Income tax withholding is an IRS regulated system that requires employers to deduct an estimated amount of income taxes from taxable wages paid to each of its employees.

Background

The Sixteenth Amendment to the Constitution, ratified on February 3, 1913, states, "The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration".

Congress has delegated to the IRS the responsibility of administering and enforcing the income tax laws known as the Internal Revenue Code (IRC). Congress enacts the tax laws, IRS enforces them.

The tax law is found in Title 26 of the United States Code. Section 6012 of the Code clarifies that only individuals whose income falls below a specified level do not have to file tax returns. Compliance with income tax laws is mandatory. State citizenship does not negate the applicability of the IRC on individuals working and residing in the United States.

Basic Payroll Tax Concepts

Most employers must withhold (except FUTA), deposit, report, and pay the following employment taxes.

• Income tax
• Social security and Medicare taxes
• Federal unemployment tax (FUTA)

There are exceptions to these requirements.

Income tax withholding is an IRS regulated system that requires employers to deduct an estimated amount of income taxes from taxable wages paid to each of its employees. The IRS provides tables, methods and other related guidance for employers in Publication 15, Employer's Tax Guide (Circular E) on how to calculate the estimated income taxes. The publication is updated periodically to reflect new tax rates and tax legislation.

Under a system that is generally devised to apply higher tax assessments on taxpayers who have a greater ability to pay, federal income taxes are generally calculated at different rates, which increase as taxable income increases. As a result of this multi-tiered rate structure, income tax rates are sometimes said to be graduated.

For example, the 2006 annual withholding tax brackets and graduated federal income tax withholding rates as published in IRS Publication 15 (Circular E) for single and married employees, respectively, are as follows:

Income Tax Withholding Calculation

The proper withholding tax can be determined in multiple ways based on information and tables published by the IRS. No matter which method is used the calculation is simply the result of multiplying taxable wages less a deduction for each withholding allowance times the applicable tax rates in each wage bracket. The deduction from gross taxable wages allowed for exemptions is based on the number of exemptions an employee claims on Form W-4.

In the IRS wage bracket tables, the withholding tax has been pre-calculated based on the mid-point of a narrow range of taxable wages.

In the percentage method, the IRS includes pre-calculated tax amounts and the applicable percentage to apply for wages over a given taxable wage amount for each pay frequency.

Under the annualized withholding method, the annual equivalent of the employee's current pay is determined by multiplying the current pay times the standard number of pay periods in the year that corresponds to the employee's pay frequency. For example, a weekly employee's pay is multiplied times 52. This method is more efficient for computer systems because only the annual percentage table is referenced using the employee's annualized income taxable wages (less any deduction for exemptions) to determine the employee's annual tax. The tax for the current pay period is easily determined by dividing the annual tax by the number of pay periods in the year that correspond to the employee's pay frequency.

No income tax withholding applies when an employee's taxable income is very low. Employees may claim an exemption from income tax withholding using Form W-4 if they paid no tax in the previous year and expect to have no tax liability for the upcoming year. In that case, no federal income taxes are withheld.

Income Taxes versus Income Tax Withholding

An individual's income tax liability is determined at the end of the year. Withholding taxes are determined during the year with each wage payment. The methods prescribed for calculating withholding taxes are not as precise and comprehensive as the procedures associated with preparing an individual's annual income tax return tax for the year. For example, for income tax withholding purposes an employee can only claim single, married, or "married, withhold at the higher single rate." On the income tax return, the employee will have additional choices, such as married, filing separately and qualifying widow or widower. Nevertheless, the IRS will assess penalties if the income tax withheld and paid over to the IRS during the year falls below prescribed guidelines. This "pay-as-you-go" system and IRS' enforcement of it helps ensure that employees are better able to pay their final tax liability for the year.

Wages and Other Compensation

Wages subject to federal employment taxes generally include all pay to an employee for services performed. The pay, or remuneration for services, may be in cash or in other forms. It includes salaries, nonqualified deferred compensation recognized under Internal Revenue Code (IRC) section 409A, vacation allowances, bonuses, commissions, and fringe benefits. It does not matter how an employer measures or makes the payments. Amounts an employer pays as a bonus for signing or ratifying a contract in connection with the establishment of an employer-employee relationship and an amount paid to an employee for cancellation of an employment contract and relinquishment of contract rights are wages subject to social security, Medicare, and federal unemployment taxes and income tax withholding. Also, compensation paid to a former employee for services performed while still employed is wages subject to employment taxes.

Form W-4, Employee's Withholding Allowance Certificate

Employers should obtain a completed Form W-4, Employee's Withholding Allowance Certificate, from each of its employees. The Form is available in the section of the IRS' web site. The amount of income tax to be withheld is determined by the employee's income taxable wages and the information submitted by the employee on Form W-4. Information on Form W-4 includes:

• Employee's marital status
• Number of withholding allowances claimed
• Employee's request to have additional tax withheld
• Employee's claim to exemption from withholding

This certificate is effective with the first wage payment and will last until the employee files a new certificate. If an employee does not submit a Form W-4, the employer must withhold tax as if the employee were a single person who has claimed no withholding allowances.

Generally, each Form W-4 is for the employer's records. The forms no longer need to be sent to the IRS. However, employers should be prepared to furnish a copy of an employee's Form W-4 if the IRS requests it.

Withholding on Fringe Benefits

Employers may add the value of fringe benefits to regular wages for a payroll period and figure withholding taxes on the total, or withhold federal income tax on the value of the fringe benefits at the flat 25 percent supplemental wage rate. However, mandatory withholding at 35 percent applies on supplemental wages when an employee receives more than $1,000,000 of supplemental wages during the calendar year.

Employers may choose not to withhold income tax on the value of an employee's personal use of a vehicle that they provide. However, employers must withhold social security and Medicare taxes on the use of the vehicle. See IRS Publication 15-B for more information on this election.