4. Religious Exemptions

Special rules apply to the treatment of ministers for social security purposes. An exemption from social security is available for ministers and certain other religious workers and members of certain recognized religious sects. For more information on getting an exemption, see Pub. 517, Social Security and Other Information for Members of the Clergy and Religious Workers.

Ministers.   Ministers are individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination. They are given the authority to conduct religious worship, perform sacerdotal functions, and administer ordinances and sacraments according to the prescribed tenets and practices of that religious organization.

A minister who performs services for you subject to your will and control is your employee. The common-law rules discussed in sections 1 and 2 should be applied to determine whether a minister is your employee or is self-employed. The earnings of a minister are not subject to income, social security, and Medicare tax withholding. They are subject to self-employment tax and income tax. You do not withhold these taxes from wages earned by a minister. However, you may agree with the minister to voluntarily withhold tax to cover the minister's liability for self-employment tax and income tax.

Form W-2.   If your employee is an ordained minister, report all taxable compensation as wages in box 1 on Form W-2. Include in this amount expense allowances or reimbursements paid under a nonaccountable plan, discussed in section 5 of Circular E. Do not include a parsonage allowance (excludable housing allowance) in this amount. You may report a parsonage or rental allowance (housing allowance), utilities allowance, and the rental value of housing provided in a separate statement or in box 14 on Form W-2. Do not show on Form W-2 or 941 any amount as social security or Medicare wages, or any withholding for social security or Medicare taxes. If you withheld tax from the minister under a voluntary agreement, this amount should be shown in box 2 on Form W-2 as Federal income tax withheld. For more information on ministers, see Pub. 517.

Exemptions for ministers and others.   Certain ordained ministers, Christian Science practitioners, and members of religious orders who have not taken a vow of poverty, who are subject to self-employment tax, may apply to exempt their earnings from the tax on religious grounds. The application must be based on conscientious opposition to public insurance because of personal religious considerations. The exemption applies only to qualified services performed for the religious organization. See Rev. Proc. 91-20, 1991-1 C.B. 524, for guidelines to determine whether an organization is a religious order or whether an individual is a member of a religious order.

To apply for the exemption, the employee should file Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners. See Pub. 517 for more information about Form 4361.

Members of recognized religious sects opposed to insurance.   If you belong to a recognized religious sect or a division of such sect that is opposed to insurance, you may qualify for an exemption from the self-employment tax. To qualify, you must be conscientiously opposed to accepting the benefits of any public or private insurance that makes payments because of death, disability, old age, or retirement, or makes payments toward the cost of, or provides services for, medical care (including social security and Medicare benefits). If you buy a retirement annuity from an insurance company, you will not be eligible for this exemption. Religious opposition based on the teachings of the sect is the only legal basis for the exemption. In addition, your religious sect (or division) must have existed since December 31, 1950.

Self-employed.   If you are self-employed and a member of a recognized religious sect opposed to insurance, you can apply for exemption by filing Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits, and waive all social security benefits.

Employees.   The social security and Medicare tax exemption available to the self-employed who are members of a recognized religious sect opposed to insurance is also available to their employees who are members of such a sect. This applies to partnerships only if each partner is a member of the sect. This exemption for employees applies only if both the employee and the employer are members of such a sect, and the employer has an exemption. To get the exemption, the employee must file Form 4029.

An employee of a church or church-controlled organization that is exempt from social security and Medicare taxes can also apply for an exemption on Form 4029.

5. Wages and Other Compensation

Circular E provides a general discussion of taxable wages. Publication 15-B discusses fringe benefits. The following topics supplement those discussions.

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.

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.

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. See 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. There are special rules that apply in determining whether benefits qualify as supplemental unemployment benefits that are excluded from wages for social security, Medicare, and FUTA purposes. To qualify as supplemental unemployment benefits for these purposes, the benefits must meet the following requirements:

1. Benefits are paid only to unemployed former employees who are laid off by the employer.
2. Eligibility for benefits depends on meeting prescribed conditions after termination.
3. The amount of weekly benefits payable is based upon state unemployment benefits, other compensation allowable under state law, and the amount of regular weekly pay.
4. The duration of the benefits is affected by the fund level and employee seniority.
5. The right to benefits does not accrue until a prescribed period after termination.
6. Benefits are not attributable to the performance of particular services.
7. No employee has any right to the benefits until qualified and eligible to receive benefits.
8. Benefits may not be paid in a lump sum.

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 Web Site at www.irs.gov. For more information, see Pub. 15-B.

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.

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(r)(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.

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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