Is it wages?

• Author: Stara, Nancy J.
• Position: Determining what constitutes wages for tax purposes

EXECUTIVE SUMMARY

* In certain cases, termination payments and settlement damages paid to an employee are not considered wages.

* An employer's withholding obligation may be reduced based on either a reasonable expectation that no obligation existed or a lack of adequate notice of the duty to withhold.

* In many cases, plan documents can provide alternative definitions of compensation for retirement benefit purposes.

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Although wages are broadly defined not all payments by employers to employees are wages subject to income tax withholding and payment of employment taxes. In fact, relief from the duty to withhold or the obligation to pay employment taxes can substantially reduce an employer's liability. This article examines recent cases defining wages and their corresponding effect on withholding and employment tax obligations and on retirement benefits.

Defining the Issue

In the absence of regulatory exclusion, wages are treated similarly for purposes of income tax withholding and employment tax obligations. (1) For employment tax purposes, Secs. 3121(a) and 3306(b) broadly define wages as "all remuneration for employment" The definition provided in Sec. 3401(a) is essentially identical for income tax withholding purposes. The question is which payments fall outside the definition of wages from the start. (2) For instance, past service and current wages may be a factor in valuing either tort and tortlike compensatory damages or contract and property rights, yet these payments ate not wages. If payments are not wages, the employer incurs neither a primary nor a secondary obligation to withhold or pay employment taxes.

If payments are wages, three additional questions arise:

* Does the obligation to withhold exist? As a secondary obligation, an employer's duty to withhold will not arise if it either reasonably expects the employee to incur business expenses or lacks adequate notice of its duty. When an employer has no obligation to withhold, the government must collect the employee's portion of the tax directly from the employee.

* When are employment taxes calculated? Is the tax rate based on the year in which the wages should have been paid or in the year actually paid? According to the Supreme Court, (3) the year the wages are paid controls.

* Will the employer incur a liability to increase retirement benefits? When definitions of compensation for purposes of retirement benefits are either ambiguous or follow one of the safe-harbor definitions provided by Regs. Sec. 1.415-2(d)(11)(i), a designation as wages for employment tax purposes may trigger a corresponding employer liability to increase an employee's retirement plan benefits.

Is It Wages?

Although wages and employment are read broadly in the FICA context, not all payments by employers to employees are clearly wages. The payments must be remuneration for services provided by the employee to his or her employer to be subject to FICA taxes. (4)

What remuneration for services is actually called and on what basis it is paid is immaterial. (5) Further, the employment relationship need not exist at the time the remuneration is paid. (6) Although wages are remuneration for employment, employment has been broadly defined to mean not only work actually done, but "the entire employer-employee relationship for which compensation is paid to the employee by the employer." (7) Yet, not all payments from employers are wages. Recognizing when payments may not be wages is the first step toward reducing withholding and employment tax liability.

Dismissal Payments

Under Regs. Sec. 31.3401(a)1(a)-1 (b)(4) and Rev. Rul. 74-252, (8) wages generally include payments made by an employer to an employee who is involuntarily dismissed, whether or not the employer is legally bound to make the payments. But even dismissal payments (voluntary or involuntary) will not be wages if they rail to represent remuneration for employment. Typically, four types of employee termination payments are made by employers; two are wages and two are not:

1. Contractual termination clause: Payments required by an employment contract termination clause usually represent anticipated earnings and are wages.

2. Rights earned by past service: A lump-sum payment made for the relinquishment of seniority rights that had been awarded based on an employee's prior service are wages.

3. Relinquishment of contract rights: Payments to obtain the release of a noncompensatory contract right are not wages.

4. Supplemental unemployment compensation: Under Sec. 3402(o), payments for involuntary termination of employment as a direct result of a reduction in workforce are not wages.

The amount of employee termination payments is calculated by considering past performance and current salary. Although this calculation is indicative of wages, the method of calculation will not be controlling if the payment is for a noncompensatory contract right protected by law and has an exchangeable value. (9) Key elements in establishing the existence of a noncompensatory contract right for which payments are made include: (1) the existence of an employment contract for either a fixed term or life (e.g...