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Payroll Taxes

REQUIREMENT OF WITHHOLDING INCOME TAXES FROM WAGES

(a) GENERAL REQUIREMENTS

Employers generally must deduct and withhold income taxes from wages
actually or constructively paid to employees. Wages are constructively
paid to an employee when they are credited to his account or set apart so
that he can withdraw them at any time without substantial limitations or
restrictions.

PRACTICE TIP: Under a special rule, employers may elect for federal
income tax withholding purposes (as well as for FUTA and FICA
withholding purposes) to treat non-cash fringe benefits as paid on a
pay period, quarterly, semi-annual, annual, or other basis, provided
that the benefits are treated as paid no less frequently than
annually. Announcement 85-113, 1985-31 I.R.B. 31.

Withholding is required regardless of the frequency, amount, or form of
wage payments. Deductions are also required on payments that are in
addition to an employee's regular wages (e.g., on bonuses, commissions,
overtime pay, or vacation allowances). In fact, with certain limited
exceptions, all remuneration for services performed by an employee for his
employer is considered wages subject to withholding. See Section
111.3 for the definition of wages for withholding purposes.

PRACTICE TIP: The 20 percent tax imposed on golden parachute payments
that are wages is tacked onto the income taxes deducted and withheld
pursuant to Code Section 3402(a)(1). Code
Section 4999(c)(1). For a general discussion of
golden parachute payments, see Ch. 106.

The amount an employer must withhold is determined by applying one of
several withholding methods. These methods rely on IRS-prepared tables to
calculate the exact amount to be withheld. See Section 111.5 for an
explanation of these methods. Employees can also request that additional
amounts be withheld from their wages. Code Section 3402(i). An employer
must comply with such a request, but only to the extent the additional
withholding amount does not reduce the employee's net pay (after other
deductions required by law) below zero. Reg. Section 31.3402(i)-2(a)(1).


COMPLIANCE TIP: Requests for additional withholding should be made on
Form W-4. Reg. Section 31.3402(i)-2(a)(1).

PRACTICE TIP: Withholdings from supplemental wage payments (e.g.,
bonuses, commissions, overtime pay, or vacation allowances) are
sometimes computed in a manner that differs from the ordinary wage
withholding requirements. For a discussion of income tax withholding
from supplemental wages, see Section 111.5(j)


(b) EXCEPTIONS TO GENERAL REQUIREMENTS

The withholding requirement does not apply to amounts that are excluded
from the definition of wages. Code Section 3401(a), See Section
111.3(b). In addition to the wage definition exclusions in Code Section
3401(a), several other Code provisions provide exceptions to the income
tax withholding requirements. For example, withholding deductions are not
required if an employee certifies that she incurred no income tax
liability in the preceding year and anticipates no income tax liability
in the current year. Code Section 3402(n). See Section 111.4(d).


PRACTICE TIP: An employee entitled to file a joint return cannot
certify that he anticipates no income tax liability for the current
year if such a statement would be false in the event he does file a
joint return, unless he filed a separate return for the preceding
year and anticipates that he will do the same for the current year.
In addition, an employee is not considered to incur liability for
income taxes for purposes of Code Section 3402(n) if
his tax liability is completely offset by certain tax credits. Reg.
Section 31.3402(n)-1.

An employer also can elect not to withhold income taxes with respect to a
vehicle fringe benefit (e.g., a company car) provided to an employee, as
long as the employee receives proper notice of the election. Code Section
3402(s).

COMPLIANCE TIP: Vehicle fringe benefits must be treated as wages from
which taxes are deducted and withheld for purposes of the employee's
Form W-2, even if taxes are not actually withheld. Code Section
3402(s). See Ch. 113 for Form W-2
reporting requirements.

Non-cash payments to a retail salesperson also can be paid without income
tax withholding if the salesperson ordinarily works solely on cash
commission. Code Section 3402(j). This exception does not apply to
non-cash wages paid for services performed in a capacity other than as a
retail commission salesperson. In addition, if the salesperson is paid
both salary and cash commissions, non-cash remuneration cannot be
disregarded in computing the amount to be deducted and withheld for income
taxes.

Under the "included-excluded" rule, if more than 50 percent of an
employee's time during a payroll period of 31 days or less is spent
working for remuneration that is not considered wages, none of the
employee's pay during the payroll period is subject to income tax
withholding. Conversely, if at least 50 percent of an employee's time
during a payroll period of 31 days or less is spent working for
remuneration that is considered wages, then all the employee's pay during
the payroll period is subject to withholding. Code Section 3402(e). If
pay periods vary so that there is no ordinary pay period, or if the pay
period exceeds 31 days, the included-excluded rule does not apply. Reg.
Section 31.3402(e)-1(e).

