5. Wages and Other Compensation Circular E provides a general discussion of taxable wages. Thefollowing topics supplement that discussion. Employee Achievement Awards Do not withhold income, social security, or Medicare taxes on thefair market value of an employee achievement award if it is excludablefrom your employee's gross income. To be excludable from youremployee's gross income, the award must be tangible personal property(not cash or securities) given to an employee for length of service orsafety achievement, awarded as part of a meaningful presentation, andawarded under circumstances that do not indicate that the payment isdisguised compensation. Excludable employee achievement awards alsoare not subject to FUTA tax. Limits.The most you can exclude for the cost of all employee achievementawards to the same employee for the year is $400. A higher limit of$1,600 applies to qualified plan awards. These awards are employeeachievement awards under a written plan that does not discriminate infavor of highly compensated employees. An award cannot be treated as aqualified plan award if the average cost per recipient of all awardsunder all your qualified plans is more than $400. If during the year an employee receives awards not made under aqualified plan and also receives awards under a qualified plan, theexclusion for the total cost of all awards to that employee cannot bemore than $1,600. The $400 and $1,600 limits cannot be added togetherto exclude more than $1,600 for the cost of awards to any one employeeduring the year. Educational Assistance Programs The income exclusion from employee gross income is limited to$5,250 per employee in educational assistance during a calendar year.The excludable amount is not subject to income tax withholding orother employment taxes. The education need not be job related.However, the exclusion does not apply to graduate level courses. Formore information on educational assistance programs, see Regulationssection 1.127-2. The exclusion will expire for courses beginning on orafter December 31, 2001. Scholarship and Fellowship Payments Only amounts you pay as a qualified scholarship to a candidate fora degree may be excluded from the recipient's gross income. Aqualified scholarship is any amount granted as a scholarship orfellowship that is used for: Tuition and fees required to enroll in, or to attend, aneducational institution or Fees, books, supplies, and equipment that are required forcourses at the educational institution. Any amounts you pay for room and board, and any amounts you pay forteaching, research, or other services required as a condition ofreceiving the scholarship, are not excludable from the recipient'sgross income. A qualified scholarship is not subject to socialsecurity, Medicare, and FUTA taxes, or income tax withholding. Formore information, see Pub. 520, Scholarships andFellowships. Outplacement Services If you provide outplacement services to your employees to help themfind new employment (such as career counseling, resume assistance, orskills assessment), the value of these benefits may be income to themand subject to all withholding taxes. However, the value of theseservices will not be subject to any employment taxes if: You derive a substantial business benefit from providing theservices (such as improved employee morale or business image) separatefrom the benefit you would receive from the mere payment of additionalcompensation, and The employee would be able to deduct the cost of theservices as employee business expenses if he or she had paid forthem. However, if you receive no additional benefit from providing theservices, or if the services are not provided on the basis of employeeneed, then the value of the services is treated as wages and issubject to income tax withholding and social security and Medicaretaxes. Similarly, if an employee receives the outplacement services inexchange for reduced severance pay (or other taxable compensation),then the amount the severance pay is reduced is treated as wages foremployment tax purposes. Dependent Care Assistance Programs The maximum amount you can exclude from your employee's grossincome for dependent care assistance is $5,000 ($2,500 for marriedtaxpayers filing separate returns). The excluded amount is not subjectto social security, Medicare, and FUTA taxes, or income taxwithholding. If the dependent is cared for in a facility at your placeof business, the amount to exclude from the employee's income is basedon his or her use of the facility and the value of the servicesprovided. Report dependent care assistance payments in box 10 on FormW-2. For more information, see chapter 5 in Pub. 535. Dependent care providers.If you were the provider of dependent care or pay the providerdirectly, your employee may ask you for help in getting a completedForm W-10, Dependent Care Provider's Identification andCertification. The dependent care credit and the exclusion foremployer-provided dependent care assistance benefits generally cannotbe claimed by your employee unless the dependent care provider isidentified by name, address, and (if not an exempt organization)taxpayer identification number. The dependent care recipient mayrequest this information on Form W-10. Adoption Assistance Plans Your employees may