EY - Employment tax year-end planning essentials

Year-in-review webcast at a glance

Employment tax year-end planning essentials

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Several significant legal decisions and statutory changes take top billing as important developments in tax year 2015 that are certain to present challenges this year-end and in the future. Also noteworthy are numerous federal, state and local reporting and tax payment changes that will require consideration.

On December 3, 2015, a five-member panel of Ernst & Young LLP’s experienced Employment Tax Services professionals shared perspectives and insights concerning these developments for participants in its webcast, 2015 employment tax year in review.

Highlights from the webcast and its key takeaways follow.

2015 employment tax webcast at a glance

  • 2015 Form W-2 reporting changes include a pilot of new verification codes to combat tax refund fraud
  • Penalties increase for Form W-2 reporting errors
  • New Affordable Care Act information reporting requirements apply this year
  • Nonqualified deferred compensation withholding errors carry new litigation risk
  • Watch out for this group-term life insurance reporting error 
  • Supreme Court ruling on state marriage equality could mean 2015 state income tax reporting adjustments.
  • State unemployment insurance key developments
  • State and local income tax key developments
  • IRS to pilot Form W-2 verification codes as potential tax refund fraud deterrent

    The IRS announced that starting with the 2016 tax filing season, it will be pilot-testing the use of a new verification code on a population of Forms W-2 provided to employees. This pilot is just one of many steps the IRS plans to take to help combat refund fraud achieved through tax-related identify theft.

    For now, only certain Payroll Service Providers (PSPs) will participate in the pilot.

    How verification codes will work. The verification code is 16 digits formatted as four groups of four alphanumeric characters (XXXX-XXXX-XXXX-XXXX). This code will appear in a separate box on some versions of the Form W-2 prepared by PSPs participating in the pilot.

    Employees will see the verification code on Copies B and C of the Form W-2, but it will not be included on Copy A filed with the Social Security Administration, nor will it affect state and local income tax returns or paper federal returns.

    The IRS states that, for the purposes of this pilot, omitted and incorrect W-2 verification codes will not delay the processing of a tax return.

    Forms W-2 containing the new verification code will include special instructions for taxpayers and tax preparers, specifically:

    • If the Verification Code field is populated, enter this code when it is requested by your tax return preparation software. It is possible your software or preparer will not request the code. The code is not entered on paper-filed returns.
    • Some Forms W-2 that employees receive will have a blank “Verification Code” box. These taxpayers do not need to enter any code data into their tax software product.

    The IRS will analyze this pilot data in a “test-and-learn” review to see if it is useful in evaluating the integrity of W-2 information.

    Puerto Rico was first to use authentication codes to combat tax fraud. The IRS is not the first to consider the use of system-generated codes in validating the authenticity of a Form W-2. Effective for tax year 2013 (filed in 2014), the Puerto Rico Department of Treasury requires that Form W-2PR filed electronically with the Department include a confirmation number given by the system after the electronic submission.

    The confirmation number consists of six digits starting with one letter. The file must be uploaded first to obtain the confirmation number from the system. The Department does not accept Forms W-2PR without the confirmation number. Handwritten confirmation numbers on the forms automatically render them invalid.

    Ernst & Young LLP insights

    IRS and US lawmakers are also considering an acceleration in the Form W-2 filing due date as another way of combating tax refund fraud. The IRS has suggested a filing due date of as early as January 31. In October, federal legislation was introduced under the Stolen Identity Refund Fraud Prevention Act of 2015 (H.R. 3832) that would require the filing of Forms W-2 by February 15. The bill currently has eight cosponsors.

    Already, Forms W-2 in 12 states are required to be filed sooner than the federal due date. Of these 12 states, only Utah added the provision that taxpayers not be allowed to obtain a tax refund prior to March 1 unless the Commission is in receipt of the employer’s Form W-2 and the individual’s income tax return.
    (S.B. 250.)