EXAMPLE: O Corp. owns an orchard that grows watermelons. The
watermelons are sold directly to the public in ten fruit stands owned
by O Corp. Andrew and Nicholas are employees of O Corp. and are paid
on a weekly basis. Andrew spends 28 hours a week working in the
watermelon fields and 12 hours a week working at one of the fruit
stands. Nicholas spends 18 hours a week working in the watermelon
fields and 22 hours a week working at one of the fruit stands.
Payment for work in the fields is not considered wages for income tax
withholding purposes under the agricultural labor exemption in Code
Section 3401(a)(2) ; however, payment for work in the
fruit stands is considered wages. Because Andrew spends more than
half his time performing services that generate non-wage
remuneration, none of the remuneration paid to Andrew is subject to
income tax withholding. Because at least half of Nicholas' time is
spent working for remuneration that is considered wages, all the
remuneration paid to Nicholas is subject to withholding.

There may be other situations in which amounts that are considered wages
are not subject to income tax withholding. In one case, for example, a
former employee was awarded deferred compensation benefits in a lawsuit,
but was simultaneously required to forfeit previously paid salary that had
already been subject to withholding. The court held that only the excess
of the deferred compensation payments over the forfeited salary was
subject to withholding, even though the entire amount constituted wages.
Aramony v. United Way of America, No. 96 Civ. 3962 (S.D.N.Y. Aug. 21,
2000).


(c) LIABILITY FOR PAYMENT OF TAX

(c)(1) Employer liability

Generally, it is the employer who is actually liable for paying the taxes
to be withheld. Code Section 3403. For purposes of the withholding rules,
an "employer" is generally any person for whom an individual performs or
performed any service, of whatever nature, as the employee of such
person. Code Section 3401(d). This broad definition includes a wide
variety of entities, including individuals, corporations, partnerships,
trusts, estates, joint stock companies, associations, syndicates, groups,
pools, joint ventures, tax-exempt organizations, and governments. <11>
The term "employer" also means any person paying wages on behalf of a
non-resident alien individual, foreign partnership, or foreign
corporation not engaged in a trade or business within the United States
or Puerto Rico. Reg. Section 31.3401(d)-1(e).

PRACTICE TIP: It is not necessary that the services be continuing at
the time the wages are paid in order to establish employer status --
i.e., payment can be made after the employment relationship
terminates. Reg. Section 31.3401(d)-1(b).

For a discussion of who is considered an employee, see Ch. 101.


(c)(2) Third-party liability

The payor of supplemental unemployment compensation benefits ("SUB pay")
that are treated as wages is treated as the employer, unless the payor is
acting solely as an agent of the employer. If SUB pay is paid from a trust
under the terms of a collective bargaining agreement, the trust is deemed
the employer. See Section 111.3(a) for a discussion of SUB pay
treated as wages.

Where the person for whom services are performed does not have legal
control over the payment of wages, then the person actually controlling
the payment of wages assumes the withholding responsibilities of an
employer. Code Section 3401(d)(1). Thus, if pension payments are
considered wages and are paid from a trust, and the person for whom the
services were performed has no legal control over the pension payments,
the trust is the employer for purposes of income tax withholding. Reg.
Section 31.3401(d)-1(f). In particular circumstances, trustees in
bankruptcy, employee-leasing agencies, labor unions disbursing settlement
funds, and voluntary employees' beneficiary association (VEBA) trusts
have all been found to be the employer. However, this provision
imposes the status of an employer only for purposes of determining who is
responsible for withholding. It does not treat a person who has control
over the payment of wages as the employer for purposes of defining
whether a particular payment constitutes wages under Code Section
3401(a) for withholding purposes. TAM 199918056. See Section
111.3 for the definition of wages for income tax withholding
purposes.

Legal control of the payment of wages is sufficient, regardless of whether
it is actually exercised. Thus, where a partnership held legal title to a
hotel, and the partners were authorized to sign checks on the partnership
account in the hotel's name, the partners were in control of the wage
payments to hotel employees for withholding purposes, even after they
delegated responsibility for managing the hotel's day-to-day operations to
certain employees. Hunison v. United States, No. A99-0622 CV (D. Alaska,
Dec. 17, 2001).

If an employer's agent pays or controls the payment of wages, the IRS can
authorize the agent to withhold and pay income taxes from those wages.
Code Section 3504. An agent authorized to withhold income taxes is
subject to all legal provisions associated with withholding that are
normally applied to the employer, including penalty provisions. Code
Section 3504. The employer remains subject to the withholding provisions
as well (including the penalty provisions). Code Section 3504.

