Do you pay your employees supplemental wages, like bonuses and stock options? Are you withholding tax for these payments, and do you adhere to the rules that govern this? Navigating this terrain can be challenging.
In this article, we delve into the IRS regulation concerning this and outline the different ways in which you can calculate tax in this context. Whether you’re an employer handling payroll or an employee receiving supplemental wages, our goal is to help you stay compliant.
Understanding Supplemental Wages
Supplemental wages are extra money paid in addition to your regular salary. This can include overtime pay, bonuses, stock options, commissions, severance payments, awards, and more. Because of the variable and sometimes unpredictable nature of these payments, the IRS has special requirements when it comes to tax for this type of compensation. You need to get the calculations right to avoid the penalties that come with both under- or overpayment of taxes.
Special Withholding Rules for Supplemental Wages
There are different methods to help you accurately calculate tax for supplemental wages. For bonuses, for example, you can use either the flat rate or the aggregate method.
- Flat Rate Method: This method applies a specific percentage to the supplemental wage amount. For instance, if bonuses and stock options are under $1 million, employers typically apply a flat withholding rate of 22%. If the total annual supplemental wages exceed $1 million, employers must withhold tax on the amount over $1 million at the highest income tax rate of 37%.
- Aggregate Method: The aggregate method requires adding the supplemental wages to the employee’s most recent regular wages and withholding tax based on the combined amount, at the employee’s regular withholding rate. This method can result in higher withholding initially but may balance out over the year.
Staff that have their supplemental pay included with their regular wages are typically taxed based on the information they provide their employer on Form W-4.
Tax Withholding on Stock Options and Equity Compensation
When it comes to stock options and other forms of equity compensation, there are specific rules and considerations when it comes to taxes, too.
- Restricted Stock Units (RSUs): RSUs are a type of equity compensation where a company promises to give an employee shares of its stock in the future, once certain conditions are met. The employee does not own the stock or have shareholder rights until the units vest. Therefore, taxes on these stocks are only due when they vest. The taxable amount is also calculated based on the market value of the stock at the time of vesting.
- Incentive stock options (ISOs): ISOs are a type of stock option that can only be granted to employees. They offer special tax benefits under the Internal Revenue Code. While there is no immediate tax withholding for ISOs if certain conditions are met, the difference between the market value and the exercise price (the fixed price at which an employee can purchase shares of company stock) may be subject to the alternative minimum tax (AMT).
- Nonstatutory stock options (NSOs): NSOs are given to employees, contractors, or board members and do not qualify for the special tax treatments available to incentive stock options (ISOs). Tax is withheld when the employee buys the stock at the predetermined option price. The taxable portion is the difference between the stock’s market value when the employee buys the stock and the exercise price.
Reporting and Remitting Withholding Tax
Employers have specific responsibilities when it comes to reporting supplemental wages. These include:
- Remit taxes timeously. Employers must withhold and remit taxes according to a specific schedule depending on the total tax liability.
- File supplemental wages accurately. Employers must report bonus and stock option payments via Forms W-2 and 1099.
Report supplemental wages for employees on Form W-2 in Box 1 (wages, tips, other compensation).
Report supplemental wages for non-employees, such as contractors, on Form 1099-MISC or Form 1099-NEC, depending on the type of payment.
Special considerations for non-residents
When dealing with non-resident aliens and foreign entities, there are additional rules that apply in this regard.
- Withholding requirements: Employers must withhold federal income tax on the supplemental wages of non-resident aliens at a flat rate of 30%, unless a lower rate applies under an applicable tax treaty.
- Reporting: Supplemental wages paid to non-resident aliens must be reported on Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding).
Employers should also keep accurate records of all transactions related to supplemental wages and the associated tax withholdings. Timely remittance and accurate reporting are critical to avoiding interest and penalties.
At Fusion, our CPAs can help you navigate the complexities of tax withholding for supplemental wages. We maintain your supporting records to ensure compliance. Our CPAs can also facilitate accurate processing of Forms W-2, 1099, and 1042-S. Contact us today!
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This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. We base articles on current or proposed tax rules at the time of writing and do not update older posts for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.