  • Penalties increase for Form W-2 reporting errors

    On June 29, 2015, President Obama signed into law the Trade Preferences Extension Act of 2015 (H.R. 1295; Public Law No: 114-27), which includes provisions to increase the penalties for late or incorrectly filed information returns, including Forms W-2, 1099 and those required under the Affordable Care Act (i.e., the 1094 and 1095 series). The increased penalties are effective with returns filed after December 31, 2015, and accordingly apply to 2015 calendar-year information returns filed in 2016.

    The failure-to-file penalties for Forms W-2/1099 filed late or incorrectly have more than doubled from $100 per return to $250 per return. The maximum penalty has doubled from $1.5 million to $3 million. The failure-to-furnish penalties for information returns furnished to payees are similarly increased.

    The penalty amount for intentional disregard has also increased to the greater of $500 or 10% of the aggregate amount incorrectly reported, with no maximum threshold.

    Here are some tips to avoid Form W-2 filing errors:

    • Test Form W-2 files using SSA’s AccuWage
    • Review the SSA’s Form W-2 file layout requirements here
    • Verify that you are using the correct rates and limits for 2015; our special report is here
  • Affordable Care Act information reporting is here

    Effective for tax year 2015, applicable large employers (ALE) are required to file Form 1095-C and transmittal Form 1094-C with the IRS. If you have 250 or more information returns during the calendar year, you must file them electronically.

    An ALE is also required to give each full-time employee a copy of the Form 1095-C that is filed with the IRS. Statements must be furnished to employees on paper, by mail or hand-delivered, unless the recipient affirmatively consents to receive the statement in an electronic format.

    Employers that are not ALEs but that sponsor self-insured group health plans must report information about employees (and their spouses and dependents) who enroll in the coverage even though they are not subject to the employer shared responsibility provisions of the ACA. Self-insured plan sponsors use Form 1095-B and transmittal Form 1094-B to meet these ACA information reporting requirements.

    ALE members that file 250 or more information returns must file them electronically through the ACA Information Returns (AIR) program.

    Statements must be provided to employees by February 1, 2016, and returns filed with the IRS are due February 29, 2016, if filed on paper and March 31, 2016, if filed electronically.

    The IRS offers guidance about these ACA reporting requirements here.

    For guidelines on electronic filing of ACA returns, refer to Publication 5165, Guide for Electronically Filing Affordable Care Act (ACA) Information Returns.

  • Nonqualified deferred compensation withholding errors carry new litigation risk

    A federal district court ruled earlier this year that an employer is liable to pay damages to employees participating in its nonqualified deferred compensation because it withheld Social Security and Medicare taxes at the time distributions were made, rather than earlier when the amounts vested. (John B. Davidson et al. v. Henkel Corp. et al.)

    The case highlights the growing risk of costly employee litigation when employers make payroll tax errors that increase employees’ tax liability.

    The significance of the FICA special timing rule. Under the special timing rule, nonqualified deferred compensation must be included in Social Security and Medicare wages at the time there is no longer a risk of forfeiture (at vesting). (IRC §3121(v)(2)(A); T.D. 8814.)

    Under the non-duplication rule, when the special timing rule is used, future investment changes on nonqualified deferred compensation balances are not taken into account for FICA purposes. (IRC §3121(v)(2)(B).)

    Conversely, in Treas. Reg. §31.3121(v)(2)-1(d)(1)(ii), it states that if an amount deferred for a period is not taken into account for FICA purposes at the time of vesting, the non-duplication rule of IRC §3121(v)(2)(B) and Treas. Reg. §31.3121(v)(2)-1(a)(2)(iii) will not apply and, instead, the benefits attributable to the amount deferred are included as wages subject to FICA taxes in accordance with the “general timing” rule (i.e., when the amounts are distributed to the employee).

    Failure to use the special timing rule could result in significantly higher FICA taxes for the employee and the employer, depending on the facts.

    Example:

    Assume that at the time of vesting on March 1, 2015, an individual’s benefits in the nonqualified deferred compensation plan are $100,000 in a year when the employee earns a regular salary (in addition to the vesting) of $150,000. Further assume that on April 1, 2019, interest and dividends have increased the balance in the plan to $120,000.

