Publication 963 (11-2014) FEDERAL-STATE REFERENCE GUIDE

 

The requirements for each of these rules are discussed in IRS

Publication 15-B

, and in the FSLG's Publication 5137,

Fringe Benefit Guide.

The value of a "qualified nonpersonal use vehicle" can be excluded from income as a working condition fringe benefit. A qualified nonpersonal use vehicle is one that, due to its nature, is not likely to be used more than a minimal amount for personal purposes. This includes, for example, a clearly marked police, fire, or public safety officer vehicle, a flatbed truck, a school bus, or ambulance. An employee is not required to substantiate the business use of a qualified nonpersonal use vehicle in order to exclude its value from income. See IRC section 274(d)(i) and Publication 15-B.

Clothing Provided by Employer

The value of work clothing provided by the employer is not taxable to the employee if:

 

It is not enough that the employee wear distinctive clothing; the employer must specifically require the clothing for work. The second test is not met solely because the employee does not, in fact, wear the work clothes away from work; the clothing must not be suitable for taking the place of regular clothing. The value and upkeep of work clothes provided to firefighters, health care workers, law enforcement officers or letter carriers is nontaxable to the employee. The value of provided items such as safety shoes or boots, safety glasses, hard hats and work gloves provided and maintained by the employer is not taxable if the employer requires the items for work and the items are not suitable for everyday use.

Health Benefits

Under IRC sections 105 and 106, contributions to or benefits provided from an employer-provided health care plan, including reimbursements and paid insurance premiums, are generally excluded from the wages of the employees and are not subject to social security, Medicare taxes or income tax withholding. A health reimbursement arrangement (HRA) may provide for the carryover of benefits from year to year, and may specify the types of medical benefits that are covered. An HRA can only be financed by employer contributions, and cannot involve an employee election to participate. For more information, see Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.

Note: The Affordable Care Act made changes affecting the tax treatment of HRAs. See http://www.irs.gov for more information.

Cafeteria (Section 125) Plans

Cafeteria plans, including flexible spending arrangements, are benefit plans under which employees can choose from among cash and certain qualified benefits. If the employee elects qualified benefits, employer contributions are generally excluded from the wages of the employees and are not subject to social security, Medicare taxes or income tax withholding. A cafeteria plan is a separate written plan maintained by an employer for employees that meets the specific requirements of section 125 of the Internal Revenue Code and associated regulations. It provides participants an opportunity to receive certain benefits on a pre-tax basis. Participants in a cafeteria plan must be permitted to choose among at least one taxable benefit (such as cash) and one qualified benefit. If an employee elects to receive cash instead of any qualified cafeteria plan benefit, that amount is treated as wages subject to all employment taxes.

A qualified benefit is a benefit that does not defer compensation and is excludable from an employee's gross income under a specific provision of the Code, without being subject to the principles of constructive receipt. Qualified benefits include:

 

Generally, qualified benefits under a cafeteria plan (including health and accident insurance) are excluded from the wages of the employees. The cost of group-term life insurance of up to $50,000 provided by an employer is excludable from income and social security, and Medicare wages. However, the cost of group-term life insurance that exceeds $50,000 of coverage is included in wages (but is not subject to income tax withholding) and is subject to social security and Medicare taxes, even when provided as a qualified benefit in a cafeteria plan. The cost of group-term life insurance that is includible in income only because the insurance exceeds $50,000 of coverage is considered a qualified benefit. Adoption plans are also subject to social security and Medicare taxes. See IRS

Publication 15-B

for details.

Health benefits provided under a cafeteria plan may include insurance or a flexible spending arrangement (FSA) for qualifying medical expenses. An employer may have both a Health Reimbursement Arrangement (HRA) and a cafeteria plan, but the salary reductions cannot be used to directly or indirectly fund an HRA (see Revenue Ruling 2005-24).

Any amounts paid for health benefits pursuant to a salary reduction election are considered paid by the employer; therefore, the employee is not entitled to exclude from income any amounts paid as "reimbursements" to the employees for benefits under the plan. See Revenue Ruling 2005-24 for more information on the interaction between an HRA and various reimbursement arrangements.

Annual Limitation

For plan years beginning after December 31, 2012, a cafeteria plan may not allow an employee to request salary reduction contributions for a health FSA in excess of $2,500. This amount will be indexed for future years.

A cafeteria plan offering a health FSA must be amended to specify the $2,500 limit (or any lower limit set by the employer). While cafeteria plans generally must be amended on a prospective basis, an amendment that is adopted on or before December 31, 2014, may be made effective retroactively, provided that in operation the cafeteria plan meets the limit for plan years beginning after December 31, 2012. A plan that does not limit health FSA contributions to $2,500 is not a cafeteria plan and all benefits offered under the plan are includible in the employees' gross income. See Notice 2012-40.

In general, all amounts credited to an employee in the plan must be used up by the end of the calendar year or are forfeited. However, under a "grace period rule" an IRC 125 cafeteria plan may permit an employee to use amounts remaining from the previous year to pay expenses incurred for certain qualified benefits during the period of up to two months and 15 days immediately following the end of the plan year. See Notice 2005-42.

A plan may be amended to provide that up to $500 of unused amounts remaining at the end of a plan year in a health FSA to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year. However, if this provision is adopted, the grace period discussed above does not apply. See Notice 2013-71.

Meals and Lodging Furnished by Employer

The value of meals is excludable if the meals are furnished on the business premises of the employer and are provided for the convenience of the employer.

The value of lodging is excludable if the lodging is furnished on the business premises, is furnished for the convenience of the employer, and if the employee is required to accept the lodging as a condition of employment. See Publication 15-B for more information.

Retirement Plans

Regardless of social security coverage, most public employees are covered by some form of retirement plan. The terms of these plans may vary greatly, but in general provide for tax-deferred income placed in trust for the benefit of employees. These plans may involve employee or employer contributions, or both. Under certain provisions of the IRC, contributions may be deferred from tax until they are withdrawn. The term "qualified" is widely used to describe private-sector plans under IRC 401 that meet specific provisions of the Employee Retirement Income Security Act (ERISA) that enable them to offer certain tax advantages to the participants. Many public employees, however, are covered by nonqualified plans, generally under IRC sections 403(b) or 457, discussed below.