COMPLIANCE TIP: An employer notifies the IRS of its authorization of
an agent for withholding purposes by filing Form 2678, Employer
Appointment of Agent (under Code Section 3504).

Generally, state law determines when a general partner is the agent of a
limited partnership. If under state law a general partner in a limited
partnership is treated as the agent of the limited partnership, the
limited partnership generally remains liable for withholding taxes on
wages paid by the general partner on behalf of the limited partnership.
Remington v. United States, 210 F.3d 281 (5th Cir. 2000). However, where
the general partner contracts to provide services (such as hotel
management services) for the limited partnership, and the applicable
state law provides that in business transacted between a partner an a
limited partnership the partner is treated as a non-partner, the general
partner is not treated as the limited partnership's agent with respect to
the services it provides. Thus, the limited partnership is not liable for
withholding taxes on wages paid by the general partner with respect to
those services. In re Sewickley Hospitality, Ltd, No. 99- 23632-C-11
(S.D. Tex. Jan. 25, 2002).

If a lender, surety, or other person who is not an employer, pays wages
directly to employees or to an agent on behalf of the employees, that
lender, surety, or other person becomes liable in his own person and
estate for the amounts required to be withheld. Code Section 3505(a).
Further, if a lender, surety, or other person supplies funds to an
employer for the specific purpose of paying employee wages and has actual
notice or knowledge that the employer does not intend to or will not be
able to pay the income taxes that should be withheld, the third party is
personally liable for such taxes in an amount up to 25 percent of the
amount supplied. The 25 percent limit applies to both the amount of tax
and prejudgment interest. Reg. Section 31.3505-1(d)(2)(iii). For a
discussion of IRS enforcement of Code Section 3505 liability, see
Section 607.4(b).

An ordinary working capital loan (with no specific purposes prescribed)
will not invoke the application of Code Section 3505(b), even though it
might be known that part of the loan proceeds may be used to pay wages.
However, Code Section 3505(b) will apply if the person supplying the
funds has actual notice or knowledge that the funds or a portion of the
funds are to be used specifically to pay net wages. Whether or not a
lender has actual notice or knowledge that funds will be used to pay net
wages depends on the facts and circumstances of each case. <15> A
district court has held that a surety was not liable for withholding and
employment taxes under a contractor's bond where the surety did not pay
wages directly to the employees or provide the funds to the employer for
the specific purpose of paying wages. Island Insurance Co. v. Hawaiian
Foliage & Landscape, Inc., Civil No. 97- 01084 DAE (D. Haw. March 10,
1999).

COMPLIANCE TIP: A lender, surety, or other person liable for income
taxes pursuant to Code Section 3505 should file Form
4219, Statement of Liability of Lender, Surety, or Other Person for
Withholding Taxes, with payment for the tax and interest due. Reg.
Section 31.3505-1(d)(1). A separate Form 4219
should be submitted, in duplicate, for each employer and for each
calendar quarter for which liability is incurred.

Payments made by a lender under Code Section 3505(b) are fully credited
against the employer's liability; however, payments made by the employer
are credited against the lender's liability only to the extent they
exceed the difference between the employer's liability and the lender's
liability. Reg. Section 31.3505-1(d)(2)(iii).

EXAMPLE: A Corp. supplies $10,000 to Z Corp, an employer, for the
payment of wages. The amount of income taxes that should be withheld
from the wages is $3,000. Z Corp. pays $250 toward the $3,000 owed
for income taxes on the wages. Z Corp.'s liability is reduced by
$250. However, A Corp.'s liability under Code Section 3505(b),
which is limited to $2,500 (i.e., 25 percent of the amount
supplied) is not reduced, because the payment ($250) does not exceed
$500 (i.e., the difference between Z Corp.'s liability ($3,000) and A
Corp.'s liability ($2,500)). If Z Corp. pays an additional $2,000
toward its liability for the withholding taxes, A Corp.'s liability
is reduced by $1,750 (i.e., Z Corp.'s total payments ($2,250) minus
the difference between A Corp.'s and Z Corp.'s liability ($500)).
Thus, after Z Corp.'s second payment, A Corp.'s liability is $750
(i.e., original liability ($2,500) minus reduction ($1,750)).


