Tax Treatment Differs for Military Differential Pay

Wednesday, May 06, 2009

Times are difficult for most Americans right now, but probably no more so than for employees who are called up for active military duty of at least 30 days. Recognizing the hardships of a military-related absence, some employers will offer to make up the difference between the military pay and the employee’s current salary. The IRS recently clarified how this “differential pay” is treated for tax purposes.

In Revenue Ruling 2009-11, the IRS answered three basic questions, based on changes to the Internal Revenue Code caused by the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act):

·         Is differential pay considered to be ”wages” for purposes of taxation under the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA) and Federal income tax (FIT) withholding?

·         How do employers calculate income taxes that must be withheld on differential pay?

·         What are the reporting requirements?

Taxation of Wages

The HEART Act reversed a 40-year-old Revenue Ruling that excluded differential pay from FICA, FUTA and FIT withholding. The IRS clarified that the HEART Act makes differential pay subject to FIT withholding only. Differential pay is not considered to be wages for FICA and FUTA purposes.

Withholding Calculation

Differential pay is classified as supplemental wages for FIT withholding purposes. Assuming that the supplemental wages do not exceed $1 million for the employee in a given calendar year, there are two ways to calculate the withholding:  aggregate and optional flat rate withholding.

The aggregate procedure simply involves adding the differential wage payment to regular wages, if any, for the payroll period and treating the aggregate of the two as a single wage payment. The withholding method used for regular wages is then used to calculate withholding on the single wage payment, taking into consideration the employee’s Form W-4.

To use the optional flat rate procedure, you must satisfy two conditions. First, the differential wage payment either cannot be paid concurrently with regular wages or must be separately stated on payroll records. Second, there must be some amount of FIT withholding from regular wages paid to the employee during the current or preceding calendar year. If these conditions are met, the rate is currently 25 percent, but this could change if income tax rates change. Thus, the optional flat rate approach does not take into account Form W-4.

If supplemental wages exceed $1,000,000, the Regulations provide that the rate must be the highest applicable rate under section 1 of the Code, currently 35 percent.

Reporting Requirements

Because differential payments are wages subject to FIT withholding, they are reportable as wages on each employee’s Form W-2.

The Revenue Ruling applies to any differential payments made on or after January 1, 2009, and provides another example of the complexity of payroll administration. If you are interested in learning more about how Infinisource Priority Pay can be your one-stop payroll solution, please contact our Sales Department at 800-300-3838