Income Tax Withholding on Qualified Retirement Plans

For income tax withholding purposes, employer and employee contributions made under qualified plans (up to the maximum allowable for the year) are deferred from income tax. The employee will be subject to tax on distributions of these amounts when they are withdrawn from the plan. In most cases, withdrawals that are not rolled over into another plan are subject to mandatory income tax withholding upon distribution.

Employer "Pick-Up" Contributions

IRC Section 414(h)(2) allows state and local government entities with governmental plans within the meaning of IRC 414(d) to treat contributions that have been designated as employee contributions, but which are "picked up" (paid) by the employer, to be treated as employer contributions, and therefore as excludable from income. These "picked up" contributions are also exempt from social security and Medicare tax as long as they are not made pursuant to a salary reduction agreement. For more information on the conditions required for employer pick-up. See IRC 414(h)(2). For more information, visit http://www.irs.gov and search for "Employer pick-up contributions."

Section 403(b) Plans

Plans under IRC section 403(b), also called tax sheltered annuities, are available to certain employees of public schools, employees of tax-exempt organizations, and certain ministers. These plans resemble qualified plans in many respects. Many public school employees are covered by 403(b) plans in addition to receiving social security coverage under a Section 218 Agreement.

Employer contributions to tax-sheltered annuities under section 403(b) for public school employees are exempt from social security and Medicare taxes, unless the contributions are made by reason of a salary reduction agreement. Eligible participants may defer amounts from income tax up to an annual limit ($18,000 in 2015). This amount may be increased for certain employees with more than 15 years of service. In addition, additional tax-deferred "catch-up" contributions may be made for employees age 50 or older.

Employee contributions, including those made by salary reduction arrangements, are subject to social security and Medicare tax. See IRC §3121(a)(5)(D).

For more information, see Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans), and the section 403(b) page on IRS.gov.

Section 457 (Nonqualified) Plans

Many public employees participate in nonqualified section 457, deferred compensation plans. These plans can be established by state and local governments or tax-exempt organizations. If they meet the requirements of IRC section 457(b), they are considered "eligible" plans; if not they are considered "ineligible" plans, and are governed by IRC section 457(f).

Section 457(b) -- Eligible Plans

Governmental 457(b) plans must be funded, with assets held in trust for the benefit of employees. Plans eligible under 457(b) may defer amounts from income tax up to an annual limit ($18,000 in 2015). Governmental 457(b) plans may make "catch-up" contributions to employees age 50 or older, in addition to the basic section 457(b) catch-up. Social security and Medicare taxes generally apply to all employer and employee contributions. For further information regarding social security and Medicare tax withholding and reporting on amounts deferred into eligible deferred compensation plans, see the section 457(b) page on IRS.gov.

Amounts deferred from wages into eligible section 457(b) plans are not subject to income tax withholding until they are distributed from the plan or made available to the participant or beneficiary. For further information regarding income tax reporting and withholding upon amounts deferred into and distributed from eligible governmental deferred compensation plans, see the section 457(b) page on IRS.gov, and Section VI of Notice 2003-20.

Section 457(f) -- Ineligible Plans

Nonqualified state or local government plans that do not meet the requirements of section 457(b) are ineligible, or section 457(f), plans. There is no limit on the annual deferrals on these plans, but to defer taxation, all deferrals must be subject to substantial risk of forfeiture. Amounts deferred under a section 457(f) plan are generally subject to social security and Medicare taxes at the later of the time 1) when the services giving rise to the related compensation are performed, or 2) when there is no substantial risk of forfeiture of the rights to the amounts.

Employer Reporting Responsibilities

Basic federal tax requirements that generally apply to all employers are discussed below. For a more detailed explanation, see Publication 15.

Employer Identification Number

IRS identifies individual taxpayers by using taxpayer identification numbers (TINs). For individuals, the TIN is the social security number. State and local entities use employer identification numbers (EINs) assigned by IRS to identify their accounts and tax returns. The EIN should be used on all employment tax returns (e.g., Form 941), information returns (e.g., Form W-2) and correspondence with the IRS. Generally, each county, city, school district or other governmental unit will have a unique EIN. However, this is not always the case within state governments. Many state agencies use an EIN assigned to another agency; some larger state agencies may use a unique EIN.

When two entities are combined (for example, when one municipality annexes another, or when school districts are consolidated) the EIN of the annexed area or abolished district should no longer be used, as it is no longer a separate entity. A continuing entity that absorbs or annexes another can retain its EIN. However, if a new entity is created from the dissolution of two or more preexisting entities, a new EIN should be obtained. When an unincorporated area is incorporated, it becomes a separate entity and must obtain its own EIN.

To obtain a new EIN, complete Form SS-4, Application for Employer Identification Number. Once you have received an EIN, ensure that it is accurate and complete on each tax document submitted. When an incorrect EIN is used, credit for tax payments can be delayed or applied incorrectly.

Note: For tax years prior to 1987, SSA assigned EINs beginning with the digits "69" for government employers to report earnings, but these are no longer used. Prior to 1987, these numbers were assigned for new modifications to Section 218 Agreements, and then used to process wage reports. Many states have a filing system based upon the 69 number and, therefore, continue to sequentially assign 69 numbers for internal recordkeeping purposes.

Form SSA-1945

State and local government employers are required to notify employees hired on or after January 1 2005, in jobs not covered by social security, of the effects of the Windfall Elimination Provision and the Government Pension Offset. The law requires newly hired public employees to sign Form SSA-1945, indicating that they are aware of a possible reduction in their future social security benefit entitlement. For more detailed information about this law, see Chapter 7 or http://www.socialsecurity.gov/form1945.

