When the Internal Revenue Service (IRS) determines during an examination that a fringe benefit should have been taxed and the employer accordingly has to pay additional taxes in a later year, how is the subsequent payment treated for tax purposes? Recent IRS guidance on this issue serves to clarify when employers will need to “gross up” these payments for the employee.
In 2018, the IRS examined an employer’s 2016 employment tax returns and discovered that the employer gave $10,000 in taxable fringe benefits to an employee but, problematically, did not report the fringe benefits that year as taxable income to the employee or withhold employment taxes. The IRS characterized the $10,000 fringe benefit amount as additional 2016 wages and assessed $4,030 in total employment tax against the employer—$2,500 for federal income tax, $765 for the employer’s share of Federal Insurance Contributions Act (FICA) taxes, and $765 for the employee’s share of FICA. The employer then paid the entire tax assessment in 2018.
The IRS examiner sought advice from the IRS Office of Chief Counsel (OCC) regarding the tax and reporting consequences of the employer’s payment of the assessed taxes. The IRS examiner asked whether the employer’s payment of the federal income tax withholding (FITW) and FICA taxes in 2018 would increase the employee’s 2016 income, requiring the employer to pay a tax gross-up for 2016, and if not, how the employer’s payments should be reported for 2016 and 2018.
In response, the OCC issued Program Manager Technical Advice 2018-015. Program Manager Technical Advice (PMTA) memoranda provide legal advice to IRS national program executives and managers. While PMTA memos are helpful in determining the IRS’s position, they cannot be used and cited as precedent.
PMTA 2018-015 highlights the difference between the federal tax liabilities of employers and those of employees, particularly with respect to employees’ tax liabilities as a result of an employer’s payment of FITW and employee FICA assessed in a tax examination. (Note: The PMTA did not address Federal Unemployment Tax Act taxes because only the employer pays those, and the facts did not implicate the Additional Medicare Tax.)
No Gross-Up Required for 2016
The IRS responded “no” to the question of whether the employer’s payment of the FITW and FICA taxes in 2018 would increase the employee’s 2016 income, requiring the employer to pay a tax gross-up for 2016.
“An employer’s payment of taxes that should have been withheld in a prior year does not create additional wages to the employee for the prior year,” the IRS explained. Because the employer’s payment of taxes did not create additional wages to the employee for 2016, no tax gross-up was required regarding that payment. Rather, the PMTA explains that when the employer paid the assessment for 2016, the employer was simply paying the taxes that it should have withheld for that year.
Employer Tax Responsibilities
The PMTA reminds readers that the employer is legally responsible for withholding both the employer’s and employee’s portions of FICA tax and FITW. If the employer fails to withhold, does not withhold the correct amount, or withholds and does not remit the taxes to the IRS, the employer is liable for the payment of the FITW and FICA. (However, the IRS will not collect the FITW that the employer failed to withhold from the employee if the employer can prove via a special IRS procedure that the employee paid the income taxes when filing his or her personal tax return.)
Because of the employer’s independent obligation to withhold FICA and FITW taxes, the IRS may assess against the employer the FICA taxes (both the employee’s and employer’s shares) and FITW attributable to the additional $10,000 wage payment. The employer’s payment of the assessment satisfies its FICA obligations and FITW liability.
The PMTA concludes that the employer’s payment of the taxes in 2018 to satisfy its own liability does not result in additional compensation or wages to the employee in 2016. In other words, the employer's payment in a later year (2018) of taxes it should have withheld from wages paid in the prior year (2016) does not create additional compensation or wages to the employee for the prior year (2016). (Note: the PMTA corrects prior IRS guidance (General Counsel Memoranda 39577, February 21, 1986) that had indicated the employer’s payment of its FITW liability in a later year would be considered additional compensation to the employee. That conclusion was “in error,” the PMTA states.)
Employee Tax Responsibilities
If the FITW was actually withheld from employee wages in 2016, then the employee would get credit for those tax withholdings in 2016. However, because the FITW assessed and paid in 2018 was not actually withheld from the employee in 2016, the employee does not get credit in 2016 for the FITW liability paid by the employer as a result of the examination and assessment.
Upon receiving the 2016 Form W-2c, an employee can seek personal tax advice (not from the employer) to determine whether he or she must file an amended personal income tax return for 2016 and whether the employee independently has any additional income tax liability with respect to the additional $10,000 of compensation reported on Form W-2c for 2016. The fact that the employee may have independent federal tax liability for 2016 supports the IRS’s conclusion that the employer’s payment of the FITW does not create additional income for the employee in 2018.
