IRS CLARIFIES SICK-PAY REPORTING RULES.

Notice 91-26

Discussions with payroll managers and third-party insurers, and examination of wage reports submitted to the Internal Revenue Service (IRS) and the Social Security Administration (SSA), indicate that confusion exists about reporting sick-pay payments when third parties are involved. Part of the confusion is caused by split reporting, which allows the third party to pass liability for the employer share of the social security and Medicare taxes back to the employer.

This notice provides clarification regarding the reporting requirements for sick-pay payments. Satisfying these requirements will ensure that IRS and SSA wage reports match. This will reduce the need for any correspondence to reconcile any differences.

Sick pay is defined as any amount paid to employees for any period during which the employee is temporarily absent from work because of sickness or accident disability. Sick pay is taxable under the Federal Insurance Contributions Act (FICA) for social security tax and Medicare tax purposes unless the sick pay (1) is received under a worker's compensation law, (2) is attributable to employee contributions, or (3) is paid after the end of 6 calendar months following the last calendar month in which the employee worked for the employer.

Under section 3121(a) of the Internal Revenue Code and section 32.1 of Temporary Employment Tax Regulations, third-party payers of sick pay may either be treated as employers or as agents of employers. Section 32.1(e)(3) of temporary regulations provides that, if an agency agreement so provides, a third party making a payment on account of sickness or accident disability to an employee as agent for the employer or making such payment directly to the employer shall not be treated as the employer with respect to such payment. The determining factor as to whether a third party is an agent of the employer is whether the third party bears any insurance risk. If the third party bears no insurance risk and is reimbursed on a cost-plus-fee basis, the third party is an agent of the employer even if the third party is responsible for making determinations of the eligibility of individual employees of the employer for payments on account of sickness or accident disability. If the third party is paid an insurance premium and not reimbursed on a cost-plus-fee basis, the third party is not an agent of the employer, but the third party is treated as the employer under the regulations.

This notice concerns only those situations in which the third party is treated as the employer under section 32.1(e)(3) of temporary regulations. It is not applicable to those situations in which a third party is an agent of the employer, unless the agent of the employer is designated as the employer according to the agency agreement.

If a third party is treated as an employer under temporary regulations, the third party is liable for the withholding and payment of the EMPLOYEE'S share of social security and Medicare taxes with respect to the sick pay. The third party is also liable for the EMPLOYER'S share of social security and Medicare taxes unless the third party satisfies the requirements for transferring such liabiilty as set forth in section 32.1(e)(1) of temporary regulations. Under those regulations, liability for the employer's share is transferred to the employer for whom services are normally rendered if the third party complies with the following requirements:

(1) Withholds the employee's share of social security and Medicare taxes from the sick pay;

(2) Deposits such tax according to the deposit rules for withheld social security, Medicare, and Federal income taxes; and

(3) Notifies the employer for whom services are normally rendered of the amount of the wages paid on which tax was withheld and deposited. Generally, this notice must be provided within the time required for the deposit of the employee's share of social security and Medicare taxes. However, see temporary regulations section 32.1(g)(3) for special rules relating to a multiemployer plan.

If the third party does not follow the requirements for transferring liability for the FICA employer taxes to the employer for whom services are normally rendered, the third party must give each employee to whom it paid sick pay a Form W-2 by January 31 of the following year. The Form W-2 must include the third party's name, address, and employer identification number (EIN); the employee's name, address, and social security number; and the following information:

(a) the Federal income tax withheld, if any, from the sick pay;

(b) the amount of the sick pay the employee must include in income (in the box titled "Wages, tips, other compensation");

(c) the amount not includible, if any, because the employee contributed to the sick-pay plan (box 17 of the 1991 Form W-2);

(d) the amount of sick pay subject to employee social security tax (in the box titled "Social security wages");

(e) the employee social security tax withheld from the sick pay (in the box titled "Social security tax withheld");

(f) the amount of sick pay subject to employee Medicare tax (in the box titled "Medicare wages and tips"); and

(g) the employee Medicare tax withheld (in the box titled "Medicare tax withheld").

If the third party satisfies the requirements for transferring liability for the employer's share of social security and Medicare taxes to the employer, the third party must give the employer for whom services are normally rendered a statement showing each person to whom sick pay was paid during the calendar year. This statement must be furnished to the employer by January 15 of the year following the calendar year in which the sick pay was paid. The sick-pay statement furnished by the third party to the employers must show:

(a) the employee's name;

(b) the social security number of each employee who had any social security, Medicare, or Federal income tax withheld from sick pay;

(c) the amount of sick pay for each employee; and

(d) the amount of Federal income tax withheld, if any, the amount of social security tax withheld, and the amount of Medicare tax withheld from each employee's sick pay.