Form W-2

An employer is responsible for furnishing Form W-2, Wage and Tax Statement, to each employee from whom income, social security or Medicare tax was withheld, or would have been withheld if the employee had claimed no more than one withholding allowance or had not claimed exemption from withholding on Form W-4. Statements to employees must be furnished by January 31 of the following year. The aggregate amounts are reported on Form W-3, Transmittal of Wage and Tax Statements. For more information, see the Instructions for Forms W-2 and W-3.

Employers who file 250 or more Forms W-2 must file them electronically. Statements may be furnished to employees electronically only if an affirmative consent has been received from the employee to do so. See Publication 1141 for more information.

An employer uses Form 941, Employer's QUARTERLY Federal Tax Return (or for certain employers, the annual Form 943 or 944) to report wages paid and taxes withheld. After the calendar year ends, employers prepare individual employee reports on Forms W-2, Wage and Tax Statement, with Form W-3, Transmittal of Wage and Tax Statements, showing the total wages paid and taxes withheld for each employee during the year. An employer reports wage information to SSA for crediting to the employees' earnings records. This is done either by sending SSA Copy A of the paper Form W-2 with a covering Form W-3, or by sending the Form W-2 information in the form of electronic reports.

If you need to talk directly to SSA about an electronic file or other wage reporting problem, you may contact an Employer Services Liaison Officer (ESLO) through the ESLO page on the SSA website, or call 1-800-772-6270 for assistance from an earnings report technician. Specifications for electronic reporting of Form W-2 information can be found at the SSA employer page or by calling the ESLO for your state.

Form 941

Form 941, Employer's Quarterly Federal Tax Return, is used to report total wages, wages subject to social security and Medicare tax, and federal income tax. Agricultural employers file Form 943, Employer's Annual Tax Return for Agricultural Employers. Form 944, discussed below, is an annual version of the form, for employers with the smallest payrolls. Generally, annual Form 941 or Form 943 totals must match the aggregate wages shown on all Forms W-2 issued to employees for the same period.

To prepare Form 941, the total wages and compensation for the quarter must be determined. Wage payments are included in the quarter in which they are paid. For example, an employee works for the county in a pay period ending on March 20, but is not paid until April 5. In this situation, the employee's wage payment is included in the second quarter when the payment is made, not the first quarter when the work was done. Total wages and compensation entered on line 2 of Form 941 includes all payments to employees. Examples of these payments include:

 

Wages from which social security and Medicare tax must be withheld may differ from total wages. This may be because certain amounts are not included in wages for income tax purposes, but are subject to social security and Medicare tax (for example, deferred compensation in a nonqualified deferred compensation plan). Another common reason for a difference in the totals is that earnings exceeding the annual wage base are not subject to the OASDI portion of social security tax. The total income tax withheld (line 3) includes all federal income tax withheld from all employees for the calendar quarter covered by the return.

Form 941 must be filed with the IRS by the last day of the month following the calendar quarter. For example, the first quarter return covering January through March is due by April 30. If all taxes are deposited when due, the employer has 10 additional days after the due date to file the return. If the return is not filed by this date, the employer may be subject to penalties and interest in addition to the tax due on the return.

Form 944

Certain taxpayers with small payrolls may report their employment taxes on an annual rather than a quarterly basis. The IRS will notify these taxpayers that they are eligible to use Form 944. Instead of the quarterly Form 941, they file annual Form 944, Employer's Annual Employment Tax Return. An employer may contact the IRS to request to file a Form 941 instead of a Form 944. See Revenue Procedure 2009-51. The deposit requirements, discussed below, are the same as for quarterly filers. For more information on eligibility, see Publication 15 or the Instructions for Form 944.

Except for the return due date, references to the requirements for quarterly Form 941 discussed in this chapter are also applicable to filers of annual Form 944.

Form 941-X

Employers correct errors to Form 941 or 944 by filing Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, or Form 944-X, Adjusted Employer's ANNUAL Federal Tax Return or Claim for Refund. Form 941-X is a stand-alone return that should be filed as soon as the error is discovered. The return for the period when the error is discovered is not affected. Additional requirements are discussed in the Instructions for Form 941 and in the Instructions for Form 941-X.

Special Reporting Situations for Government Employers

These are some circumstances commonly facing government employers that involve special reporting rules.

Multiple Employers and the Wage Base

Because each employer must withhold social security tax on wages up to the annual maximum, an employee who works for more than one employer in one calendar year may have excess social security taxes withheld. In order to get a refund of the excess social security tax withheld by the employers, the employee shows the overpayment on Form 1040. Employers are not responsible for making any adjustments based on wages paid by other employers and cannot claim a refund in this situation, because each employer is responsible for withholding and paying social security tax on wages paid to each employee up to the wage base.

For the purpose of determining responsibility for reporting wages, a state is considered to be one employer and each political subdivision is considered a separate employer. An employee who transfers from one state agency to another during a calendar year does not change employers. In this case, the state should withhold and pay social security tax only up to the wage base for that employee. However, an employee who transfers from a state agency to a political subdivision of the state, a city or county, has changed employers. Each employer must withhold and pay social security tax up to the wage base for that employee, regardless of other employment.

Medicare Qualified Government Employment (MQGE)

As explained in Chapter 2, all employees hired after March 31, 1986, are subject to Medicare tax. State and local employers that provide coverage under a public retirement system may have employees who are not subject to social security but are subject to Medicare tax. This is referred to as Medicare Qualified Government Employment (MQGE). MQGE Forms W-2 are filed separately from those for employees covered by social security and Medicare, or from Forms W-2 having no social security or Medicare wages. Paper MQGE Forms W-2 must be transmitted with a covering Form W-3 with "Medicare Govt. Emp." checked in box b. See the Instructions for Forms W-2 and W-3 or contact your ESLO for more information. Note: Electronically transmitted records should be grouped to follow a "Code RE" record with an Employment Code of "Q". All other W-2 records should be grouped to follow a Code RE record with an Employment Code of "R". Do not group MQGE W-2 records and non-MQGE W-2 records together after a single Code RE record. See SSA Publication 42-007, Specifications for Filing Forms W-2 Electronically (EFW2).