be able to exclude from gross income payments orreimbursements you make under an adoption assistance program. Amountsyou pay or incur for an employee's qualified adoption expenses are notsubject to income tax withholding. However, these amounts (includingadoption benefits paid from a cafeteria plan, but not includingadoption benefits forfeited from a cafeteria plan) are subject tosocial security, Medicare, and FUTA taxes. If the adoption assistancebenefits are part of a cafeteria plan, they are still subject to theseemployment taxes. Report adoption benefits in box 13, using code T, onForm W-2. See Pub. 968, Tax Benefits for Adoption, for moreinformation. Withholding for Idle Time Payments made under a voluntary guarantee to employees foridle time (any time during which an employee performs noservices) are wages for the purposes of social security, Medicare, andFUTA taxes, and income tax withholding. Back Pay Treat back pay as wages in the year paid and withhold and payemployment taxes as required. If back pay was awarded by a court orgovernment agency to enforce a Federal or state statute protecting anemployee's right to employment or wages, special rules apply forreporting those wages to the Social Security Administration. Theserules also apply to litigation actions, and settlement agreements oragency directives that are resolved out of court and not under a courtdecree or order. Examples of pertinent statutes include, but are notlimited to, the National Labor Relations Act, Fair Labor StandardsAct, Equal Pay Act, and Age Discrimination in Employment Act. GetPub. 957, Reporting Back Pay and Special Wage Payments tothe Social Security Administration, and Form SSA-131,Employer Report of Special Wage Payments, for details. Supplemental Unemployment Benefits If you pay, under a plan, supplemental unemployment benefits to aformer employee, all or part of the payments may be taxable andsubject to income tax withholding, depending on how the plan isfunded. Amounts that represent a return to the employee of amountspreviously subject to tax are not taxable and are not subject towithholding. You should withhold income tax on the taxable part of thepayments made, under a plan, to an employee who is involuntarilyseparated because of a reduction in force, discontinuance of a plantor operation, or other similar condition. It does not matter whetherthe separation is temporary or permanent. The taxable part is notsubject to social security, Medicare, or FUTA taxes. Withholding on taxable supplemental unemployment benefits must bebased on the withholding certificate (Form W-4) the employee gave you. Golden Parachutes (Excessive Termination Payments) A golden parachute is a contract entered into by a corporation andkey personnel under which the corporation agrees to pay certainamounts to the key personnel in the event of a change in ownership orcontrol of the corporation. Payments under golden parachute contracts,like any termination pay, are subject to social security, Medicare,and FUTA taxes, and income tax withholding. Beginning with payments under contracts entered into, significantlyamended, or renewed after June 14, 1984, no deduction is allowed tothe corporation for excess parachute payments. The employeeis subject to a 20% nondeductible excise tax to be withheld by thecorporation on all excess payments. The payment is generallyconsidered an excess parachute payment if it equals or exceeds threetimes the average annual compensation of the recipient over theprevious 5-year period. The amount over the average is the excessparachute payment. Example.An officer of a corporation receives a golden parachute payment of$400,000. This is more than three times greater than his or heraverage compensation of $100,000 over the previous 5-year period. Theexcess parachute payment is $300,000 ($400,000 minus $100,000). Thecorporation cannot deduct the $300,000 and must withhold the excisetax of $60,000 (20% of $300,000). Exempt payments.Most small business corporations are exempt from the goldenparachute rules. See Code section 280G for more information. Interest-Free and Below-Market-Interest-Rate Loans If an employer lends an employee more than $10,000 at an interestrate less than the current applicable Federal rate (AFR), thedifference between the interest paid and the interest that would bepaid under the AFR is considered additional compensation to theemployee. This rule applies to any such loan, regardless of amount, ifone of its principal purposes is the avoidance of Federal tax. This additional compensation to the employee is subject to socialsecurity, Medicare, and FUTA taxes, but not to income tax withholding.Include it in compensation on Form W-2 (or Form 1099-MISC for anindependent contractor). The AFR is established monthly and publishedby the IRS each month in the Internal Revenue Bulletin. You can getthese rates by calling 1-800-829-1040 or byaccessing the IRS's Internet Web Site at www.irs.gov. Formore information, see chapter 8 in Pub. 535. Group-Term Life Insurance Include in wages the cost of group-term life insurance you providedto an employee for more than $50,000 of coverage, or for coverage thatdiscriminated in favor of the employee. This amount is subject tosocial security and Medicare taxes, but not FUTA tax or