The impact to the employee in 2018 is different with regard to the employer's payment of the employee FICA tax liability. Unlike the FITW liability that is only imposed on the employer, the employee FICA tax is imposed on the employee. The PMTA explains that while the employer withholds the employee FICA tax (and is liable for failure to withhold), the employee is ultimately liable for the tax. Another key difference is that once the employer pays the employee’s share of FICA, the employee receives credit for it.
As a result, if the employer pays the employee FICA tax without recouping it from the employee (either by direct payment or, if the employee continues to be employed, by a wage deduction in 2018), the employee will receive a taxable benefit in 2018 (i.e., the 2018 payment of 2016 employee FICA tax).
In the scenario described, because the employer paid the employee’s 2016 FICA tax liability of $765 in 2018, the employer can choose to (1) deduct that amount from the employee’s 2018 remuneration (if any), (2) obtain payment directly from the employee, or (3) not collect the 2016 employee FICA from the employee at all.
If the employer deducts the 2016 employee FICA tax from the employee’s 2018 remuneration or otherwise is repaid by the employee in 2018, then the employee receives no additional compensation for 2018. However, if the employer chooses not to collect the 2016 employee FICA tax from the employee in 2018, the PMTA concludes that the $765 of employee FICA tax paid by the employer in 2018 is additional wages and is subject to employment taxes. With respect to these additional wages, the employer can:
- withhold the employee FICA and federal income tax from other wages;
- obtain payment directly from the employee; or
- provide a tax gross-up in 2018 by paying the employee FICA and FITW on the $765 of additional wages in 2018.
Form W-2c Reporting
In this case, the employer must prepare a Form W-2c for 2016 that includes the $10,000 taxable fringe benefit paid to the employee, furnish the employee a copy of the Form W-2c, and file a copy with the Social Security Administration, according to the PMTA.
Specifically, the employer should add the $10,000 to the corrected wages on the 2016 Form W-2c in boxes 1 (Wages, tips other compensation), 3 (Social security wages), and 5 (Medicare wages and tips). The additional employee FICA tax paid by the employer should be reported in boxes 4 (Social security tax withheld) and 6 (Medicare tax withheld). However, the federal income tax paid by the employer should not be reported in box 2 as federal income tax withholdings because the employer did not withhold the tax from employee wages.
Surprisingly, the PMTA’s instruction to report the FICA tax contradicts Internal Revenue Manual (IRM) Section 188.8.131.52.1 (last updated May 17, 2018). This section, titled “Delinquent Forms W-2/W-2c Secured by Examiner Due to Examination Adjustments,” provides that,
“[e]mployers will be advised to prepare Form W-2 or Form W-2c, whichever is applicable, to report the amount of wage adjustments for each individual who was affected by the employment tax examination. Since no taxes were withheld from the employee’s wages as a result of the examination, no withheld taxes should be reported on delinquent Form W-2 or Form W-2c statements in Boxes 2, 4, or 6.”
In our view, the IRM is incorrect regarding the tax reporting in Boxes 4 and 6. We are following up with the IRS to confirm.
Tax Gross-Up Takeaways
In sum, the PMTA provides that (1) there is no tax gross-up obligation with respect to the additional 2016 wages but (2) there could be a tax gross-up obligation in 2018 with respect to the employer’s 2018 payment of the 2016 employee FICA taxes, if that payment constitutes additional wages in 2018. The latter may come as a surprise to readers.
Cost of the Tax Gross-Up
Assuming the employee is subject to a 22 percent flat rate for supplemental wages, a 6 percent state income tax rate, and a 7.65 percent tax for employee FICA (together, a marginal tax rate of 35.65 percent), the tax gross-up on $765 is $423.81.
The formula to calculate a tax gross-up is: Gross-up = [Net Amount / (1 – Tax Rate)].
In this formula, the net amount is the dollar amount you want to end up with after taxes, and the tax rate is the rate of tax to apply to the payment (expressed as a percentage).
Assume a marginal tax rate of 35.65 percent, and assume further that the desired result is $765 after taxes. In such a case, the calculation would be as follows:
Gross-up = [$765 / (1 – .3565)]
= [$765 / .6435]
If you multiply the gross-up with the marginal tax rate as a percentage, $423.81 is the tax amount. If you subtract the tax amount from the gross-up amount, the result is the net amount.
Gross-up – Tax = $1,881.81 – 423.81 = $765 = Net Amount
Here, the employer pays the net amount, $765, to the IRS when paying the assessment. The employer includes the $765 payment in the employee’s 2018 wages and remits additional taxes ($423.81) to the IRS as a tax withholding deposit in 2018. As a result, the employer’s payment of the $765 in 2018 on behalf of the employee was tax-neutral to the employee because the employer paid the resulting 2018 taxes on the employee’s behalf.