Employees Covered for MQGE and FICA

If they are employed in more than one capacity, some state and local employees may be subject to both Medicare-only withholding and full social security and Medicare in the same reporting year. When an employee is in a continuous employment relationship with the same employer for the year, and the employer has both types of employees, the employer has two reporting options:

 

Information Reporting for Election Workers

If the compensation of an election workers is less than a statutorily established amount ($1,600 for calendar year 2015), it is generally not subject to mandatory social security and Medicare tax. See IRC sections 3121(u)(2)(B)(ii)(V). However, under a state's Section 218 Agreement an election workers' compensation may be subject to social security and Medicare taxes at a level below the statutory amount. In any case, compensation of election workers is not subject to income tax withholding.

If an election worker's wages are subject to withholding of social security and Medicare tax, Form W-2 reporting is required for all compensation, regardless of the amount. If an election worker's compensation is not subject to withholding of social security and Medicare tax, Form W-2 reporting is required for payments that aggregate $600 or more in a calendar year. See Revenue Ruling 2000-6 for a discussion of information reporting with respect to election workers.

Information Returns

Any entity, including a governmental organization, conducting a trade or business, is required to file with the IRS, and furnish to recipients, information returns for certain types of payments. In most cases, these payments are reported on Form 1099-MISC, Miscellaneous Income.

IRC 6041(a) states that all persons engaged in a trade or business and making payment in the course of the trade or business to another person of rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments, or other fixed and determinable gains, profits, and income (with certain exceptions) of $600 or more in any year must furnish an information return indicating the amount of such income and the name and address of the recipient of such payment. The return with respect to certain payments of compensation to an employee is made on Forms Form 1099-MISC to report payments for services by an employee. The recipient of the payment is required to furnish to you the entity's name, address and identification number. You should obtain this information before payments are made. This identification number must be included on the information return. Payments for nonemployee compensation are discussed in the Instructions for Form 1099-MISC.

Governments must file Form 1099-G, Certain Government Payments, for certain payments, including tax refunds, unemployment compensation, and taxable grants. See the Instructions for Form 1099-G for more information. A variety of information returns are required to report various other types of payments.

Payers responsible for filing 250 or more information returns of one type (for example, Form 1099-MISC) are required to file these electronically. Regardless of whether the returns are filed electronically, a paper statement must be furnished to each recipient unless correct procedures are followed for establishing an electronic system for furnishing statements, including affirmative consent from each individual to receive the information electronically. For more information, see the General Instructions for Certain Information Returns and Publication 1179.

Depositing Taxes

In general, employers are required to deposit federal employment taxes if the total tax liability for Form 941 for the current or previous quarter is $2,500 or more. These taxes are required to be deposited using the Electronic Federal Tax Payment System (EFTPS). You can no longer make deposits using paper coupons. A balance due on the Form 941 or 944 of less than $2,500 is not required to be deposited; it may be paid with the return.

Note: As of November 30, 2009, federal agencies can no longer use FEDTAX II for deposits and must use EFTPS. Publication 966 explains the EFTPS system.

See Notice 2003-20 for guidance on depositing and reporting of income tax withheld upon distributions from eligible deferred compensation plans described in section 457(b).

When to Deposit

An employer will use either the monthly or the semiweekly schedule for deposit of federal employment taxes. These schedules indicate when a deposit is due after a tax liability arises (a pay date). Before the beginning of each calendar year, employers must determine which of the two deposit schedules they are required to use. The deposit schedule used is based on the total tax liability reported on Form 941 or Form 943 during a four-quarter lookback period as discussed below. The deposit schedule is not determined by how often employees are paid.

Lookback Period

The deposit schedule an employer must use for a calendar year is determined from the total taxes reported on Forms 941 (line 8) in a four-quarter "lookback" period that applies to that year. The lookback period begins July 1 of the second preceding year, and ends June 30 of the preceding year. If the employer reported $50,000 or less of taxes for the lookback period, the employer is a monthly schedule depositor; if it reported more than $50,000, the employer is a semiweekly schedule depositor.

The rules for making deposits are summarized in the table on the next page.

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Summary of Federal Tax Deposit (FTD) Rules

 

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If the employer       And the payroll            Then a deposit must

 

 is a . . .            date is . . .              be made:

 

 ----------------------------------------------------------------------

 

 Monthly schedule      Any time during the month  On or before the 15

^th

 

 depositor

($50,000

                               of the month

 

 

or less during the

 

 lookback period)

 

 ----------------------------------------------------------------------

 

 Semiweekly schedule   Saturday, Sunday, Monday,  On or before the

 

 depositor

(More than

  Tuesday                    following Friday

 

 

$50,000 during the

    ------------------------------------------------

 

 

lookback period)

      Wednesday, Thursday,       On or before the

 

                       Friday                     following Wednesday

 

 ----------------------------------------------------------------------

 

 

Special Rules:

 

 

$2,500 Rule:

 Accumulated taxes less than $2,500 in a quarter do not

 

 have to be deposited if paid with a timely filed return.

 

 

$100,000 Next Day Rule:

 $100,000 or more within a deposit period must

 

 be deposited on the next banking day. Monthly depositors become

 

 semiweekly depositors on the next day and remain so for the remainder

 

 of the year and all of the following year.

 

 

Accuracy of Deposits Rule:

 An employer who inadvertently underdeposits

 

 will not be penalized if the shortfall does not exceed $100 or 2% of

 

 the amount of employment taxes required to be deposited. Balance due

 

 must be deposited by a shortfall make-up date. See IRS

Publication 15

 

 for details.

 

 

Deposits on Banking Days Only:

 If a deposit is required to be made on

 

 a day that is not a banking day, the deposit is considered timely

 

 made if it is made by the close of the next banking day. Legal

 

 holidays (days that are legal holidays in the District of Columbia)

 

 are considered non-banking days, as are Saturday and Sunday.

