Employment tax and reporting treatment of differential payments to active duty reservists.

• Author: Dyson, Marianna G.

In the category of "no good deed goes unpunished," civilian employers seeking to ease the financial strain for employees recently called to active military duty are faced with having to determine the correct federal employment tax and reporting treatment of "differential" or "supplemental" payments made to these employees without the benefit of updated and concise guidance. Calculated to make up the difference between the employee's regular civilian pay and his or her active duty wages while serving in the U.S. Armed Forces, these voluntary employer payments have resulted in disagreements with the very employees (and their families) that these payments were designed to help.

The Internal Revenue Service first ruled on the issue of differential payments more than 60 years ago. Differential payments clearly constitute income under section 61 of the Internal Revenue Code and would appear to be "wages" for purposes of federal income tax withholding (FITW), Federal Insurance Contributions Act (FICA) taxes, and Federal Unemployment Tax Act (FUTA) taxes, because the benefits are being provided based on the employee's past employment relationship with the civilian employer. Even IRS regulations describe differential payments to military personnel as "compensation paid by other employers." (1)

There is no indication, however, that the IRS intends to retreat from its historic ruling position that differential payments to former employees called to active duty by the Federal government or into federal service as a member of the National Guard are not wages for employment tax purposes because the employment relationship was "interrupted." Since the most recent iteration of the guidance nearly 35 years ago, there has been no additional guidance addressing whether the conclusion that the employment relationship was "interrupted" still holds true today. It simply is not clear whether the relationship has in fact been interrupted when civilian employers are more generous than what appears to have been contemplated by IRS rulings or by federal law guaranteeing reemployment and the protection of certain health and pension benefits to veterans. In other words, employers are struggling to be fully compliant with federal tax laws while doing "the right thing" by their employees, but without the benefit of updated IRS guidance and, therefore, they are potentially exposed to liabilities for the failure to subject the differential payments to federal employment taxes.

Until the IRS issues updated guidance, the IRS will not likely challenge a civilian employer's treatment of differential payments as not constituting "wages" for employment tax purposes. Moreover, even if the IRS were to challenge the employer's reliance on its outdated rulings, it will likely be precluded from arguing against the public guidance articulated in an outstanding revenue ruling. (2) In addition, if the employer decides not to treat the payments as "wages," there is an argument in support of entering into a voluntary income tax withholding agreement with the employee called to active duty, so that the latter is not greeted with a big tax liability when he or she returns from active duty. Furthermore, even if voluntary withholding is not elected by the military member, the employer may report the differential payments on Forms W-2 in Box 1 as opposed to reporting the payments on Forms 1099-MISC.

1. Historical Treatment of Differential Payments to Reservists: Rev. Rul. 69-136

   The most recent formal guidance from the Internal Revenue Service on the employment tax treatment of differential payments came in 1969. Rev. Rul. 69-136 (3) concludes, in two hypothetical situations, that differential payments made by civilian employers to "former" employees who have been called to active duty in the U.S. Armed Forces or for service with the National Guard are "not 'wages' for services performed in 'employment' for the companies." In Situation 1 of the ruling, the differential payments were made to a reservist by a civilian employer who had also committed to making every effort to reemploy the veteran, but had not guaranteed such reemployment. The fact pattern of Situation 2, involving differential payments made to employees called for indefinite service in the National Guard, is silent on the issue of reemployment.

   Rev. Rul. 69-136 was issued on the heels of Rev. Rul. 68-238. (4) The earlier ruling had concluded that differential payments made to employees on temporary duty (such as training) with the National Guard constituted "wages" for payroll tax purposes, because the employment relationship was not disturbed during this time. (5) In distinguishing Rev. Rul. 68-238, the 1969 ruling focuses on the employees' being called for active military service and concludes that the employment relationship had in fact "terminated" during the period of active duty...