The Internal Revenue Service (“IRS”) recently released proposed regulations for the Additional Medicare Tax, a new levy on high-income taxpayers created by the Pension Protection and Affordable Care Act. The tax is charged solely to employees, but employers are responsible for withholding a portion of wages above $200,000, to be applied towards the tax. If an employer fails to withhold the proper amount, it may be liable for penalties and additions. Accordingly, employers should work with payroll staff and vendors to reform their withholding procedures before the new year begins.
The New Tax and Withholding Obligation
Under the Federal Insurance Contributions Act (“FICA”), employers must collect 2.9% of employee wages in order to fund Medicare. Half of this amount, or 1.45%, is withheld from employee wages, and the remaining half is paid by the employer. Beginning in 2013, the Additional Medicare Tax increases the employee portion of the Medicare tax by an additional 0.9% of wages in excess of certain thresholds (see table below).
Click here to see table.
The Additional Medicare Tax differs from the standard Medicare tax in that (i) the tax is not imposed until the wages exceed the threshold amount and (ii) there is no employer portion corresponding to the amount owed by the employee.
The proposed regulations, issued on November 30, 2012, provide detail on employers’ Additional Medicare Tax withholding obligations. Employers must withhold Additional Medicare Tax only to the extent that the wages paid by the employer to the employee exceed $200,000 within the calendar year. In performing its withholding obligations, the employer may disregard the employee’s filing status and income from other sources, including wages paid to the employee’s spouse. Withholding should not commence until the pay period in which calendar year wages exceed $200,000.
Examples: (1) Employer X pays Ann $150,000 annually. Ann’s compensation is under $200,000, so no Additional Medicare Tax withholding is required. X does not withhold even if Ann informs X that she will be filing separately from her spouse, and thus will exceed the $125,000 MFS threshold. X does not withhold even if it employs Ann’s spouse Ben and pays Ben $150,000 annually, thus placing Ann and Ben above the $250,000 MFJ threshold.
(2) X must withhold Additional Medicare Tax if it pays Carol $220,000 in 2013. This is true even if X knows Carol will file MFJ and her spouse does not work, thus bringing the couple below the $250,000 MFJ threshold. If Carol’s wages are paid ratably twice a month, X will have paid Carol $192,500 prior to November 30, 2013. No withholdings should be made on those wages. On November 30th, X will pay Carol $9,166.67, pushing her current year wages to $201,666.67. X must withhold 0.9% of the last $1,666.67 of that paycheck and 0.9% of both December 2013 paychecks.
Employers need not inform employees before making Additional Medicare Tax withholdings, but employers may wish to educate employees about the new tax, so that employees can plan for income tax liabilities. For instance, two spouses that individually earn less than $200,000—but jointly earn more than $250,000—might ask their employer(s) to make supplemental income tax withholdings in anticipation of their Additional Medicare Tax charge. To the extent that there is a mismatch between the amount withheld and the Additional Medicare Tax owed, the ultimate liability will be reconciled on the employee’s income tax return.
Compensation Counted Towards the Additional Medicare Tax Threshold
When calculating the Additional Medicare Tax $200,000 withholding threshold, the employer must take care that all proper forms of compensation are included. The same compensation elements subject to FICA taxes generally are used for determining the Additional Medicare Tax. Beyond base salary, bonuses and commissions, employers must generally include the following items:
- Certain noncash fringe benefits;
- Restricted stock, restricted stock units and phantom stock, upon date of vesting;
- Nonqualified stock options and stock appreciation rights, upon date of exercise;
- Tips included as wages;
- Vacation allowances;
- Sick pay paid by a third party; and
- The imputed cost of group term life insurance exceeding $50,000 for current employees.
Withholding Errors, Sanctions and Correction Methods
Employers that fail to withhold the requisite 0.9% on wages above $200,000 are liable to the IRS for that amount until the corresponding Additional Medicare Tax is paid. Such an employer also faces a 20% penalty if the withholding error constituted negligence. In addition, the IRS may seek reporting penalties. The penalties and additions may apply even if the IRS collects the shortfall from the employee.
However, the proposed regulations clarify that employers may make an interest-free adjustment by submitting the missing withholding to the IRS along with an adjusted return (on Form 941-X) and a detailed explanation before both (1) the end of the calendar year in which the error occurred and (2) the due date for the return period during which the error was discovered (generally, the next Form 941 due date). The calendar year deadline may be extended if the underpayment was caused by an administrative error. Once an adjustment is properly filed, the employer may deduct the adjustment payment from future remuneration paid to the employee during the same calendar year.