Supplemental wages are wages paid in addition to regular
wages, including, but not limited to, overtime pay, sick leave pay,
vacation pay, bonus payments, commissions, severance pay, awards,
prizes, back pay, retroactive pay increases for current employees,
payments for nondeductible moving expenses, and tips. Withholding
practices vary depending upon how the wages are paid.
If an employee receives supplemental wages exceeding
$1,000,000 in a calendar year, the excess is subject to a tax withholding
of 35 percent (or the highest income tax rate in effect for that year).
Employers must use the 35 percent rate regardless of the information
on the employee's Form W-4.
The following rules apply when an employee receives less
than or equal to $1,000,000 in supplemental wages in a calendar year.
Unidentified supplemental wages. When supplemental wages are combined with regular wages without identification,
employers should withhold taxes as if the total were a single payment
for a regular payroll period.
Identified supplemental wages. When supplemental wages are identified separately from regular wages,
the income tax withholding method will depend on how income taxes
are withheld from the employee's regular wages.
Employers that withheld income tax from an employee's
regular wages can either:
1. Withhold a flat
25 percent; or
2. Add the supplemental
and regular wages for the most recent payroll period, calculating
the withholding as if the total were a single payment, and then subtract
the tax already withheld from the regular wages and withhold the remaining
tax from the supplemental wages.
Employers that do not withhold income tax from
an employee's regular wages should use method 2, above.
According to the IRS, supplemental wages are subject to Social
Security, Medicare, and FUTA taxes regardless of the withholding method
Whether severance pay is subject to Federal
Insurance Contributions Act (FICA) taxes has often been a source of
confusion for employers. However, the U.S. Supreme Court recently
clarified the issue in U.S. v. Quality Stores, Inc., holding
that generally, severance pay is subject to FICA tax withholding (United States v. Quality Stores, Inc., No. 12-1408
(U.S. S.Ct., 2014)). Quality Stores, Inc. made severance payments
to employees who where involuntarily terminated as part of its bankruptcy.
The severance payments were not tied to the receipt of state unemployment
insurance and varied based on job seniority and time served. Quality
Stores initially paid and withheld FICA taxes, but it later tried
to get a refund for itself and its former employees, claiming that
the severance payments should not have been taxed as wages under FICA.
The District Court and the 6th Circuit both concluded that severance
payments were not “wages” under FICA. The Supreme Court disagreed,
holding that such severance payments are taxable wages for FICA purposes.
The Court noted that FICA defines the term “wages” broadly, and severance
payments fit within this definition. It also pointed out that FICA
contains no general exception for severance payments. Finally, the
Court determined that the Internal Revenue Code chapter governing
income tax withholding does not limit the meaning of “wages” for FICA
Sick leave and disability pay are subject to federal
income taxation; however, only the first 6 months of sick and disability
pay are subject to Social Security, Medicare, and federal unemployment
taxes. Employees may request that third-party payers withhold taxes
from sick and disability pay.
Vacation pay alone is subject to withholding as if it
were a regular wage payment. When vacation pay is in addition to regular
wages, it should be treated as a supplemental wage.
Federal income tax, FICA tax, and Medicare tax must be
withheld from all supplemental wage payments made to employees. For
bonuses that are less than or equal to $1,000,000, employers deduct
income tax either according to the individual's schedule or at a flat
25 percent rate. Some executives may want an even larger-than-normal
deduction to be made for withholding when the bonus is a considerable
Any bonus can be paid in a separate check. If combined
with a regular paycheck, and the portion attributed to the bonus is
not specified, the amount to be withheld on the combined amount must
then be computed from the regular tables for withholding.
Tips are generally subject to withholding. Employees
will report tips on Form 4070 (Employee's Report of Tips to Employer)
when tips received are more than $20 per month. Employers may implement
a system that allows employees to report their tips electronically.