    If the employer applies the special timing rule within the statute of limitations (before April 15, 2019), the $20,000 increase in the account balance is exempt from Social Security and Medicare tax under the non-duplication rule. Additionally, because the employee’s annual earnings exceeded the Social Security wage base of $118,500 in 2015, the $100,000 vested benefit in the nonqualified deferred compensation plan is subject only to Medicare tax of 1.45% (and $50,000 is subject to the Additional Medicare Tax of 0.9%).

    If the employer fails to apply the special timing rule before the statute expires, the general timing rule applies. Accordingly, if the benefits are distributed after April 15, 2019, the full $120,000 is subject to Medicare tax and Social Security tax up to the 2016 Social Security wage base.

    In this example, the account balance increased over time. It can also be the case that the account balance loses value over time, and in that case, employees may actually reap a FICA tax benefit from the employer’s failure to use the special timing rule. For this reason, the extent of an employee’s damages can vary significantly depending on multiple facts, including the extent of investment gain in the employees’ account and their year-to-date earnings at the time of vesting compared with their earnings in the year of distribution.

    The facts of the case. To supplement the company’s qualified retirement plan, it makes available to select highly compensated employees a “top hat” (nonqualified deferred compensation) plan into which qualified employees can elect to defer amounts from their base salaries or bonuses. Supplemental retirement benefits from this top hat plan are paid to participants at the time of retirement.

    On September 15, 2011, the company sent top hat plan participants a letter informing them that “during recent compliance reviews performed by an independent consulting firm, it was determined that Social Security FICA payroll taxes associated with your nonqualified retirement benefits have not been properly withheld.” To remedy the error, the company informed participants that FICA tax would be owed on prior plan distributions retroactive to 2008 and on a pay-as-you-go basis for all future payments.

    In 2011, the company deposited with the IRS the employee and employer FICA taxes owed for open years (2008–2011) with the intention of recovering the employee portion from future benefits paid to affected plan participants.

    In 2012, a class action was brought against the company by 49 retirees alleging in part that they were subject to excessive FICA taxes because of the company’s negligence in failing to withhold FICA taxes in accordance with the special timing rule and that this failure resulted in reducing promised benefits.1

    In 2013, the case was allowed to move forward on the premise that the nonqualified retirement plan was governed by IRC §502(a)(1)(B) of the Employee Retirement Income Security Act (ERISA).

    The court’s ruling. In 2015, the court ruled that the company violated provisions of the plan and the plan’s purposes to reduce the tax burden of the compensation. Furthermore, the court stated that the plan agreement required the company to properly withhold the participants’ taxes when they were assessable or due. Rather than properly withholding the plaintiffs’ taxes as required by the plan, the company paid the taxes at the time of each benefit payment and acknowledged in a letter to plan participants that they had not properly withheld taxes. The court noted that this approach resulted in the participants’ losing the benefit of the non-duplication rule and owing more in FICA taxes than they would have owed had the company properly and timely paid taxes when they were due.

    The court awarded summary judgment to the participants because the company failed to adhere to the purpose and terms of the plan, resulting in a reduced benefit to the plaintiffs.

    Damages are still to be determined.

    Ernst & Young LLP insights

    Employers should carefully review when they are collecting and remitting FICA taxes for all of their nonqualified deferred compensation plans. If it is discovered that FICA taxes were not taken into account at the time of vesting, and the statute of limitations has not expired, the FICA wages and taxes should be reported and paid under the special timing rule using Form 941-X. Keep in mind that adjustments timely reported on Form 941-X carry no interest or penalty.

    It is also important to carefully review the terms of nonqualified deferred compensation plans to ensure they are properly administered. Employees can bring costly suits against the employer for plan administration failures, including those that result in the erroneous timing or calculation of withholding taxes and reporting of wages on Form W-2.


    “Businesses should carefully review their compliance with nonqualified qualified deferred compensation tax and reporting rules, taking into consideration employee litigation for FICA timing errors.”

