Chapter 5
Wages & Other Compensation

Circular E provides a general discussion of taxable wages. The following topics supplement that discussion.

Employee Achievement Awards

Do not withhold income, social security, or Medicare taxes on the fair market value of an employee achievement award if it is excludable from your employee's gross income. To be excludable from your employee's gross income, the award must be tangible personal property (not cash or securities) given to an employee for length of service or safety achievement, awarded as part of a meaningful presentation, and awarded under circumstances that do not indicate that the payment is disguised compensation. Excludable employee achievement awards also are not subject to FUTA tax.

Limits. The most you can exclude for the cost of all employee achievement awards to the same employee for the year is $400. A higher limit of $1,600 applies to qualified plan awards. These awards are employee achievement awards under a written plan that does not discriminate in favor of highly compensated employees. An award cannot be treated as a qualified plan award if the average cost per recipient of all awards under all your qualified plans is more than $400.

If during the year an employee receives awards not made under a qualified plan and also receives awards under a qualified plan, the exclusion for the total cost of all awards to that employee cannot be more than $1,600. The $400 and $1,600 limits cannot be added together to exclude more than $1,600 for the cost of awards to any one employee during the year.

Educational Assistance Programs

The income exclusion from employee gross income is limited to $5,250 per employee in educational assistance during a calendar year. The excludable amount is not subject to income tax withholding or other employment taxes. The education need not be job related. However, the exclusion does not apply to graduate level courses. For more information on educational assistance programs, see Regulations section 1.127-2. The exclusion expires for courses beginning on or after December 31, 2001.

Scholarship and Fellowship Payments

Only amounts you pay as a qualified scholarship to a candidate for a degree may be excluded from the recipient's gross income. A qualified scholarship is any amount granted as a scholarship or fellowship that is used for:

• Tuition and fees required to enroll in, or to attend, an educational institution or
• Fees, books, supplies, and equipment that are required for courses at the educational institution.

Any amounts you pay for room and board, and any amounts you pay for teaching, research, or other services required as a condition of receiving the scholarship, are not excludable from the recipient's gross income. A qualified scholarship is not subject to social security, Medicare, and FUTA taxes, or income tax withholding. For more information, see Pub. 520, Scholarships and Fellowships.

Outplacement Services

If you provide outplacement services to your employees to help them find new employment (such as career counseling, resume assistance, or skills assessment), the value of these benefits may be income to them and subject to all withholding taxes. However, the value of these services will not be subject to any employment taxes if:

1. You derive a substantial business benefit from providing the services (such as improved employee morale or business image) separate from the benefit you would receive from the mere payment of additional compensation, and
2. The employee would be able to deduct the cost of the services as employee business expenses if he or she had paid for them.

However, if you receive no additional benefit from providing the services, or if the services are not provided on the basis of employee need, then the value of the services is treated as wages and is subject to income tax withholding and social security and Medicare taxes. Similarly, if an employee receives the outplacement services in exchange for reduced severance pay (or other taxable compensation), then the amount the severance pay is reduced is treated as wages for employment tax purposes.

Dependent Care Assistance Programs

The maximum amount you can exclude from your employee's gross income for dependent care assistance is $5,000 ($2,500 for married taxpayers filing separate returns). The excluded amount is not subject to social security, Medicare, and FUTA taxes, or income tax withholding. If the dependent is cared for in a facility at your place of business, the amount to exclude from the employee's income is based on his or her use of the facility and the value of the services provided. Report dependent care assistance payments in box 10 on Form W-2. For more information, see Pub. 15-B, Employer's Tax Guide to Fringe Benefits.

Dependent care providers. If you were the provider of dependent care or pay the provider directly, your employee may ask you for help in getting a completed Form W-10, Dependent Care Provider's Identification and Certification. The dependent care credit and the exclusion for employer-provided dependent care assistance benefits generally cannot be claimed by your employee unless the dependent care provider is identified by name, address, and (if not an exempt organization) taxpayer identification number. The dependent care recipient may use Form W-10 to request this information.