If liability for the employer's share of social security and Medicare taxes has been transferred by the third party to the employer, the third party does not furnish Forms W-2 to the recipients of sick pay. When the employer is given the sick-pay statement by the third party, the employer is responsible for including the sick pay on Forms W-2 furnished to the employees. The employer may include the sick pay in the Form W-2 that includes the employee's other wages or it may furnish the employee a separate Form W-2 that includes only the sick pay. An employer who receives a sickpay statement from a third party is required to file Forms W-2 with respect to the sick pay by January 31 of the year following the year in which the sick pay was paid. The Form W-2 filed with respect to the sick pay is required to include the following information:

(a) the employer's name, address, and EIN;

(b) the employee's name, address, and social security number;

(c) the Federal income tax withheld, if any, from the sick pay;

(d) the amount of sick pay the employee must include in income (in the box titled "Wages, tips, other compensation");

(e) the amount not includible, if any, because the employee contributed to the sick-pay plan (box 17 of the 1991 Form W-2);

(f) the amount of sick pay subject to employee social security tax (in the box titled "Social security wages");

(g) the employee social security tax withheld from the sick pay (in the box titled "Social security tax withheld");

(h) the amount of sick pay subject to employee Medicare tax (in the box titled "Medicare wages and tips"); and

(i) the employee Medicare tax withheld (in the box titled "Medicare tax withheld").

NOTE: FROM NOW ON, THE THIRD-PARTY PAYER THAT IS TREATED AS AN EMPLOYER UNDER THE REGULATIONS SHALL BE REFERRED TO AS SIMPLY THE "THIRD PARTY." THE EMPLOYER FOR WHOM SERVICES ARE NORMALLY PROVIDED SHALL BE REFERRED TO AS THE "EMPLOYER." SEE TEMPORARY REGULATIONS SECTION 32.1(g)(1). ALL LINE AND BOX REFERENCES ARE TO EITHER THE JANUARY 1991 REVISION OF FORM 941, EMPLOYER'S QUARTERLY FEDERAL TAX RETURN; 1991 FORM W-2, WAGE AND TAX STATEMENT; OR 1991 FORM W-3, TRANSMITTAL OF INCOME AND TAX STATEMENTS.

IF THE THIRD PARTY TRANSFERS THE SOCIAL SECURITY AND MEDICARE TAX LIABILITY TO THE EMPLOYER

The employer is required to include third party sick-pay wages on its Form 941, line 2, Total wages and tips subject to withholding, plus other compensation. The sick-pay wages would also be included in the amounts on line 6a, Taxable social security wages and line 7, Taxable Medicare wages and tips. Once the taxes have been calculated and included in line 8, Total social security and Medicare taxes, the employee portion of the social security and Medicare taxes withheld and deposited by the third party is subtracted on line 9, Adjustment of social security and Medicare taxes. "Sick pay" should be noted in the right-hand margin by the amount entered on line 9. If the employer's adjustments for social security and Medicare taxes include adjustments that are unrelated to sick pay, the employer should enter the amount of the adjustment that is attributable to sick pay in the right-hand margin.

The third party is also required to file Form 941 with the IRS to show the employee's portion of the social security and Medicare taxes the third party withheld. The third party should not include any wages paid as a third party on line 2. Line 6a would show the total amount of wages the third party paid subject to social security. This amount would include both wages paid to its own employees and wages paid as a third party. Line 7 would be completed in a similar manner. Line 9 would be used to deduct the share of the social security and Medicare taxes required to be paid by the employer. "Sick pay" would be noted in the right-hand margin by the amount entered on line 9. If the third party's adjustments for social security and Medicare taxes include adjustments that are unrelated to sick pay, the words "sick pay" and the amount of the adjustment that is attributable to sick pay should also be entered in the right margin.

By January 15 of the following year, the third party is required to furnish the employer statements showing for each person to whom sick pay was paid: the employee's name; the social security number of the employee (if social security, Medicare, or income tax was withheld); the amount of sick pay paid to the employee; the amount of Federal income tax withheld, if any; the employee social security tax withheld; and the employee Medicare tax withheld.

The employer is responsible for issuing Forms W-2 to the employee. On the Form W-2, box 10, Wages, tips, other compensation, should reflect the total wages paid by the employer plus the sick pay paid by the third party. Box 11, Social security tax withheld, should include the employee's share of the social security tax withheld by the employer and the third party. Box 12, Social security wages, should reflect the total social security wages paid to the employee by the employer and third party. Box 14, Medicare wages and tips, should reflect the total Medicare wages paid to the employee by the employer and the third party. Box 15, Medicare tax withheld, should include the employee's share of the Medicare tax withheld by the employer and the third party. If the employer chooses to issue a separate Form W-2 to the employee for the sick pay, the sick pay information should be reflected in boxes 10, 11, 12, 14, and 15.

The IRS compares amounts reported on Forms 941 with amounts reported on Forms W-2 and W-3 that are filed with SSA. Therefore, third parties must prepare a "dummy" Form W-2 for sick-pay payments made during the year.