(d) EMPLOYEES SUBJECT TO WITHHOLDING

Only wages paid to employees are subject to income tax withholding under
Code Section 3402(a). Whether an individual is classified as an
employee for purposes of triggering the income tax withholding
requirements depends on common law rules. Generally, an employment
relationship exists if the person for whom the services are performed has
the right to control and direct the individual, not only as to the result
to be accomplished by the work, but also as to the details and means by
which that result is accomplished. Reg. Section 31.3401(c)- 1(b).
Lawyers, physicians, and other professionals or independent contractors
are typically not employees; however, corporate officers, government
officers, and elected officials usually are considered employees for
purposes of income tax withholding. <18> In doubtful situations, the
existence of an employer-employee relationship is determined by examining
the particular facts of the case. Reg. Section 31.3401(c)-1(d). For a
discussion of the distinction between employees and independent
contractors, see Ch. 101.


(e) FAILURE TO WITHHOLD TAXES

Employers are liable for income taxes on employee wages whether or not the
taxes are actually collected from the employee, or if not enough taxes are
collected. Reg. Section 31.3403-1. Willful failure to withhold income
taxes can lead to a host of penalties and additions to the tax. For
example, a willful failure to collect income taxes may result in a civil
penalty equal to the amount of tax not collected, a $10,000 criminal
fine, and up to five years imprisonment. Other potential penalties
exist for violations such as fraud, failure to pay income taxes that are
collected, or failure to properly deposit collected taxes. <20> For a
discussion of the penalties associated with the failure to pay the
withheld taxes, see Section 607.4 For a general discussion of taxpayer
penalties, see Ch. 606.

PRACTICE TIP: The IRS has instituted a temporary, experimental
program, the Voluntary Compliance on Alien Withholding Program
(VCAP), for certain public and not-for-profit colleges and
universities and their charitable affiliates with defective
compliance in the payment, withholding, and reporting of certain
taxes due on payments made to alien individuals. An organization
requesting consideration under the VCAP agrees to (1) identify areas
of non-compliance with tax, withholding, and reporting obligations on
payments to alien individuals, (2) compute and pay any tax due, and
(3) institute procedures to ensure future compliance. The
organization will receive assurance that its proposed procedures are
acceptable to the IRS, and the IRS generally will not impose
penalties for identified underpayments or deficiencies. Compliance
defects eligible for VCAP consideration include failure to pay or
withhold the correct amount of income taxes on wages paid to alien
individuals. The VCAP is available for submissions made before March
1, 2002. Rev. Proc. 2001-20, 2001-1 C.B. 738.

If an employer fails to deduct and withhold income taxes because he
mistakenly treats an employee as a non-employee, his liability for income
taxes with respect to that employee is limited to 1.5 percent of the
employee's untaxed wages. However, if the employer also fails to
comply with the Code Section 6041(a), 6041A, or 6051 reporting
requirements, and no reasonable cause is shown, the employer's liability
for withholding taxes on wages for an employee mistakenly treated as a
non-employee is doubled to 3 percent. Code Section 3509(b). Code Section
3509 does not apply where an employer intentionally disregards the
withholding requirements. Code Section 3509(c).

PRACTICE TIP: Although Code Section 3509 does not
relieve an employer from liability for any penalties, additions to
tax, or additional amounts otherwise applicable with respect to a
failure to deduct and withhold taxes, the employer's tax liability
determined under Code Section 3509 is treated as the tax the employer
should have withheld for purposes of applying any penalty or
additional payment. Prop. Reg. Section 31.3509-1(d)(6).

Income and employment taxes collected by an employer are to be held in
trust for the United States. Code Section 7501(a). However, there is no
general requirement that the withheld sums be segregated from the
employer's general funds or that they be deposited in a separate bank
account until required to be paid to the government. Slodov v. United
States, 436 U.S. 238 (1978). The IRS can require a designated bank account
in trust for the United States if it determines that the employer is not
properly collecting, accounting for, or paying over the taxes.
Failure to properly collect, withhold, and pay over "trust" fund taxes
can result in imposition of the 100 percent penalty of Code Section
6672(a) and/or criminal prosecution under Code Section 7202. Code Section
7501(b). See Sections 607.4 and 607.6(d).

PRACTICE TIP: Payment of income taxes by an employee does not
necessarily relieve an employer of liability for penalties or
additional taxes resulting from the initial failure to deduct and
withhold those taxes. Code Section 3402(d). However,
if an employee pays the tax due and the employer inadvertently failed
to withhold the taxes, an interest-free adjustment is available if
the employer files timely supplemental returns reporting the
underpayment.

An employer may not use amounts incorrectly withheld from non-employees to
offset the employer's withholding shortfall with respect to employees.
Consolidated Flooring Services v. United States, Nos. 94- 352T, 95-1T
(Fed. Cl. June 8, 2000).

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