Adoption Assistance Plans

Your employees may be able to exclude from gross income payments or reimbursements you make under an adoption assistance program. Amounts you pay or incur for an employee's qualified adoption expenses are not subject to income tax withholding. However, these amounts (including adoption benefits paid from a cafeteria plan, but not including adoption benefits forfeited from a cafeteria plan) are subject to social security, Medicare, and FUTA taxes. If the adoption assistance benefits are part of a cafeteria plan, they are still subject to these employment taxes. Report adoption benefits in box 13, using code T, on Form W-2 (box 12 on the 2001 Form W-2). See Pub. 968, Tax Benefits for Adoption, for more information.

Withholding for Idle Time

Payments made under a voluntary guarantee to employees for idle time (any time during which an employee performs no services) are wages for the purposes of social security, Medicare, and FUTA taxes, and income tax withholding.

Back Pay

Treat back pay as wages in the year paid and withhold and pay employment taxes as required. If back pay was awarded by a court or government agency to enforce a Federal or state statute protecting an employee's right to employment or wages, special rules apply for reporting those wages to the Social Security Administration. These rules also apply to litigation actions, and settlement agreements or agency directives that are resolved out of court and not under a court decree or order. Examples of pertinent statutes include, but are not limited to, the National Labor Relations Act, Fair Labor Standards Act, Equal Pay Act, and Age Discrimination in Employment Act. Get Pub. 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration, and Form SSA-131, Employer Report of Special Wage Payments, for details.

Supplemental Unemployment Benefits

If you pay, under a plan, supplemental unemployment benefits to a former employee, all or part of the payments may be taxable and subject to income tax withholding, depending on how the plan is funded. Amounts that represent a return to the employee of amounts previously subject to tax are not taxable and are not subject to withholding. You should withhold income tax on the taxable part of the payments made, under a plan, to an employee who is involuntarily separated because of a reduction in force, discontinuance of a plant or operation, or other similar condition. It does not matter whether the separation is temporary or permanent. The taxable part is not subject to social security, Medicare, or FUTA taxes.

Withholding on taxable supplemental unemployment benefits must be based on the withholding certificate (Form W-4) the employee gave you.

Golden Parachutes (Excessive Termination Payments)

A golden parachute is a contract entered into by a corporation and key personnel under which the corporation agrees to pay certain amounts to the key personnel in the event of a change in ownership or control of the corporation. Payments under golden parachute contracts, like any termination pay, are subject to social security, Medicare, and FUTA taxes, and income tax withholding.

Beginning with payments under contracts entered into, significantly amended, or renewed after June 14, 1984, no deduction is allowed to the corporation for excess parachute payments. The employee is subject to a 20% nondeductible excise tax to be withheld by the corporation on all excess payments. The payment is generally considered an excess parachute payment if it equals or exceeds three times the average annual compensation of the recipient over the previous 5-year period. The amount over the average is the excess parachute payment.

Example. An officer of a corporation receives a golden parachute payment of $400,000. This is more than three times greater than his or her average compensation of $100,000 over the previous 5-year period. The excess parachute payment is $300,000 ($400,000 minus $100,000). The corporation cannot deduct the $300,000 and must withhold the excise tax of $60,000 (20% of $300,000).

Exempt payments. Most small business corporations are exempt from the golden parachute rules. See Code section 280G for more information.

Interest-Free and Below-Market-Interest-Rate Loans

If an employer lends an employee more than $10,000 at an interest rate less than the current applicable Federal rate (AFR), the difference between the interest paid and the interest that would be paid under the AFR is considered additional compensation to the employee. This rule applies to a loan of $10,000 or less if one of its principal purposes is the avoidance of Federal tax.

This additional compensation to the employee is subject to social security, Medicare, and FUTA taxes, but not to income tax withholding. Include it in compensation on Form W-2 (or Form 1099-MISC for an independent contractor). The AFR is established monthly and published by the IRS each month in the Internal Revenue Bulletin. You can get these rates by calling 1-800-829-1040 or by accessing the IRS's Internet Web Site at www.irs.gov. For more information, see Pub. 15-B.

Group-Term Life Insurance

You may exclude the cost of life insurance benefits for the first $50,000 of coverage for each employee, if your plan meets the following requirements.