income taxwithholding. Plan requirements for exclusion.To exclude the cost of life insurance benefits from the wages over$50,000 of your employees, your plan must meet the followingrequirements. It provides a general death benefit that is not included inincome. You provide it to a group of employees. It provides an amount of insurance to each employee based ona formula that prevents individual selection, using factors such asage, years of service, pay, or position. You provide it under a policy you carry directly orindirectly. Even if you do not pay any of the policy's cost, you areconsidered to carry it if you arrange for payment of its cost by youremployees and charge at least one employee less than, and at least oneemployee more than, the cost of his or her insurance. Determine thecost of the insurance, for this purpose, using the table for themonthly cost per $1,000 of insurance below. Note: UntilJanuary 1, 2003, you may use the table previously in effect to makethis determination. See Reg. 1.79-1 or the January 1999 revisionof Pub. 15-A. It meets certain nondiscrimination requirements. See chapter5 of Pub. 535, Business Expenses, for moreinformation. The tax treatment is the same if the premiums are paid through acafeteria plan (section 125). See Cafeteria Plans, later.This taxable insurance cost can be treated as paid by the pay period,by the quarter, or on any basis as long as the cost is treated as paidat least once a year. Permanent benefits.Group-term life insurance may be provided as part of a policy thatincludes permanent benefits. Permanent benefits are any benefits thatextend beyond one policy year, such as insurance with a paid-up orcash surrender value. If your policy includes permanent benefits, you must include inyour employees' wages the cost of the permanent benefits minus theamount the employee pays for them. For more information, see section 1.79-1(d) of theRegulations. Monthly cost.You determine the monthly cost of group-term life insurance bymultiplying the number of thousands of dollars of insurance coverage(figured to the nearest 10th) by the appropriate cost per thousand permonth. You determine age on the last day of the tax year. If youprovide group-term life insurance for a period of coverage of lessthan 1 month, you prorate the monthly cost over that period. Themonthly cost of each $1,000 of group-term life insurance protection isas follows: Age Monthly Cost Under 25 $ .05 25 through 29 .06 30 through 34 .08 35 through 39 .09 40 through 44 .10 45 through 49 .15 50 through 54 .23 55 through 59 .43 60 through 64 .66 65 through 69 1.27 70 and over 2.06 Coverage for dependents.Group-term life insurance coverage paid by the employer for thespouse or dependents of an employee may be excludable from income as ade minimis fringe benefit (see section 6). This part of the coveragethat the employee paid on an after-tax basis is also excludable fromincome. For this purpose, the cost is figured using the monthly costtable above. Former employees.For group-term life insurance over $50,000 provided to formeremployees (including retirees), the former employees must pay theemployee's share of social security and Medicare taxes with theirincome tax returns. You are not required to collect those taxes. Usethe table above to determine the amount of social security andMedicare taxes owed by the former employee for coverage provided afterseparation from service. Report those uncollected amounts separatelyin box 13 on Form W-2 using codes M and N. See the Instructionsfor Form W-2 and Form W-3. Workers' Compensation--Public Employees State and local government employees, such as police officers andfirefighters, sometimes receive payments due to injury in the line ofduty under a statute that is not the general workers'compensation law of a state. If the statute limits benefits towork-related injuries or sickness and does not base payments on theemployee's age, length of service, or prior contributions, the statuteis "in the nature of" a workers' compensation law. Payments underthe statute are not subject to FUTA tax or income tax withholding, butthey are subject to social security and Medicare taxes to the sameextent as the employee's regular wages. However, the payments are nolonger subject to social security and Medicare taxes after theexpiration of 6 months following the last calendar month in which theemployee worked for the employer. Leave Sharing Plans If you establish a leave sharing plan for your employees thatallows them to donate leave to other employees for medicalemergencies, the amounts paid to the recipients of the leave areconsidered wages. These amounts are includible in the gross income ofthe recipients and are subject to social security, Medicare, and FUTAtaxes, and income tax withholding. Do not include these amounts in theincome of the donors. Cafeteria Plans Cafeteria plans, including flexible spending arrangements, arebenefit plans under which all participants are employees who canchoose from among cash and certain qualified benefits. If the employeeelects qualified benefits, employer contributions are excluded fromthe employee's wages if the benefits are excludable from gross incomeunder a specific section of the Internal Revenue Code (other thanscholarship and fellowship grants under