 

 

Special Rules for Non-Banking Days:

 Semiweekly depositors have at

 

 least three banking days following the close of the semiweekly period

 

 to deposit taxes accumulated during the semiweekly period. For more

 

 information, see IRS

Publication 15

.

 

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Deposit Requirements for Nonpayroll (Form 945) Tax Liabilities

 

 

The deposit rules and dollar thresholds to figure when deposits for nonpayroll tax withholding are the same as they are for employment taxes; however, they are aggregated separately, and the deposit thresholds above apply separately. Do not combine Form 945 with deposits for employment tax liabilities (Form 941 or Form 944). See the instructions for Form 945 for details on reporting nonpayroll withholding.

For more information on the deposit rules, see IRS Publication 15. For more information on using the Electronic Federal Tax Payment System (EFTPS), see IRS Publication 966.

Calculating Federal Income Tax Withholding

Employers are generally required to withhold federal income tax from the wages paid to employees. The withheld amount is credited to the employees' individual income taxes.

Each employee should submit a signed Form W-4, Employee's Withholding Allowance Certificate, when employment begins. The amount of federal income tax withheld on an employee depends on five factors:

 

Publication 15

, furnished by the IRS to each employer at the beginning of each calendar year, contains the tax withholding tables and percentage tables to use to determine actual withholding based on the above criteria. Refer to

Publication 15

for specific instructions on calculating withholding from your employees.

Federal Unemployment Tax Act

The Federal Unemployment Tax Act (FUTA) provides a federal-state insurance system for workers who lose their jobs. Most private employers pay both a federal and state unemployment tax. States and their political subdivisions are exempt from paying tax under FUTA. However, state and local government employees, with certain exceptions, must be covered by state unemployment insurance. Contact your state employment or labor agency for more information.

Interest and Penalties

Tax that is not paid when due or in the manner required may be subject to civil penalties as well as interest on the amount due.

Employment Tax Penalties

The following are the most commonly assessed penalties related to employment tax. There are penalties for filing a return late and paying or depositing taxes late, unless there is reasonable cause.

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IRC

 

 Section        Penalty Assessed For:             Penalty Rates:

 

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 6651(a)(1)  Failure to file a tax return   5% of the tax due per month

 

             (failure to timely file)       up to 25%

 

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 6651(a)(2)  Failure to pay tax shown on    0.5% (one half of one

 

             the return (failure to timely  percent) of the tax due per

 

             pay) (imposed if the amount    month up to 25%

 

             of tax shown on the return is

 

             not paid on or before the

 

             prescribed date)

 

 ----------------------------------------------------------------------

 

 6651(c)     Both failure to timely file    When both penalties apply

 

             and failure to timely pay      for any month, the failure

 

                                            to file penalty is assessed

 

                                            at 4.5%

 

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 6652(b)     Failure to report tips         Imposes a penalty for tip

 

                                            income unreported to the

 

                                            employer; the penalty is

 

                                            50% of the employee social

 

                                            security and Medicare tax

 

                                            on the unreported tip

 

                                            income

 

 ----------------------------------------------------------------------

 

 6656        

Deposit penalties:

 

 ----------------------------------------------------------------------

 

             1-5 days late                  2%

 

             ----------------------------------------------------------

 

             6-15 days late                 5%

 

             ----------------------------------------------------------

 

             More than 15 days late, but    10%

 

             paid by the 10

^th

 day after

 

             notice and demand (Notice

 

             and demand date is the

 

             assessment date)

 

             ----------------------------------------------------------

 

             Taxes still unpaid after the   15%

 

             10

^th

 day following notice and

 

             demand

 

             ----------------------------------------------------------

 

             Failure to deposit             10%

 

             electronically

 

 ----------------------------------------------------------------------

 

 6662        Underpayment of employment     20% of the underpayment

 

             taxes due to disregard of the  attributable to negligence

 

             rules and regulations          or disregard of rules and

 

             (accuracy-related)             regulations

 

 ----------------------------------------------------------------------

 

 6672        Failure to withhold or pay     100% of unpaid tax (see

 

             over trust fund taxes          below)

 

 ----------------------------------------------------------------------

 

 

 

Trust Fund Recovery Penalty

 

 

Under section

6672

, if withheld taxes that must be withheld are not withheld or are not deposited or paid, the trust fund recovery penalty may apply. The penalty is the full amount of the unpaid trust fund tax. This penalty may be imposed on all persons who are determined by the IRS to be responsible for collecting, accounting for, and paying over these taxes, and who acted willfully in not doing so.

A responsible person can be an officer, employee, or volunteer. A responsible person also may include one who signs checks for the business or otherwise has authority to cause the spending of funds. "Willfully" means voluntarily, consciously, and intentionally. A responsible person acts willfully if the person knows that the required actions are not taking place.

Information Reporting Penalties

The following are the most commonly assessed penalties as they relate to information reporting:

 ----------------------------------------------------------------------

 

                                             

Rate for Returns Required

 

                                              To Be Filed January 1,

 

 IRC Section          Penalty                 2011, or Later*

 

 ----------------------------------------------------------------------

 

 6721         Failure to file correct         The penalty for failure

 

              information returns on or       to file information

 

              before the required filing      returns without all

 

              date or failure to include all  required and correct

 

              information required to be      information (including

 

              shown on the return (or         missing, incorrect and/or

 

              where there is incorrect        unissued TINs) is $100

 

              information shown)              for each failure to a

 

                                              maximum of $1,500,000 per

 

                                              calendar year

 

 ----------------------------------------------------------------------

 

 6722         Failure to furnish correct      The penalty is $100 for

 

              payee statements on or before   each failure, not to

 

              the date prescribed to the      exceed $1,500,000 per

 

              person to whom such statement   calendar year, when there

 

              is required to be furnished,    is failure to furnish a

 

              or a failure to include all     timely and correct

 

              of the information required     payee statement

 

              to be shown on the payee

 

              statement or where the

 

              information is incorrect

 

 ----------------------------------------------------------------------

 

 6723         Failure to comply with other    The penalty is $50 for

 

              specific information reporting  each failure, not to

 

              requirements on or before the   exceed $100,000 per

 

              prescribed time (usually        calendar year, when

 

              related to failure to furnish   there is failure to

 

              a TIN)                          comply with any

 

                                              information reporting

 

                                              requirement

 

 ----------------------------------------------------------------------

 

 * - Reduced penalties may apply for returns filed within 30 days, by

 

 August 1, or for entities with gross receipts no more than $5,000,000.