1. It provides a general death benefit that is not included in income.
2. You provide it to a group of employees.
3. It provides an amount of insurance to each employee based on a formula that prevents individual selection, using factors such as age, years of service, pay, or position.
4. You provide it under a policy you carry directly or indirectly. Even if you do not pay any of the policy's cost, you are considered to carry it if you arrange for payment of its cost by your employees and charge at least one employee less than, and at least one employee more than, the cost of his or her insurance. Determine the cost of the insurance, for this purpose, using the table for the monthly cost per $1,000 of insurance below. Note: Until January 1, 2003, you may use the table previously in effect to make this determination. See Reg. 1.79-1 or the January 1999 revision of Pub. 15-A.
5. It meets certain nondiscrimination requirements. See Pub. 15-B for more information.

The tax treatment is the same if the premiums are paid through a cafeteria plan (section 125). See Cafeteria Plans, later. This taxable insurance cost can be treated as paid by the pay period, by the quarter, or on any basis as long as the cost is treated as paid at least once a year.

Benefits extending beyond one year. Group-term life insurance may be provided as part of a policy that includes permanent benefits. Permanent benefits are any benefits that extend beyond one policy year, such as insurance with a paid-up or cash surrender value.

If your policy includes permanent benefits, you must include in your employees' wages the cost of the permanent benefits minus the amount the employee pays for them.

For more information, see section 1.79-1(d) of the Regulations.

Amount included in wages. Include in wages the cost of group-term life insurance you provided to an employee for more than $50,000 of coverage, or for coverage that discriminated in favor of the employee. This amount is subject to social security and Medicare taxes, but not FUTA tax or income tax withholding.

Monthly cost. If the group-term life insurance plan meets the exclusion requirements listed above, figure the monthly cost of this insurance on the amount of coverage exceeding $50,000. The taxable cost is based on the following table rather than on the employer's actual premium costs for the insurance coverage. You determine the monthly cost of group-term life insurance by multiplying the number of thousands of dollars of insurance coverage (figured to the nearest 10th) by the appropriate cost per thousand per month. You determine age on the last day of the tax year. If you provide group-term life insurance for a period of coverage of less than 1 month, you prorate the monthly cost over that period. The monthly cost of each $1,000 of group-term life insurance protection is as follows:

Coverage for dependents. Group-term life insurance coverage paid by the employer for the spouse or dependents of an employee may be excludable from income as a de minimis fringe benefit (see section 6). This part of the coverage that the employee paid on an after-tax basis is also excludable from income. For this purpose, the cost is figured using the monthly cost table above.

Former employees. For group-term life insurance over $50,000 provided to former employees (including retirees), the former employees must pay the employee's share of social security and Medicare taxes with their income tax returns. You are not required to collect those taxes. Use the table above to determine the amount of social security and Medicare taxes owed by the former employee for coverage provided after separation from service. Report those uncollected amounts separately in box 13 on Form W-2 using codes M and N (box 12 on the 2001 Form W-2). See the Instructions for Form W-2 and Form W-3.

Workers' Compensation--Public Employees

State and local government employees, such as police officers and firefighters, sometimes receive payments due to injury in the line of duty under a statute that is not the general workers' compensation law of a state. If the statute limits benefits to work-related injuries or sickness and does not base payments on the employee's age, length of service, or prior contributions, the statute is "in the nature of" a workers' compensation law. Payments under the statute are not subject to FUTA tax or income tax withholding, but they are subject to social security and Medicare taxes to the same extent as the employee's regular wages. However, the payments are no longer subject to social security and Medicare taxes after the expiration of 6 months following the last calendar month in which the employee worked for the employer.

Leave Sharing Plans

If you establish a leave sharing plan for your employees that allows them to donate leave to other employees for medical emergencies, the amounts paid to the recipients of the leave are considered wages. These amounts are includible in the gross income of the recipients and are subject to social security, Medicare, and FUTA taxes, and income tax withholding. Do not include these amounts in the income of the donors.

Cafeteria Plans

Cafeteria plans, including flexible spending arrangements, are benefit plans under which all participants are employees who can choose from among cash and certain qualified benefits. If the employee elects qualified benefits, employer contributions are excluded from the employee's wages if the benefits are excludable from gross income under a specific section of the Internal Revenue Code (other than scholarship and fellowship grants under section 117, employee fringe benefits under section 132, and educational assistance programs under section 127). The cost of group-term life insurance that is includible in income only because the insurance exceeds $50,000 of coverage is considered a qualified benefit under a special rule.

