Although it might not be obvious, tax law permeates most HR responsibilities – from paying an employee, to arranging for benefit coverages, to settling employment lawsuits, and paying pensions. Knowing a few key tax principles may help employers understand why things are done in a certain way, what questions to ask when discussing possible solutions to a problem, and how to avoid unpleasant surprises. Three key principles are as follows:
- Anything (cash, property, benefits, rights, etc.) that an employer provides to an employee (including a former employee) is income to that employee and the employer has an obligation to withhold income and payroll taxes from the payment unless a specific section of the Internal Revenue Code (“Code”) provides otherwise. This principle originates from Code §61, which provides that “[E]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived. . .” The Code requires employers to withhold income taxes and the employee’s share of FICA taxes from wages as defined in Code §§3121 and 3401. Employers that fail to withhold the required taxes from wages remain liable to the IRS for the required withholding, including the employee’s share of FICA.
As mentioned above, this principle also applies to former employees. For example, a for-profit employer was considering replacing its retiree health care coverage with cash payments that retirees could use to purchase medical insurance. Currently, the retirees do not include in income the value of the employer provided coverage. Employer-paid premiums for health care coverage, even coverage for retirees, are exempt from federal income tax pursuant to Code §106. The proposed direct payment of cash to a retiree would be taxable income to the retiree unless the employer conditioned the payment upon the retiree first providing proof that the retiree had paid premiums or incurred medical expenses equal to the amount of the cash payment. Payments made to a retiree under such a health reimbursement arrangement would be tax-free to the retiree under Code §106.
The settlement of an employment lawsuit is another situation where this rule applies. Payments for back pay, emotional distress, and punitive and liquidated damages are taxable income to the former employee and therefore the employer must withhold income taxes from these payments. Only in situations where the former employee can document bodily injury may the portion of the settlement intended to compensate the former employee for damages on account of personal physical injuries or physical sickness be excluded from taxable income under Code §104.
- Written documents may be required to obtain the intended tax benefit. Numerous Code sections provide that favorable tax treatment is available only if there is a written plan document and the terms of that document are followed. For example, Code §125 allows employees to pay their share of premiums for employer sponsored medical coverage with pre-tax dollars and Code §3121(a)(5)(G) excludes the pre-tax payments from both the employee and employer required FICA withholdings. To obtain these tax favored treatments, the regulations under Code §125 require that the employer have a written plan document in place prior to implementing the pre-tax deductions. That written plan document, as it may be amended from time to time, must be produced if the IRS were to audit the employer’s benefit plans. More importantly, the written plan document should be available to the HR professional that is responsible for implementing and administering the plan.
- Changes in an organization may impact the anticipated tax benefits. Anytime an employer makes a change that affects payroll, the HR professional should look for any corresponding changes that need to be made to retain the anticipated tax benefits. Take, for example, a Code §401(k) plan that provides for salary deferrals to be withheld from all compensation paid to an employee. When the employer adds a new item of compensation, such as a perfect attendance bonus, the coding on the payroll system must be reviewed to ensure that deferrals will be withheld from these payments, or that the plan is amended to exclude the new form of bonus if that is what the employer wants.
Corporate reorganizations are another area where a change may jeopardize an intended tax benefit. Consider a business that establishes a new subsidiary with a separate employer identification number with the intent of transferring some of its current employees to the new business. Most Code §401(k) plan documents require that each separate legal entity must be listed in the plan document or sign a separate adoption agreement as a participating employer. Failure to list the new legal entity prior to the date that the entity has employees could result in the employees being excluded from participation in the 401(k) plan or require the employer to request IRS approval of a retroactive plan amendment if the employees were allowed to contribute under the plan prior to its being amended.
These three principles were synthesized from my experience advising HR professionals about the tax laws that impact their responsibilities and how to avoid unpleasant surprises.