Understanding Overpayments Involves Legal, Tax Considerations

Employers that accidentally overpay employees must consider possible legal restrictions to recovering overpayments and how repayments will affect employment taxes, two payroll experts said May 8.

“Doing nothing at all is the easiest [solution], yet completely compliant,” said Gretchen Inouye, Payroll Manager for The Smith Center for the Performing Arts. The overpayment amount is simply treated as regular wages for tax purposes. “If we overpay an employee, there is absolutely no legal obligation for us to get the money back.”

However, if an employer decides to recover the amount of the overpayment, it must consider the laws of the employee’s work state, she said at PayrollOrg’s 42nd Payroll Congress. For example, some states require employee authorization or notification, limit the amount of money that may be deducted from employee pay, or prohibit certain methods of recovery.

Some portions of overpayments, such as employee contributions to 401(k) plans, are also simply not recoverable, she added. An employer might be able to able to recover the employer portion of a retirement contribution under certain circumstances, however.

“You really need to have a good relationship with your retirement department and understand those programs and plans and how they work,” said Karen Ward, Payroll Compliance and Education Consultant for Spanish Oak Solutions, LLC. “You always have to look at the [retirement] plan.”

Employers might want to consider having employees repay the amount over time instead of through a lump sum. Doing so could help reduce financial hardship for employees, although employers should beware any state laws that place time restrictions on how long employers can attempt to recover overpayments, Ward advised.

Extending an employee’s repayment over time can also create tax complications, she said. Unless an employee completely repays the employer in the same calendar quarter in which the overpayment occurred, the employer will need to file a federal Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return. If the repayment continues through multiple tax years, the employer will also need to issue a Form W-2c, Corrected Wage and Tax Statement, to the employee.

An employer can offset the net amount of an overpayment from an employee’s wages during the year in which the overpayment occurred, Ward said. This will reduce the employee’s gross income for the year, and the employer can apply a credit to the employee’s withheld income, Social Security, and Medicare taxes that were attributable to the overpayment.

If a repayment occurs in a subsequent year, however, the employee should repay the gross amount of the overpayment, which includes any federal or state income taxes, she said.

“If they repay us in a subsequent year, the employee was in constructive receipt of the overpayment in the year in which they received it,” Ward said. “If they repay that in a subsequent year, we do not reduce income tax. And we cannot get income tax back from anybody except the employee.”

This will reduce the employee’s Social Security and Medicare wages for the subsequent year, so the employer should refund the excess Social Security and Medicare taxes withheld from the overpayment to the employee, she said.

Another possible option for repayments that occur in a subsequent year is to have the employee repay the gross amount of the overpayment minus the amount of Social Security and Medicare tax, Ward said. In this case, the employee would be repaying the net amount of the overpayment plus the income tax withheld, and the employer would not have to refund any excess Social Security or Medicare taxes to the employee.