This week, I have a couple of updates on the tax rates and procedures for withholding federal income taxes on supplemental payments.

2013 Supplemental Withholding Rates
When Jenn blogged about the American Taxpayer Relief Act last week, the ink was still wet on President Obama’s signature on the Act and we were all still trying to figure out exactly what it meant in terms of tax withholding in 2013.  It now seems clear that the flat rate that applies to supplemental payments of $1 million or less per year will remain at 25% and the flat rate that applies to supplemental payments of more than $1 million has increased to 39.6%.

ADP has confirmed these rates and, while that isn’t quite the same thing as the IRS confirming them, my sense is that ADP knows what they are talking about, their confirmation agrees with my understanding of how these rates work, and it agrees with what I’ve heard from other practitioners (e.g., Baker & McKenzie), so I’m considering this issue put to rest.

No Other Rate is Allowed
While we’re on the topic of supplemental rates, a question I get frequently is whether companies can permit employees to request that taxes on their stock plan transactions be withheld at a higher rate than the prescribed flat rate.  This was a topic of two of my earliest blog entries (“Excess Tax Withholding,” December 1, 2008 and “Excess Tax Withholding – Part 2,” December 9, 2008).

In September of last year, the IRS issued Information Letter 2012-0063 confirming that when you are using the flat rate (regardless of whether you are choosing to use the flat rate over the employee’s W-4 rate on an optional basis or the employee has received over $1 million in supplemental payments for the year and you are required to withhold at the maximum rate), you are required to withhold at the specified rate (25% for optional flat rate withholding, 39.6% for mandatory flat rate withholding).  From the IRS’s discussion of optional flat rate withholding:

“If the employer is using the optional flat rate withholding method, the employer must withhold at the optional flat rate and cannot take into account requests by the employee that the rate be increased or lowered. Only one rate applies for purposes of optional flat rate withholding on supplemental wages.”

Where employees have received more than $1 million in supplemental payments, you have to withhold federal income tax at 39.6% on their stock plan transactions–no other rate (either higher or lower) is permissible.

Where employees have recieved $1 million or less in supplemental payments, the only way to withhold federal income tax at a rate of other than 25% is to use the employee’s W-4 rate (which the IRS refers to as the “aggregate procedure”).  In that case, you could have the employee complete a new W-4 requesting the higher rate for federal income tax purposes just prior to his/her stock plan transaction and then complete another W-4 resetting the FIT rate back to the prior rate after the stock plan transaction is concluded (without the second W-4, the higher rate will apply to all of the employee’s regular pay).  But then you’d have to figure out the W-4 rate–good luck with that.

Where you don’t want to deal with the hassle of figuring out W-4 rates, you can offer employees two other alternatives when they are worried that the withholding on their stock plan transactions isn’t sufficient:

1. Increase the withholding on their regular pay (which does require a new W-4, but at least you don’t have to be involved).
2. Make estimated payments to the IRS.

The information letter doesn’t provide any information on what the penalties would be if you do withhold at a different rate without following the W-4 procedure or whether those penalties would apply to the company or the employee. For now, those mysteries remain unsolved.

– Barbara