 

 See the Instructions for Certain Information Returns for more

 

 information.

 

 ======================================================================

 

 

 

Interest

 

 

Interest is assessed on any taxes due and unpaid, in addition to any penalties that may be imposed. However, the law allows an employer who has made an undercollection or underpayment of social security and Medicare taxes or income tax withholding to make an interest free-adjustment (IRC section 6205(a)(1)). The following two requirements must be met:

 

Frequently Asked Questions

 

Chapter 4. Determining Worker Status

It is critical for any entity paying compensation to know whether its workers are properly classified as employees or independent contractors. In some cases, workers may be designated as employees by a Section 218 Agreement. In other cases, workers may be defined as "statutory employees" or "statutory nonemployees" because specific laws address the occupation (see Publication 15-A for more information on these workers). In general, however, the determination of worker status is made by applying an established common-law standard that addresses the facts and circumstances concerning how the work is performed. Whether workers are employees has significant consequences for tax liability and reporting.

Generally, when workers are employees, the government entity that employs them must withhold and pay employment taxes and file employment tax returns. Employment taxes consist of federal income tax withholding, Old-Age, Survivors and Disability Insurance (OASDI), or social security tax and the Hospital Insurance tax (Medicare tax). The social security tax and Medicare tax make up the Federal Insurance Contributions Act (FICA) contributions, which are paid through employer and employee shares. State and local governments generally pay the social security tax on employees covered under Section 218 Agreements and on employees not covered by a public retirement system (mandatory coverage), and generally pay the Medicare portion on all other employees hired after March 31, 1986. Wages paid by state and local governments are not subject to taxes under the Federal Unemployment Tax Act (FUTA) but state unemployment taxes may apply.

When workers are independent contractors, the governmental entity may have information-reporting and backup withholding responsibilities, but it is not required to withhold and pay employment taxes on behalf of those workers.

This chapter deals with the general rules for determining whether workers are employees, and the laws that apply to different categories of public employment.

Workers Covered Under Section 218 Agreements

As discussed in Chapter 1, states can enter into agreements with SSA to provide social security and Medicare coverage for their employees pursuant to section 218 of the Social Security Act (Section 218 Agreements). If a position is covered by a Section 218 Agreement, then anyone holding that position is an employee. Therefore, the first question for a government to ask about a worker's status is whether the worker is in a position covered under a Section 218 Agreement. If Section 218 coverage applies, this fact takes precedence over other considerations, including the common-law tests discussed below and the mandatory coverage rules.

If you are not sure whether the Section 218 Agreement covers a specific position, contact your State Social Security Administrator, or the SSA Regional Office for assistance. If a group of workers is covered under a Section 218 Agreement, the Agreement cannot be terminated or modified to exclude that coverage group.

Employees who are not covered under a Section 218 Agreement are generally subject to social security and Medicare unless they participate in a public retirement system that serves as a FICA replacement plan, discussed in Chapter 6. However, Medicare taxes generally apply to wages of all state and local government employees hired after March 31, 1986. See Chapter 5, Social Security and Medicare Coverage, for further information.

Indian tribal governments are not treated as states for purposes of Section 218. See IRC section 7871 for information on the treatment of Indian tribes as governments. For more information about social security coverage, Medicare, and tribal governments, see the IRS Indian Tribal Governments website.

Common-Law Standard -- Employee Status for FICA Purposes

Internal Revenue Code (IRC) section 3121(d)(2) states that, for purposes of social security and Medicare, an employee is "any individual who, under the usual common-law rules applicable in determining the employer-employee relationship, has the status of an employee." The IRS has interpreted the common-law test for determining whether a worker is an employee as whether the service recipient (i.e., the government entity) has the right to direct and control the worker as to the manner and means of the worker's job performance. In other words, does the entity have the right to tell the worker not only what shall be done, but how it shall be done?

All the facts and circumstances must be considered in deciding whether a worker is an independent contractor or an employee. The facts fall into three main categories:

 

These facts are discussed below, with emphasis given to governmental situations.

Behavioral Control

Facts that fall under this category show whether the entity has a right to direct and control how the worker performs the specific task for which he or she is engaged. Many times, when workers perform their tasks satisfactorily, the entity does not appear to exercise much control. The critical question, however, is whether there is a right to control. If the entity has the right to do so, it is not necessary that it actually direct and control the manner in which the services are performed.

The following table addresses the elements of behavioral control with respect to government employees:

 Instructions,   An employee is generally subject to the government

 

 

Training and

    entity's instructions about when, where, and how to

 

 

Required

        work. The employer has established policies, which the

 

 

Procedures

      workers are required to learn and follow. Daily or

 

                 ongoing instructions regarding the expected tasks are

 

                 especially indicative of employee status. Training is

 

                 a classic means of explaining detailed methods and

 

                 procedures to be used in performing a task. Periodic

 

                 or ongoing training about procedures to be followed

 

                 and methods to be used indicates that the employer

 

                 wants the services performed in a particular manner.

 

                 This type of training is strong evidence of an

 

                 employer-employee relationship. For instance, police

 

                 officers and firefighters must be trained to comply

 

                 with departmental rules and regulations. They do not

 

                 have the independence characteristic of independent

 

                 contractors. Other examples of training that indicates

 

                 employment include a state statute requiring that

 

                 animal control officers receive state-sponsored

 

                 training, and a statute requiring that inspectors of

 

                 sanitary facilities be trained and state-certified.