section 117, employee fringebenefits under section 132, and educational assistance programs undersection 127). The cost of group-term life insurance that is includiblein income only because the insurance exceeds $50,000 of coverage isconsidered a qualified benefit under a special rule. Generally, qualified benefits under a cafeteria plan are notsubject to social security, Medicare, and FUTA taxes, or income taxwithholding. However, group-term life insurance that exceeds $50,000of coverage is subject to social security and Medicare taxes, but notFUTA tax or income tax withholding, even when provided as qualifiedbenefits in a cafeteria plan. Adoption assistance benefits provided ina cafeteria plan are subject to social security, Medicare, and FUTAtaxes, but not income tax withholding. If an employee elects toreceive cash instead of any qualified benefit, it is treated as wagessubject to all employment taxes. For more information, see chapter 5in Pub. 535. Nonqualified Deferred Compensation Plans Social security, Medicare, and FUTA taxes.Employer contributions to nonqualified deferred compensation ornonqualified pension plans are treated as social security, Medicare,and FUTA wages when the services are performed or the employee nolonger has a substantial risk of forfeiting the right to the deferredcompensation, whichever is later. This is true whether the plan isfunded or unfunded. Amounts deferred are subject to social security, Medicare, and FUTAtaxes unless the value of the amount deferred cannot be determined;for example, if benefits are based on final pay. If the value of thefuture benefit is based on any factors that are not yet reasonablydeterminable, you may estimate the value of the future benefit andwithhold and pay social security, Medicare, and FUTA taxes on thatamount. If amounts that were not determinable in prior periods are nowdeterminable, they are subject to social security, Medicare, and FUTAtaxes on the amounts deferred plus the income attributable to thoseamounts deferred. For more information, see Regulation section31.3121(v)(2)-1. Income tax withholding.Amounts deferred under nonqualified deferred compensation plans arenot subject to income taxes until benefit payments begin. Withholdincome tax on nonqualified plans as follows: Funded plan. Withhold when the employees' rightsto amounts are not subject to substantial risk of forfeiture or aretransferable free of such risk. A funded plan is one in which anemployer irrevocably contributes the deferred compensationto a separate fund, such as an irrevocable trust. Unfunded plan. Generally, withhold when you makepayments to the employee, either constructively or actually. For more information, see Regulations section 31.3121(v)-1. Employee Stock Options There are three classes of stock options--incentive stockoptions, employee stock purchase plan options, and nonqualifiedoptions. Generally, incentive stock options and employee stockpurchase plan options are not taxable to the employee either when theoptions are granted or when they are exercised (unless the stock isdisposed of in a disqualifying disposition). However, the spread(between the exercise price and fair market value of the stock at thetime of exercise) on employee stock purchase plan options is subjectto social security, Medicare, and FUTA taxes when the options areexercised. Additionally, the spread on nonqualified options normallyis taxable to the employee as wages when the options are exercised(see Regulations section 1.83-7). These wages are subject tosocial security, Medicare, and FUTA taxes, and income tax withholding. Tax-Sheltered Annuities Employer payments made by an educational institution or atax-exempt organization to purchase a tax-sheltered annuity for anemployee are included in the employee's social security and Medicarewages if the payments are made because of a salary reductionagreement. They are not included in box 1 on Form W-2 and are notsubject to income tax withholding. Contributions to a Simplified Employee Pension (SEP) An employer's SEP contributions to an employee's individualretirement arrangement (IRA) are excluded from the employee's grossincome. These excluded amounts are not subject to social security,Medicare, and FUTA taxes, or income tax withholding. However, any SEPcontributions paid under a salary reduction agreement (SARSEP) areincluded in wages for purposes of social security and Medicare taxesand FUTA. See Pub. 560, Retirement Plans for Small Business(SEP, SIMPLE, and Keogh Plans), for more information about SEPs. Salary reduction simplified employee pensions (SARSEP)repealed.You may not establish a SARSEP after 1996. However, SARSEPsestablished before January 1, 1997, may continue to receivecontributions. SIMPLE Retirement Plans Employer and employee contributions to a savings incentive matchplan for employees (SIMPLE) retirement account (subject tolimitations) are excludable from the employee's income and are exemptfrom Federal income tax withholding. An employer's nonelective (2%) ormatching contributions are exempt from social security, Medicare, andFUTA taxes. However, an employee's salary reduction contributions to aSIMPLE are subject to social security, Medicare, and FUTA taxes. Formore information about SIMPLE retirement plans, see Pub. 560.