The "dummy" Form W-2 should be filled out by the third party as follows:

(1) Box 2 should show the third party's name and address.

(2) Box 3 should show the third party's EIN.

(3) Box 9 should show the Federal income tax withheld, if any, from the sick pay.

(4) Box 10 should show total sick pay paid.

(5) Box 11 should show employee social security tax withheld from sick pay.

(6) Box 12 should show the amount of sick pay subject to employee social security tax.

(7) Box 14 should show the amount of sick pay subject to employee Medicare tax.

(8) Box 15 should show the employee Medicare tax withheld.

(9) Box 19a should show the words "Third-party sick pay" in place of the employee's name.

The "dummy" Form W-2 must then be attached by the third party to a separate Form W-3. Only boxes 2, 9, 10, 11, 12, 14, 15, 18, 20, 22, 23, and 24 should be completed on the separate Form W-3. No entry should be made in box 25 of Form W-3 by the third party. This information will be provided by the employer on its Form W-3.

IF THE THIRD PARTY DOES NOT TRANSFER THE SOCIAL SECURITY AND MEDICARE TAX LIABILITY TO THE EMPLOYER

The employer reports on the Form 941 only the wages the employer paid the employees. Line 2 should not include the sick-pay amount paid to the employees by the third party. Likewise, lines 6a and 7 should show only the amount of employer-paid wages for social security and Medicare tax computation purposes. The lines should not include sick-pay payments from the third-party payer.

The Form 941 prepared by the third party will show the amount of sick pa paid to the insured employee(s) on line 2. This amount will also be included on lines 6a and 7 as wages for social security and Medicare tax computation purposes.

Both the employer and the third-party must issue Forms W-2 to the employees and send copies to the SSA. The employee's Form W-2 from the employer will reflect the wages paid and taxes withheld by the employer, while the Form W-2 from the third party will reflect the sick-pay payments and taxes withheld by the third party.

ILLUSTRATION OF COMPLETED FORMS WHEN THE THIRD PARTY TRANSFERS THE SOCIAL SECURITY AND MEDICARE TAX LIABILITY TO THE EMPLOYER

For 1991, X Co. (employer) paid its employees $250,000 in social security and Medicare wages. In the first quarter of 1991, it paid $50,000 in social security and Medicare wages.

Employee T of X Co. received $5,000 of sick pay from A Co. (third party) in the first quarter. A Co. withheld the employee's share of social security and Medicare taxes and income taxes for the $5,000 paid. A Co. deposited these taxes and provided X Co. timely notification of the amount of wages paid on which the taxes were withheld and deposited. By taking these steps, A Co. transferred the employer tax liability to X Co.

For 1991, A Co. paid its employees $120,000 in social security and Medicare wages. It paid $200,000 of sick pay to employees of its various clients. For the first quarter of 1991, A Co. paid $30,000 in social security and Medicare wages to its employees. It paid $50,000 of sick pay to employees of its various clients (including the $5,000 to employee T of X Co.).

The companies would complete Forms 941, W-2, and W-3 as follows.

X CO. (EMPLOYER)

On Form 941 for the first quarter, X Co. reports $55,000 in total wages and tips subject to withholding, plus other compensation (line 2, figure 1). This includes the $5,000 of sick pay employee T received from A Co. However, because A Co. withheld and deposited employee T's share of social security and Medicare taxes for the $5,000 of sick pay, X Co. reports an adjustment to these taxes (line 9 figure 1) and notes "sick pay" in the right-hand margin.

At the end of the year, X Co. issues a Form W-2 to employee T (figure 2). The form combines $20,000 of wages X Co. paid and $5,000 of sick pay from A Co. It also combines the taxes withheld by both companies. On its Form W-3, X Co. shows the amount of income tax withheld by A Co. on employee T's sick pay (line 25, figure 3).

A CO. (THIRD PARTY)

On Form 941 for the first quarter, A Co. reports the $30,000 in total wages and tips subject to withholding, plus other compensation it paid its employees (line 2, figure 4). Because it paid $50,000 of sick pay to employees of its various clients, A Co. reports $80,000 of taxable social security and Medicare wages (lines 6a and 7, figure 4).

Because A Co. transferred the employer tax liability to its various clients, it must adjust social security and Medicare taxes (line 9, figure 4). It also reports a $2,000 decrease to social security tax for the third quarter of 1990. (This adjustment would be detailed on Form 941c (not shown), which would be attached to Form 941.) Because the adjustment includes an amount that is not related to sick pay, the amount of the adjustment that is attributable to sick pay is noted in the right-hand margin (figure 4).

At the end of the year. A Co. prepares a "dummy" Form W-2 to report all the sick pay it paid employees of its various clients in 1991 (figure 5). It prepares two Forms W-3, one for its own employees (figure 6) and one for the "dummy" W-2 (figure 7).