Generally, qualified benefits under a cafeteria plan are not subject to social security, Medicare, and FUTA taxes, or income tax withholding. However, group-term life insurance that exceeds $50,000 of coverage is subject to social security and Medicare taxes, but not FUTA tax or income tax withholding, even when provided as qualified benefits in a cafeteria plan. Adoption assistance benefits provided in a cafeteria plan are subject to social security, Medicare, and FUTA taxes, but not income tax withholding. If an employee elects to receive cash instead of any qualified benefit, it is treated as wages subject to all employment taxes. For more information, see Pub.15-B.

Nonqualified Deferred Compensation Plans

Social security, Medicare, and FUTA taxes. Employer contributions to nonqualified deferred compensation or nonqualified pension plans are treated as social security, Medicare, and FUTA wages when the services are performed or the employee no longer has a substantial risk of forfeiting the right to the deferred compensation, whichever is later. This is true whether the plan is funded or unfunded.

Amounts deferred are subject to social security, Medicare, and FUTA taxes unless the value of the amount deferred cannot be determined; for example, if benefits are based on final pay. If the value of the future benefit is based on any factors that are not yet reasonably determinable, you may estimate the value of the future benefit and withhold and pay social security, Medicare, and FUTA taxes on that amount. If amounts that were not determinable in prior periods are now determinable, they are subject to social security, Medicare, and FUTA taxes on the amounts deferred plus the income attributable to those amounts deferred. For more information, see Regulations sections 31.3121(v)(2)-1 and 31.3306(v)(2)-1.

Income tax withholding. Amounts deferred under nonqualified deferred compensation plans are not subject to income taxes until benefit payments begin. Withhold income tax on nonqualified plans as follows:

• Funded plan. Withhold when the employees' rights to amounts are not subject to substantial risk of forfeiture or are transferable free of such risk. A funded plan is one in which an employer irrevocably contributes the deferred compensation to a separate fund, such as an irrevocable trust.
• Unfunded plan. Generally, withhold when you make payments to the employee, either constructively or actually.

For more information, see Regulations section 31.3121(v)-1.

Employee Stock Options

There are three classes of stock options--incentive stock options, employee stock purchase plan options, and nonstatutory options. Generally, incentive stock options and employee stock purchase plan options are not taxable to the employee either when the options are granted or when they are exercised (unless the stock is disposed of in a disqualifying disposition). However, the spread (between the exercise price and fair market value of the stock at the time of exercise) on employee stock purchase plan options is subject to social security, Medicare, and FUTA taxes when the options are exercised. Additionally, the spread on nonstatutory options normally is taxable to the employee as wages when the options are exercised (see Regulations section 1.83-7). These wages are subject to social security, Medicare, and FUTA taxes, and income tax withholding.

Tax-Sheltered Annuities

Employer payments made by an educational institution or a tax-exempt organization to purchase a tax-sheltered annuity for an employee (annual deferrals) are included in the employee's social security and Medicare wages if the payments are made because of a salary reduction agreement. They are not included in box 1 on Form W-2 in the year the deferrals are made and are not subject to income tax withholding.

Contributions to a Simplified Employee Pension (SEP)

An employer's SEP contributions to an employee's individual retirement arrangement (IRA) are excluded from the employee's gross income. These excluded amounts are not subject to social security, Medicare, and FUTA taxes, or income tax withholding. However, any SEP contributions paid under a salary reduction agreement (SARSEP) are included in wages for purposes of social security and Medicare taxes and FUTA. See Pub. 560, for more information about SEPs.

Salary reduction simplified employee pensions (SARSEP) repealed. You may not establish a SARSEP after 1996. However, SARSEPs established before January 1, 1997, may continue to receive contributions.

SIMPLE Retirement Plans

Employer and employee contributions to a savings incentive match plan for employees (SIMPLE) retirement account (subject to limitations) are excludable from the employee's income and are exempt from Federal income tax withholding. An employer's nonelective (2%) or matching contributions are exempt from social security, Medicare, and FUTA taxes. However, an employee's salary reduction contributions to a SIMPLE are subject to social security, Medicare, and FUTA taxes. For more information about SIMPLE retirement plans, see Pub. 560.

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