    — Deborah Spyker,
    Executive Director, Employment Tax Services


    1 The company argued that it correctly withheld FICA tax in accordance with the general timing rule and is not required to use the special timing rule. Although TD 8814 states that the special timing rule must be used, the court agreed with the company that use of the special timing rule was not mandatory and that the participants have not shown that the company failed to withhold taxes in accordance with federal law. Nonetheless, the court ruled that damages were owed participants because of the excess FICA taxes that were the result of losing the benefit of the non-duplication rule.

  • Don’t make this mistake when reporting taxable group-term life insurance on the Form W-2

    The IRS requires that employers pay the employee portion of Social Security and Medicare tax (FICA) whether or not these taxes were withheld from taxable wages. An exception to this rule applies only with respect to tips and taxable group-term life insurance provided to former employees. (2015 Instructions for Forms W-2 and W-3, Wage and Tax Statement and Transmittal of Wage and Tax Statements.)

    Since the requirement that employers pay the employee portion of FICA is rarely waived, an IRS audit could likely focus on whether employers have properly applied these two exceptions. This is particularly the case with former employees’ group-term life insurance.

    Background. The employer is relieved of collecting or paying a former employee’s share of FICA, but only to the extent that the group-term life insurance coverage was provided during periods in which the employment relationship did not exist. In cases in which the employer failed to collect FICA for taxable group-term life insurance provided during the employment relationship, it remains the employer’s obligation to withhold or pay the employee’s share of FICA.

    Example: Employee John receives taxable group-term life insurance valued at $10 per month. He worked for the employer through September 30, 2015, when he was laid off. His employer agreed to provide his benefits through December 31, 2015. The employer must collect or pay John’s share of FICA for taxable group-term life insurance provided through September 30.

    John may be responsible for paying his share of FICA for taxable group-term life insurance provided in October through December. The employer will match the FICA that John pays.

    The employer is required to report the former employee’s taxable group-term life insurance in Form W-2, boxes 1, 3 and 5 and in box 12, code C. Additionally, Social Security (code M) and Medicare (code N) tax not withheld by the employer is reported in box 12.

    If the employer fails to report the FICA obligation of the employee, it is the employer’s responsibility to collect or pay the former employee’s share of FICA. The amount of FICA to be paid by former employees must be reported as a credit on Line 9 of the Form 941.

    Ernst & Young LLP insights

    Reporting uncollected FICA in Form W-2, box 12, codes M and N without showing taxable group-term life insurance in box 12, code C raises an IRS audit flag that you may have failed to pay employees’ FICA taxes that you failed to withhold from their taxable compensation. For this reason, before processing Forms W-2, you should carefully review earnings and deductions for proper mapping to the Form W-2.


    “One important item on your year-end checklist should be a detailed review of the tax setups for your system pay and deduction codes.”

    — Debera Salam,
    Director, Payroll Information Services


  • Supreme Court ruling on state marriage equality could mean 2015 state income tax adjustments

    In the second of two landmark decisions on same-gender marriage, the US Supreme Court ruled on June 26, 2015, that the Fourteenth Amendment requires all states to license marriage between two people of the same gender and recognize same-gender marriages lawfully licensed and performed in another state. (Obergefell v. US, No. 14–556, June 26, 2015.)

    As of the date of the ruling, 37 states and the District of Columbia allowed same-gender couples to marry, leaving 13 states that continued to prohibit these marriages. In the weeks following the decision, all of these states released directives necessary for issuing marriage licenses to same-gender couples. At the same time, these states and Kansas subsequently issued guidance announcing that same-gender married couples have the same tax status as all married persons in the state.

    For federal income tax purposes, health and other tax-exempt benefits provided to an employee’s same-gender spouse are tax-free, provided the employee was lawfully married under state or country law. The IRS makes it clear that health and other benefits provided to an employee’s domestic partner (including civil unions and registered domestic partners) continue to be taxable. (Revenue Ruling 2013-17)

    Whether the value of same-gender spouse or domestic partner benefits is included in taxable wages for state unemployment insurance or income tax withholding depends on the state’s applicable tax rules (and not its marriage laws), making their tax and reporting requirements complex.

