PAYMENT OF EMPLOYEE FICA TAX BY EMPLOYER WITHOUT DEDUCTION OCCUPANCY INSURANCE CONTRACT.

Rev. Rul. 86-14

ISSUE

What are the federal income and employment tax consequences when an employer agrees with an employee to pay the employee Federal Insurance Contributions Act (FICA) tax imposed by section 3101 of the Internal Revenue Code without deducting the amount of the taxes from the employee's pay?

FACTS

Situation 1. During 1985, an employer agreed to pay an employee $200 weekly. The payments are "wages" for "employment" under section 3121(a) of the Code (relating to the FICA), section 3306(b) (relating to the Federal Unemployment Tax Act (FUTA)), and section 3401(a) (relating to income tax withholding). The payments are not for domestic service in the employer's private home or for agricultural labor. The employer further agreed to pay the employee FICA taxes imposed by section 3101 without deducting them from the $200 paid to the employee.

Situation 2. The facts are the same as in Situation 1, except that the pay was either for domestic service in the employer's private home or for agricultural labor.

LAW AND ANALYSIS

Section 61(a) of the Code defines gross income as all income from whatever source derived, including compensation for services.

Taxes assessed against an employee and paid by an employer in partial consideration for service are includible in the employee's gross income. Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929), VIII-2 C.B. 222 (1929).

Sections 3121(a)(6)(A) and 3306(b)(6)(A) of the Code except from "wages," for FICA and FUTA purposes, respectively, and employer's payment (without deduction from the employee's pay) of the employee FICA taxes imposed by section 3101, in the case of pay for domestic service in the employer's private home or for agricultural labor. Those sections previously excepted from wages all payments of employee FICA taxes by an employer without deduction from the employee's pay, but the exception was limited to domestic service in the employer's home and agricultural labor by section 1141 of the Omnibus Reconciliation Act of 1980, 1980-2 C.B. 509, 530, effective for remuneration paid after December 31, 1980. (December 31, 1983, in the case of certain state and local government employees who are covered for social security purposes under an agreement under section 218 of the Social Security Act, 42 U.S.C. section 418 (1982).)

Section 31.3401(a)-1(b)(6) of the Employment Tax Regulations states that "wages", for income tax withholding purposes, includes amounts paid by an employer on behalf of an employee (without deduction from the employee's pay) of the employee FICA taxes imposed by section 3101 of the Code.

Section 3401(a)(2) of the Code excepts from wages for income tax withholding purposes payments for agricultural labor, and section 3401(a)(3) excepts payments for domestic service in a private home.

Rev. Proc. 81-48, 1981-2 C.B. 623, provides a formula for determining the amount of wages under sections 3121(a), 3306(b), and 3401(a) of the Code if an employer, under an arrangement with an employee, pays the employee FICA taxes imposed by section 3101 after December 31, 1980, without deducting them from the employee's pay. However, the revenue procedure and the formula do not apply if the pay is for domestic service in the employer's private home or for agricultural labor.

The effect of section 1141 of the 1980 Act is that if an employer pays the employee FICA taxes imposed by section 3101 of the Code without deducting them from the employee's pay, the amount of the employee's wages under section 3121(a) is increased by the amount of the taxes. This increase in the wage payment is also subject to the employee FICA taxes, which has the effect of again increasing the employee's wages under section 3121(a) by the amount of the additional taxes paid by the employer. This continuing series of additional wages and additional taxes on such wages is known as "pyramiding." See Rev. Proc. 81-48.

The formula for determining an employee's FICA wages set forth in Rev. Proc. 81-48 is:

                         W = S

S = State pay (the pay before taking into account the pyramiding effect), and

R = Rate of employee FICA taxes.

During 1985, the employee FICA taxes imposed by section 3101 of the Code are 7.05 percent (.0705) of the wages received by the employee during the year.

In addition, in order to determine the increased wages under section 3306(b) of the Code (FUTA) and section 3401(a) (income tax withholding), it is first necessary to compute the employee FICA tax under section 3101. See section 3306(b)(6)(A) of the Code (as amended by the 1980 Act) and section 31.3401(a)-1(b)(6) of the regulations, above.

HOLDINGS

SITUATION 1. Using the formula set forth above, weekly FICA wages are $215.17 ($200/.9295). The weekly employee FICA taxes are 7.05 percent of those wages or $15.17.

For income tax purposes, the entire $215.17($200 + $15.17) is includible in the employee's gross income as compensation under section 61(a)(1) of the Code.

For FUTA and income tax withholding purposes, the employee's weekly wages are $215.17.

On the Form W-2, Wage and Tax Statement, for 1985, the employer should report the weekly $215.17 as "wages" paid subject to both income tax withholding and the FICA taxes in the boxes entitled "Wages, tips, other compensation" and "social security wages". The employer should report the weekly $15.17 in the box entitled "Social security tax withheld," even though the tax was not actually withheld.

Assuming that it is otherwise appropriate, the employer may deduct the $215.17 attributable to agricultural labor as an ordinary and necessary business expense under section 162 of the Code. Ordinarily, wages paid for domestic services in one's home are not deductible under section 162 of the Code.

SITUATION 2. Because in this situation FICA and FUTA wages do not include the employee FICA taxes paid by the employer, FICA and FUTA wages are equal to the $200 stated pay. The employee FICA taxes are $14.10 (7.05 percent of FICA wages).

For income tax purposes, $214.10 ($200 = $14.10) is includible in the employee's gross income as compensation under section 61(a)(1) of the Code.

Pursuant to section 3401(a)(2) or (3) of the Code, none of the $214.10 is wages for purposes of income tax withholding.

On the Form W-2 for 1985, the employer should report the weekly $214.10 as "other compensation" in the box entitled "Wages, tips, other compensation"; the weekly $200 in the box entitled "Social Security wages"; and the weekly $14.10 in the box entitled "Social Security tax withheld," even though the tax was not actually withheld.

Assuming that it is otherwise appropriate, the employer may deduct the $214.10 attributable to agricultural labor as an ordinary and necessary business expense under section 162 of the Code. Ordinarily, wages paid for domestic services in one's home are not deductible under section 162.

BOTH SITUATIONS. If the employee received wages subject to FICA taxes from two or more employers during the year, and as a result the wages exceeded the annual limitation on wages subject to FICA taxes under section 3121(a)(1) of the Code ($39,600 in 1985), the employee is entitled, under section 6413(c)(1), to a special refund of the excess FICA taxes paid. That section indicates that the refund is conditioned on the taxes being deducted from the employee's wages. Because of the tax liability incurred on behalf of the employee in either situation is included in the employee's gross income, it was, in effect, deducted from the employee's pay.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 74-75, 1974-1 C.B. 19, is modified.