 

                 These facts are indicative of a right to control.

 

                 Election workers are trained to follow uniform

 

                 procedures established for the polling place. They are

 

                 directed by a supervisor. These facts suggest they

 

                 would typically be employees. Government employees

 

                 often work subject to regulations and manuals, which

 

                 specify how their jobs are to be done. Teachers are

 

                 required to receive periodic training in departmental

 

                 policies. They are required to attend meetings, to

 

                 follow an established curriculum, to use certain

 

                 textbooks, to submit lesson plans, and to abide by

 

                 departmental policies concerning professional conduct.

 

                 However, some types of training or minimal

 

                 instructions may be provided to either an employee or

 

                 an independent contractor, including orientation or

 

                 information sessions about a government entity's

 

                 policies and voluntary programs for which there is no

 

                 compensation.

 

 

Government

      Government workers may be required to identify

 

 

Identification

  themselves by wearing a uniform, driving a marked

 

                 vehicle, etc. When an individual represents himself or

 

                 herself as an agent of a government, that gives the

 

                 individual an appearance of authority. Wearing a

 

                 uniform, displaying government identification, or

 

                 using forms and stationery that indicate one is

 

                 representing a government are highly indicative of

 

                 employee status.

 

 

Nature of

       The nature of the worker's occupation affects the

 

 

Occupation

      degree of direction and control necessary to determine

 

                 worker status. Highly-trained professionals such as

 

                 doctors, accountants, lawyers, engineers, or computer

 

                 specialists may require very little, if any,

 

                 instruction on how to perform their specific services.

 

                 Attorneys, doctors and other professionals can,

 

                 however, be employees. In such cases, the entity may

 

                 not train the individuals or tell them how to practice

 

                 their professions, but may retain other kinds of

 

                 control, such as requiring work to be done at

 

                 government offices, controlling scheduling, holidays,

 

                 vacations, and other conditions of employment. Again,

 

                 the government entity should consult state statutes to

 

                 determine whether a professional position is

 

                 statutorily created. On the other hand, professionals

 

                 can be engaged in an independent trade, business, or

 

                 profession in which they offer their services to the

 

                 public, including work for government entities. In

 

                 this case, they may be independent contractors and not

 

                 employees. In analyzing the status of professional

 

                 workers, evidence of control or autonomy with respect

 

                 to the financial details is especially important, as

 

                 is evidence concerning the relationship of the parties

 

                 as discussed below.

 

 

Evaluation

      Evaluation systems are used by virtually all

 

 

Systems

         government entities to monitor the quality of work

 

                 performed. This is not necessarily an indication of

 

                 employee status. In analyzing whether a government

 

                 entity's evaluation system provides evidence of the

 

                 right to control work performance, consider how the

 

                 evaluation system may influence the workers' behavior

 

                 in performing the details of the job. If there is a

 

                 periodic, formal evaluation system that measures

 

                 compliance with performance standards concerning the

 

                 details, the system and its enforcement are evidence

 

                 of control over the workers' behavior.

 

 

 

Financial Control

 

 

This second category includes evidence of whether the entity controls the business and financial aspects of the workers' activities. Employees do not generally have the risk of incurring a loss in the course of their work, but generally receive a salary for as long as they work. An independent contractor has a genuine possibility of profit or loss. Facts showing possibility of profit or loss include: significant investment in equipment, tools or facilities; unreimbursed expenses, including the requirement to provide materials or hiring helpers; working by the day or by the job rather than on a continuous basis; having fixed costs that must be paid regardless of whether the individual works; and payment based on contract price, regardless of what it costs to accomplish the job.

The following table addresses the elements of financial control.

 Method of  The method of payment must be considered. An individual who

 

 

Payment

    is paid a contract price, regardless of what it costs to

 

            accomplish the job, has a genuine possibility of profit or

 

            loss and therefore would not generally be considered an

 

            employee. An individual who is paid by the hour, week, or

 

            month is typically an employee. However, this is not always

 

            the case; for example, independent contractor attorneys

 

            usually bill by the hour. An individual who is paid by the

 

            unit of work, such as a court reporter, may or may not be

 

            an independent contractor, depending on the facts.

 

 

Offering

   Another factor favoring independent contractor status

 

 

Services

   exists when the individual makes his or her services

 

 

to the

     available to the public or a relevant segment of the

 

 

Public

     market. Relevant questions that address this issue include:

 

            • Does the individual advertise?

 

            • Does the individual use a private business logo?

 

            • Does the individual maintain a visible workplace?

 

            • Does the individual work for more than one entity?

 

 

Corporate

  If the individual is incorporated and observes corporate

 

 

Form of

    formalities associated with this status, this makes it

 

 

Business

   unlikely that he or she is an employee of the government

 

            entity. (A corporate officer will be an employee of the

 

            corporation.) The mere fact of incorporation or use of a

 

            corporate name, however, does not transform an employee

 

            into an independent contractor. The corporation must serve

 

            an intended business function or purpose, or be engaged in

 

            business.

 

 

Part-Time

  The fact that workers work on a part-time or temporary

 

 

Status

     basis, or work for more than one entity, does not make them

 

            independent contractors. A part-time, temporary or seasonal

 

            worker may be an employee or an independent contractor

 

            under the common-law rules.

 

 

 

Relationship of the Parties

 

 

The third category used to determine worker status is evidence of the relationship between the parties, including how they view their relationship. The relationship of the parties is generally evidenced by examining the parties' agreements and actions with respect to each other, paying close attention to those facts that show not only how they perceive their relationship, but also how they represent their relationship to others.

For example, a fact illustrating how the parties perceive their relationship is the intent of the parties as expressed in a written contract. A written agreement describing the worker as an independent contractor is evidence of the parties' intent, and in situations where it is unclear whether a worker is an independent contractor or employee, the intent of the parties, as reflected in the contract, may resolve the issue.

