While this may not be obvious, tax law permeates most HR tasks – from paying an employee to organizing benefit coverage to settling labor disputes and paying pensions. Understanding some key tax principles can help employers understand why certain things are being done, what questions to ask when discussing possible solutions to problems, and how to avoid unpleasant surprises. Three basic principles are as follows:
- Anything (cash, property, benefits, rights, etc.) that an employer provides to an employee (including a former employee) is an income for that employee, and the employer is required to withhold income and wage taxes from the payment, unless a specific section of the Internal Revenue Code (“Code”) is available, provides otherwise. This principle comes from the Code §61, which provides that “[E]Unless otherwise stated in this subheading, gross income means all income from any source. . . ”The Code requires employers to withhold income taxes and the employee’s share of FICA taxes from wages, as defined in Code Sections 31121 and 3401. Employers who fail to withhold required taxes from wages remain liable to the IRS for required withholding taxes, including the employee’s portion of the FICA.
As mentioned above, this principle also applies to former employees. For example, a for-profit employer considered replacing its retiree health insurance with cash payments that retirees could use to purchase health insurance. Currently, retirees do not include the value of employer-provided insurance in income. Health insurance premiums paid by the employer, including those for pensioners, are exempt from federal income tax in accordance with Code §106. The proposed direct payment of cash to a retiree would be taxable income for the retiree, unless the employer made the payment conditional on the retiree first providing evidence that the retiree paid bonuses or medical expenses of the amount of the cash payment. Payments to a pensioner under such a health reimbursement agreement would be tax-free for the pensioner according to Code §106.
Settling a labor dispute is another situation in which this rule applies. Payments for back payments, emotional stress, and penalties and damages are taxable for the former employee and therefore the employer must withhold income tax from these payments. Only in situations in which the former employee can prove bodily harm can the part of the settlement that is intended to compensate the former employee for damage due to bodily harm or physical illness be excluded from taxable income in accordance with Code §104.
- Written documents may be required in order to receive the intended tax benefit. Many sections of the Code state that favorable tax treatment is only possible if a written planning document is available and the provisions of this document are complied with. For example, code §125 allows workers to pay their share of employer-sponsored health insurance premiums using pre-tax dollars, and code §3121 (a) (5) (G) excludes required pre-tax payments from both Employees as well as FICA withholding from the employer. In order to receive this tax-privileged treatment, the regulations according to Code §125 require that the employer has a written planning document before the implementation of the input tax deductions. This written planning document, which may be changed from time to time, is required if the IRS is to review the employer’s pension plans. More importantly, the written planning document is available to the HR professional who is responsible for implementing and managing the plan.
- Changes in an organization can affect the expected tax benefits. Whenever an employer makes a change that affects payroll, the HR professional should look for changes that need to be made in order to maintain the expected tax benefits. For example, consider a §401 (k) plan that provides for deferred pay to be withheld from any compensation paid to an employee. When the employer adds new compensation, e.g. B. a perfect attendance bonus, the coding in the payroll system needs to be checked to ensure that deferrals are withheld from those payments or that the plan is changed to exclude the new form of bonus if that is what the employer wants .
Corporate restructuring is another area where a change can jeopardize an intended tax benefit. Imagine a company creating a new subsidiary with a separate employer identification number to transfer some of its current employees to the new company. Most code §401 (k) planning documents require each individual legal entity to be listed in the planning document or to sign a separate adoption agreement as a participating employer. Failure to list the new legal entity prior to the date the individual has employees may result in the employees being excluded from participating in the 401 (k) plan or requiring the employer to approve a retrospective plan change Request the IRS if employees have been approved to contribute to the plan prior to the change.
These three principles were put together from my experience advising HR professionals about the tax laws that affect their responsibilities and how to avoid unpleasant surprises.