    Pennsylvania, for instance, extends tax-free status to health benefits whenever there is a moral or legal obligation of the employee to provide them to a partner (marriage is not a determining factor).

    Missouri banned the marriage of same-gender couples until the US Supreme Court ruling in Obergefell; nonetheless, for income tax purposes, the state has consistently followed the federal tax guidance in Revenue Ruling 2013-17. (Missouri Governor Executive Order 13-14.)

    In contrast, Kansas’ same-gender marriage ban was overturned in 2014; however, under guidance issued by the Kansas Department of Revenue, same-gender married couples were unable to file as married joint or married filing separately in calendar year 2014.

    Effective date for tax treatment of spousal benefits. Generally, in the year that a state’s taxing authority allows same-gender married couples to file “married joint” or “married filing separately,” spousal benefits are tax-free for that entire calendar year, or, if the couple married later in the year, for the months lawfully married. For example, if a resident/work state’s income tax regulations are amended to recognize same-gender marriage for tax year 2015, those couples lawfully married in the state of celebration as of January 1, 2015, will generally be treated as married in the resident/work state for the entire 2015 calendar year.


    “Businesses frequently underestimate the complexity of same-gender partner benefit taxability and mistakenly rely on outdated processes and system configurations to get the job done. Whether many or few employees are affected, a comprehensive tax-focused review is necessary to meet the changing landscape of state marriage equality laws.”

    — Peter Berard,
    Senior Manager, Employment Tax Services


    Here’s what you need to consider now in response to the changing state tax laws on marriage equality

    • Does your benefit enrollment process identify which employees are covering a same-gender spouse?
    • Are employees given a clear way of telling you if their spouse or partner is a qualified dependent?
    • Are you separately tracking employees with civil union or registered domestic partner licenses?
    • Do you have tax research supporting your system taxability configurations, or are you relying on a tax advisor to provide this information to you?

    Read our special report here.

  • 2015 unemployment insurance roundup

    The markets’ collapse in 2007 and 2008 placed an unusual strain on state unemployment insurance (SUI) trust funds, so much so that, at the peak of the recession in 2009, 21 states had taken loans from the federal government. In addition to higher federal unemployment insurance taxes (FUTA) that apply to employers in states with an outstanding federal unemployment insurance (UI) loan balance, higher SUI taxes can also apply.

    SUI taxes have declined somewhat in response to the improved economy. For tax year 2015, for instance, 21 states lowered their base SUI tax rates.

    Recovery, however, has been much slower for many of those states with sizable federal UI loans. Employers in states with an outstanding federal UI loan balance as of November 10 of the calendar year are subject to a FUTA credit reduction that increases the FUTA tax rate that applies to them. In 2015, employers in four jurisdictions were subject to a higher FUTA tax because of the FUTA credit reduction, compared with eight in 2014. Several states will continue to have federal loan balances on November 10, 2016, and employers in those states face FUTA tax rates of 2.4% or more (as compared with the normal net FUTA tax rate of 0.6%).

    For several years, the Administration has proposed raising the federal wage base from $7,000 to $15,000; however, in its fiscal year 2016 budget, it proposed an increase to $40,000, a move that would automatically increase the state SUI wage base in all states except Hawaii and Washington. New this year, the Administration has also proposed that employers be required to pay a minimum annual state unemployment insurance of $70 per worker. It is speculated that making these changes would pave the way for future solvency of state unemployment insurance trust funds and reduce the higher costs employers incur when SUI benefit payouts are financed.


    “Proactive management of SUI claims, tax rate review and effective implementation of statutory elections, such as voluntary contributions and joint accounts, continue to be employer leading practices for holding down SUI costs.”

