions: (1) the optional 22% flat rate is allowed and the employer elects to use it, or (2) the mandatory flat rate applies. If the mandatory flat rate applies, it must be used to compute the withholding on the supplemental wages to which it applies.

Several alternative withholding methods are described in Publication 15-T. These methods are based on the employee’s W-4 factors and are compatible with the aggregate method.

Under current rules, unless the mandatory rate applies, in a week in which an employee receives supplemental pay and no regular pay an employer can aggregate the supplemental pay with $0 regular pay to determine the total wages for the pay period.

For example, suppose an employee is paid severance pay of $2,000 per semimonthly pay period. The employee receives no other pay. On the 2020 Form W-4, the employee claims single filing status with no dependents or other deductions. Severance pay is supplemental pay.

If the employer uses the aggregate method, the amount of income tax to withhold is $170, computed by adding the $2,000 severance pay to $0 regular pay and applying the percentage method tax table to the $2,000 total pay for the pay period. The $0 withholding for regular pay is subtracted from the $170 withholding on the aggregate gross pay, leaving $170 to be withheld from the $2,000 severance payment.

If taxes had been withheld from the employee’s regular pay during the current calendar year or the immediately preceding calendar year, the employer may elect to use the 22% optional flat rate to compute the amount to withhold. The amount to withhold is 22% of $2,000, which is $220.

Question: A client issues weekly commission “draw” payments to a group of employees, and the payments are taxed on a weekly basis. Their current provider is withholding from their monthly “true-up” commissions based on the monthly tables and not performing aggregate or flat-rate method calculations. The provider claims that the true-up commission payments are like the “no regular payroll period” example under Section 8 of IRS Publication 15, because the payments are not part of the regular weekly payroll period and that using weekly tax tables for monthly payments would not comply with IRS guidelines. Can different pay periods be used for the same employee when the employee receives different types of payments?

Answer: An employee may not have weekly pay periods for regular pay and monthly pay periods for commissions. Congress intended to avoid that situation by establishing the supplemental pay rules.

The method used by the service provider is not an allowable method. It will fail to withhold the correct amount with respect to the employee’s elections on Form W-4, Employee’s Withholding Certificate. The employer could face penalties for failing to withhold and pay over the correct amount of tax.

The service provider is misinterpreting the “no regular pay period” concept. The monthly payment of the commissions is a monthly period that occurs regularly. However, the weekly draw – an advance on the expected monthly commission payment – is more frequent, which makes it the employee’s regular pay period.

Commission payments are supplemental pay, by definition. Based on weekly draw payments with a monthly true-up and the provider’s “no regular pay period” comment, it appears that the employees are paid on a commission-only basis. If there has been no withholding from regular pay during the current or immediately preceding calendar years, the employer may not use the optional 22% flat rate. That would be the case if the employees had been paid only commissions during the current and previous calendar years.

Given commissions with no regular pay, the weekly draw establishes the pay period as weekly. This is because both the employee and the employer, despite any “true-up” at the end of the month, expect that the employee will be able to keep the draw paid against the commissions.

Revenue Ruling 2008-29 provides some insight into how pay periods work when commissions are involved.

The Revenue Ruling describes a scenario, in Situation #3, in which an employee’s only compensation is commissions. The employee is paid a semimonthly draw of $5,000. With the second draw payment of the month, the employee is paid any commissions earned during the month, less the $10,000 draw for the month. However, if the commissions earned during the month are less than the draw, the shortfall reduces the draw payments for the following month. If the employee’s employment terminates, the employee is obligated to repay any draw that exceeds commissions earned.

The IRS states that the pay period is semimonthly. Unless the mandatory flat rate applies, the aggregate method must be used to compute withholding. The optional flat rate may not be used because there has been no withholding from regular pay.

Situation 4 describes a “no regular pay period” situation, which bears no resemblance to the monthly commission payment described by the service provider. In the IRS example, employee D is paid on a commission-only basis whenever the accrued commissions reach at least $1,000.

In the example, on Jan. 13, D has $1,350 in accumulated commissions, and the employer pays the full commission on Jan. 14. On Jan. 31, D has $2,125 in accumulated commissions credited to her account. This is the next day in the calendar year that the amount of commissions credited to her has exceeded $1,000. The accumulated commissions ($2,125) are fully paid on Feb. 1. Because there was no regular pay during the current and preceding calendar years, the optional flat rate cannot be used. The aggregate method must be used, and the tax to withhold is computed using the daily or miscellaneous pay period.

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.