In Revenue Ruling 2008-29, the IRS provides guidance on when and how to withhold income taxes from supplemental wages such as commissions, severance pay and signing bonuses. The ruling presents different scenarios to clarify issues that have sometimes puzzled payroll departments.
The way wages are classified — as regular or supplemental — affects the amount of income tax employers must withhold. Income tax is withheld from regular wages at the rate specified on the employee’s Form W-4, the Employee’s Withholding Allowance Certificate, the withholding method used by the employer and the appropriate IRS withholding tax table.
Supplemental Wage Withholding
Supplemental wages are all employer-paid wages that are not regular wages. There are two ways of calculating the amount of income taxes to withhold from supplemental wages:
- Aggregate method
- 25 percent flat-rate method
To use the aggregate method, the employer adds supplemental wages to regular wages and figures the taxes as if the entire amount were regular wages. The taxes already withheld from the regular wages are then subtracted from the total income tax amount, and the remaining tax is then subtracted from the supplemental payment.
Employers must use the aggregate method in two situations: (1) if income taxes were not withheld from regular wages during the current or previous calendar year or (2) if the supplemental wages are not separated from regular wages in the payroll records.
If an employee receives more than $1 million in supplemental payments in a year, the employer must withhold 35 percent of the amount over $1 million.
The revenue ruling illustrates how the rules apply in nine situations:
- Monthly commissions: An employee receives all compensation as monthly commissions.
Ruling: Because income taxes are not withheld from regular wages and the payment is made monthly, the employer must use the aggregate method and the monthly withholding tax table.
- Weekly commissions paid in addition to monthly salary: The employee receives a monthly salary along with weekly commissions. The employer withholds income taxes from the regular monthly salary. Ruling: The commissions are supplemental payments, and the employer may use either the aggregate or flat-rate (25 percent) withholding method.
- Semimonthly advances on anticipated commissions: All an employee’s compensation is paid as semimonthly advances on future commissions. If the commission turns out to be less than the advance, the employer reduces future advances. Terminating employees must return any overpayments. Ruling: The advances are supplemental wages, and the employer must use the aggregate method and the semimonthly tax table.
- Commissions paid at irregular intervals: The employee receives a commission whenever his or her earnings reach $1,000. There are no other wages. Ruling: The employer must use the aggregate method and the daily/miscellaneous tax table.
- Signing bonus: An employee receives a $2,100,000 signing bonus before receiving any regular wages. Ruling: The signing bonus is a supplemental wage payment, and $1,100,000 is subject to 35 percent withholding. For the remaining $1 million, the employer may withhold 35 percent or use the aggregate method and monthly tax table.
- Severance pay: An employee is fired and receives severance pay in the amount of his weekly salary when he was terminated. The severance payments continue for 51 weeks, stretching into the next calendar year. Ruling: The severance payments are supplemental wages, and the employer may use either the aggregate or flat-rate withholding method.
- Payment of annual leave at termination: A terminating civil service employee receives a lump sum for unused annual leave. Ruling: The payment is supplemental wages. Assuming that the employer withheld income taxes from regular wages during the current or previous year, the employer may use either the aggregate or flat-rate withholding method.
- Payment of vacation and sick leave allowance: An employer plan pays employees a lump sum — called a vacation and sick leave allowance — every 12 months. All employees receive this payment, but employees who use vacation or sick leave do not receive regular pay for those days off. Ruling: The lump sum payment is supplemental wages, and the employer may use either the aggregate or flat-rate withholding method.
- Sick pay at a different rate than regular wages: An employer pays employees one rate for working days and another rate for sick days. Employees receive all pay in one payment, but the employer separates the amounts in payroll records. Ruling: The sick pay is supplemental wages, and the employer may use either the aggregate or flat-rate withholding method.