    — Kenneth Hausser,
    Executive Director, Employment Tax Services


    2015 key state unemployment insurance developments

    Arkansas
    Effective with initial claims filed on and after the first day of the quarter following the effective date of the bill (generally 90 days from the date the Arkansas legislature officially adjourns for the year), the maximum number of weeks an individual may collect SUI benefits is reduced from 25 to 20. (H.B. 1489, signed by the governor on March 17, 2015.)

    Maine
    Legislation enacted in 2015 allows a business acquiring all of another business the option of whether to transfer unemployment tax experience from the predecessor if there is no common ownership involved. (LD 701, Ch. 107.)

    Illinois
    The Department of Employment Security recently discovered program errors that incorrectly increased the average industry tax rates for 2013 through 2015 for new employers. See the Department’s website here.

    Nevada
    Effective for tax year 2015, client companies of professional employer organizations (PEOs) are considered to be the employer of leased employees for SUI purposes, not the PEO. As a result, the client company must pay SUI for tax year 2015 and must start over on the SUI taxable wage base for these employees for the fourth quarter 2015, even if the PEO previously reported and paid SUI taxes on the employees’ wages during the first three quarters of 2015. (A.B. 389, Chapter 458.)

    Louisiana
    Effective January 1, 2016, the Louisiana Workforce Commission will require that employers supply information on two additional data elements when electronically filing the quarterly SUI wage report — the employee’s hourly rate of pay and the employee’s occupational code or job title. See the Department’s website here.

    Rhode Island and New Mexico
    Effective in 2015, New Mexico no longer allows voluntary contributions (S.B. 334), but Rhode Island law (S.B. 813) now allows for them.

    Learn more about unemployment insurance

    • Download our 2015 Guide to unemployment insurance and other reference tools
    • Get essential state facts and participate in our benchmark survey at http://uifactfinder.ey.com
  • 2015 state and local income tax roundup

    Mobile workforce tax compliance is a continued concern as several states maintain their aggressive nonresident income tax withholding audits. State rules vary considerably in terms of the amount of time or wages, if any, that can be overlooked in determining if a nonresident income tax obligation applies. It appears that Congress will not enact federal legislation (Mobile Workforce State Income Tax Simplification Act of 2015, H.R. 2315/S. 386) this year that would prohibit states from imposing an income tax on wages earned by employees who have spent 30 or fewer days in the calendar year working in a state.

    At the state and local level, there have been several developments that will simplify state and local income tax compliance for businesses and their mobile employees in the years ahead. These and other key state/local income tax developments are summarized in the chart below.

    2015 key state and local income tax changes

    Connecticut
    Under legislation approved by the House and Senate on December 10, 2015, and effective January 1, 2016, the compensation of Connecticut nonresident employees is exempt from state income tax and income tax withholding if employees are present in the state for 15 or fewer days in the calendar year. (Act No. 15-1)

    Nevada Effective July 1, 2015, S.B. 483 generally makes the following changes to the Modified Business Tax (MBT):

    •   Mining employers are subject to the same MBT as financial institutions.
    • The MBT is imposed on businesses other than a financial institution or a mining business at the rate of 1.475% (up from 1.17%) of the total wages paid by the business each calendar quarter that exceed $50,000 (down from $85,000).

    See the Department’s website here.

     

    Indiana
    A law effective in 2017 consolidates the three local income tax rates (COIT, CAGIT, CEDIT) into one but increases the tax that nonresidents pay. (Public Law 243.)

    Ohio
    Effective in 2016, the de minimis threshold for nonresident local income tax withholding is increased from 12 to 20 days. The provision applies only to employers that have offices or operations within Ohio. (Sub. H.B. 5.)

    Maryland 
    In 2015, the US Supreme Court held that Maryland’s law disallowing a tax credit against local income taxes for tax paid in other states is unconstitutional. The ruling will likely influence all local tax laws with similar restrictions. More information is available here.

    West Virginia 
    Effective in 2016, all employees working within the City of Morgantown, West Virginia, are subject to a service fee of $3 per week to a maximum of $156 per year. (Meeting Minutes, October 20, 2015, Common Council of the City of Morgantown.)


For more information

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