In Program Manager Technical Advice 2018-015 the IRS analyzes how to handle the implications to the employee of an examination of an employer where it is determined the employer failed to properly classify fringe benefits received by an individual as taxable wages.  Specifically, the guidance looks at whether the employer’s payment of the federal income taxes and FICA not withheld creates income for the employee.

The PMTA begins with the following fact pattern:

During an examination performed in 2018 of an employer’s Forms 941, Employer’s QUARTERLY Federal Tax Return, for all quarters of tax year 2016, Exam identifies $10,000 of taxable fringe benefits provided by the employer to an employee that was not included in wages in 2016 or reported on a Form W-2, Wage and Tax Statement, or Form 1099-MISC, Miscellaneous Income, provided to the employee. The employee earned less than the annual social security wage limit for 2016 after inclusion of the $10,000 fringe benefit amount in the employee’s wages.

Exam correctly characterizes the $10,000 fringe benefit amount as additional wages in 2016 and computes the total employment tax due from the employer on the additional wages as follows:

·         Federal income tax withholding - $10,000 x 25% = $2,500

·         Employer share of FICA - $10,000 x 7.65% = $765

·         Employee share of FICA - $10,000 x 7.65% = $765

·         Total tax: $4,030

The employer pays the full tax assessment of $4,030 in 2018.

Now the memorandum goes on to ask whether the employee has income (in either 2016 or 2018) from the employer’s payment of taxes that should have been withheld from the employee’s paychecks.  And, interestingly enough, the IRS concludes the answer is different for federal income tax withholding and for FICA taxes.

The PMTA notes that for both taxes an employer is supposed to withhold the taxes from employees, but if the employer fails to do so, the employer is liable for the tax withheld. [1] But there are some interesting differences.

For federal income taxes withheld, the employer’s liability is reduced if it can be shown that the employee paid the tax due. [2]

There is no equivalent provision for FICA.  Rather, in that case Reg. §301.3102-1(d) provides that the employee remains liable for the FICA tax that should have been withheld when the employer fails to withhold the tax.

Looking at these provisions, the PMTA first holds:

Pursuant to the rules described above, Exam is authorized to assess against the employer the FICA taxes (both the employee and employer shares) and income tax withholding attributable to the additional $10,000 wage payment.6 The payment of the assessment by the employer satisfies the employer’s FICA obligations under sections 3102 and 3111, and income tax withholding liability under section 3403.

But the question posed was whether that should not represent additional wages to the employee for 2016—wages upon which additional income tax withholding would be due.  The IRS concludes that answer is no.

The payment of the taxes by the employer in 2018, in satisfaction of its own liability, does not result in additional compensation or wages to the employee in 2016. In other words, the employer’s payment in a subsequent year of taxes that should have been withheld from wages paid in the prior year does not create additional compensation or wages to the employee for the prior year. Accordingly, the employer’s payment of the assessment does not provide a basis for Exam to assess an additional FICA tax and income tax withholding amount on the employer with respect to the $10,000 payment for the prior year. To the extent the $10,000 payment creates any income tax liability for the employee, section 6201 does not provide a basis for assessing the employee’s income tax liability against the employer.

But what about the FICA impact for 2016?  That is a bit different in the view of the PMTA’s author.

However, the determination of additional wages, tax assessment, and employer’s payment of its FICA tax and income tax withholding liability with respect to the $10,000 does have certain consequences for the employee who received the wages in 2016.

Consistent with the determination of additional wages, the tax assessment and the employer’s payment of its income tax withholding and its FICA tax liability in a subsequent year for amounts not treated as wages in a prior year, the employer is required to prepare a Form W-2c for the prior year, furnish the employee with the appropriate copy of the Form W-2c, and file the appropriate copy of the Form W-2c with the Social Security Administration. Accordingly, the employer is required to file and furnish Form W-2c for 2016 to include the $10,000 taxable fringe benefit paid to the employee.

In accordance with section 31, because the income tax withholding assessed in 2018 was not tax actually withheld from the employee in 2016, the employee gets no credit for the income tax withholding liability paid by the employer as a result of the examination and assessment. Accordingly, no amount should be reported by the employer in box 2, Federal income tax withheld, of the 2016 Form W-2c for the income tax withholding assessed and paid by the employer in 2018, and the employee does not get credit for the employer’s payment of its assessed income tax withholding liability under section 3403 on any 2016 Form 1040X filed by the employee.

Furthermore, the Employment Tax Regulations do not authorize the employer to recover the amount paid in 2018 as its income tax withholding liability for 2016 from the employee. See section 31.6205-1(d)(2).

The PMTA, in a footnote, does note that if the employee files the Form 1040X and pays the tax due, the employer can receive an abatement of the $2,500 due by obtaining Form 4669, Statement of Payments Received, from the employee.

The analysis of the treatment of the FICA tax is somewhat different.  As the PMTA continues:

Consistent with this placement of liability on both the employer and employee, but ultimately on the employee, the regulations under section 6205 provide that, if an employer collects less than the correct amount of FICA tax from an employee, the employer must collect the amount of the undercollection by deducting the amount from remuneration of the employee, if any, paid after the employer ascertains the error. The correct amount of employee tax must be reported and paid in accordance with these regulations, whether or not the undercollection is corrected by a deduction under this regulation and even if the deduction is made after the return on which the employee tax must be reported is due under these regulations. If such deduction is not made, the obligation of the employee to the employer is a matter for settlement between the employee and the employer. See section 31.6205-1(d)(1).

Once the employee FICA is paid by the employer or employee, the employee receives credit for the employee FICA tax. In this case the $10,000 should be added by the employer to the corrected wages on the 2016 Form W-2c in box 1, Wages, tips other compensation, box 3, Social security wages, and box 5, Medicare wages and tips, and the additional employee FICA tax paid by the employer should be reported in box 4, Social security tax withheld, and box 6, Medicare tax withheld, as applicable.

Since, unlike the federal income tax withholding, the employer has a right to seek reimbursement from the employee, the simple payment by the employer is not immediately income to the employee.  Rather, the PMTA notes:

If the employer deducts the employee FICA tax from other remuneration paid to the employee or otherwise collects the amount from the employee in accord with section 31.6205-1(d)(1), the payment of employee FICA tax by the employer is not additional compensation to the employee in 2018. However, if the employer does not seek repayment of the employee FICA tax from the employee, the $765 of employee FICA tax paid by the employer in 2018 without collecting the amount from the employee is additional wages to the employee when paid in 2018 and is subject to employment taxes. The employer may either withhold the employee's FICA tax and income tax on such additional wages in 2018 from other wages or via payment by the employee or may calculate the applicable employment taxes on such additional wages in 2018 by grossing up the employee FICA tax and income tax withholding under the procedures of Rev. Proc. 81-48 and Rev. Rul. 86-14.

[1] IRC §§3102, 3403 and Treas. Reg. §§31.3403-1 and 31-3102-1(d)

[2] IRC §3402(d), Treas. Reg. §31.3402(d)-1