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Revamp employment contracts to account for new tax rules

by on
in Employee Benefits Program,Employment Law,Human Resources,Small Business Tax,Small Business Tax Deduction Strategies

Issue: A new IRS ruling says signing bonuses and early-termination payments are considered taxable wages.

Risk: Overlooking that decision can trigger compensation problems or IRS penalties.

Action: Take this ruling into account when withholding taxes and crafting bonus programs, settlements or other payments.

Sometimes, you need bigger bait to lure bigger fish. That's why many organizations use financial incentives, such as signing bonuses, to entice new employees. In the past, both sides won tax-wise because this add-on has been exempt from payroll taxes.

But in a stunning reversal of past guidance, the IRS now says that signing bonuses (and early-termination payments) are subject to FICA, FUTA and income tax withholding. So, your organization can no longer tilt the deal in its favor by loading up on such incentives.

Ruling 1: Signing bonuses. The first ruling clarifies that employment taxes must be paid, and income taxes withheld, on bonuses paid for signing an employment contract. (IRS Revenue Ruling 2004-109)

Ruling 2: Early-termination payments. The IRS now says that if an employer gives a severance or some other payment in exchange for canceling an employment contract early, that payment is treated as wages for purposes of employment tax and income-tax withholding. (IRS Revenue Ruling 2004-110)

Bottom line: When you craft settlements, bonus programs or other nonstandard payments to employees, you need to determine ahead of time whether they'll be taxable as wages. And, as the new ruling shows, the IRS takes a broad view of what constitutes wages. So, in most cases, payments relating to an employer-employee relationship will likely be deemed wages, for which you must withhold taxes.

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