However, a contractual designation, in and of itself, is not sufficient evidence for determining worker status. The facts and circumstances under which a worker performs services are determinative. The substance of the relationship, not the label, governs the worker's status. See Employment Tax Regulation §31.3121(d)-1(a)(3). The following items may reflect the intent of the parties:

 

The following are key considerations in evaluating the elements involving the relationship of the parties.

 Discharge or  The circumstances under which a business and a worker

 

 

Termination

   can terminate their relationship have traditionally been

 

               considered useful evidence concerning the status of the

 

               worker. However, business practices and legal standards

 

               governing worker termination have changed since these

 

               general principles developed. Under a traditional

 

               analysis, a government entity's ability to terminate the

 

               work relationship at will, without penalty, provided a

 

               highly effective method to control the worker. The

 

               ability to fire at will is indicative of employee

 

               status. In the traditional independent contractor

 

               relationship, the government entity could terminate the

 

               relationship only if the worker failed to provide the

 

               intended product or service, thus indicating that the

 

               business did not have the right to control how the work

 

               was performed. In the current environment, however, a

 

               government entity rarely has complete flexibility in

 

               discharging employees. The reasons a government entity

 

               can terminate an employee may be limited by law, by

 

               contract, or by its own practices. Consequently,

 

               inability to freely discharge a worker, by itself, no

 

               longer constitutes persuasive evidence that the worker

 

               is an independent contractor.

 

 

Termination

   Historically, a worker's ability to terminate work at

 

 

of Contracts

  will was considered to illustrate that the worker merely

 

               provided labor and tended to indicate an employer-

 

               employee relationship. In contrast, if the worker

 

               terminated work, and payment could be refused, or the

 

               worker could be sued for nonperformance, this

 

               traditionally tended to indicate an independent

 

               contractor relationship. Today, however, it is more

 

               common that independent contractors may enter short-term

 

               contracts for which nonperformance remedies are

 

               inappropriate, or may negotiate limits on their

 

               liability for nonperformance. For example,

 

               professionals, such as doctors and attorneys, are

 

               typically able to terminate their contractual

 

               relationship without penalty. Accordingly, the worker's

 

               protection from liability for terminating the

 

               relationship does not necessarily indicate employee

 

               status.

 

 

Non-

          Employers may successfully sue employees for substantial

 

 

performance

   damages resulting from their failure to perform the

 

 

of Employees

  services for which they were engaged. As a result, the

 

               presence or absence of limits on a worker's ability to

 

               terminate the relationship, by itself, is less relevant

 

               in determining worker status. On the other hand, a

 

               government entity's ability to refuse payment for

 

               unsatisfactory work continues to be characteristic of an

 

               independent contractor relationship. Because the meaning

 

               of the right to discharge or terminate is so often

 

               unclear, and depends primarily on contract and labor

 

               law, these facts should be viewed with great caution.

 

 

Permanency

    The permanency of the relationship between the worker

 

               and service recipient is somewhat relevant to

 

               determining whether there is an employer-employee

 

               relationship. If a worker is engaged with the

 

               expectation that the relationship will continue

 

               indefinitely, rather than for a specific project or

 

               period, this is generally considered evidence of intent

 

               to create an employment relationship. However, a

 

               long-term relationship may also exist between a

 

               government entity and an independent contractor. There

 

               may be a long-term contract, or contracts may be renewed

 

               regularly due to superior service, competitive costs, or

 

               lack of alternative service providers. Part-time,

 

               seasonal or temporary workers may also be employees

 

               under the common law. The fact that workers do not have

 

               full-time, permanent status is irrelevant to their

 

               classification.

 

 

 

Common-Law Standard - Summary

 

 

In many worker classification cases, some facts will support independent contractor status and others will support employee status. Independent contractors are rarely totally unconstrained in the performance of their contracts, and employees almost always have some degree of autonomy. The determination of a worker's status, therefore rests on the weight given to the facts as a whole, keeping in mind that no one factor is determinative.

Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding

In difficult cases, the IRS can provide a determination as to whether a worker is an employee or an independent contractor. To obtain a determination from the IRS, file Form SS-8. Either a governmental entity or a worker may submit Form SS-8. The IRS will acknowledge receipt of the Form SS-8 and will also request information from the other party. If a contract has been executed between the worker and the entity, a copy of the contract should be submitted with Form SS-8. In some cases, the IRS will contact the State Social Security Administrator to determine whether the entity and position are covered by a Section 218 Agreement. The IRS will generally issue a formal determination to the entity and will send a copy to the worker.

Note: The SS-8 determination is not an examination. It does not reopen a closed examination or change the findings for years previously examined.

Employee Status for Income Tax Withholding

"Employment" for income tax purposes is generally governed by regulations under Code section 3401. As explained above, for purposes of social security and Medicare (FICA) FICA, employee status is determined under the common-law control test, unless a Section 218 Agreement is in place and specifically covers the position. In general, the common-law factors apply to the determination of whether a worker is an employee for income tax purposes as it does for FICA taxes. The regulations under IRC 3401(c) contain nearly identical language to the regulations under IRC 3121(d)(2), reciting the same "right to control" text that appears in 31.3121(d)-1(c). See Regulations

Classification Issues Involving Government Employee

The following discussion addresses some special worker classification situations involving governmental employees.

Public Officials

The term "public official" refers to someone who has authority to exercise the power of the government and does so as an agent and employee of the government. The Internal Revenue Code does not define the term "public official," but Regulation §1.1402(c)-2(b), addressing of self-employment tax, indicates that holders of "public office" are not in a trade or business and are therefore not subject to self-employment tax. This Regulation states that the performance of the functions of a public office does not constitute a trade or business. If self-employment tax is not applicable to the services, the individuals who perform them are presumed to be employees.

An exception to this rule applies for certain public officials paid solely on a fee basis (see Chapter 5). The regulations give the following specific examples of positions that constitute "public office":

 

• Governor

• Mayor

• Member of a legislature or elected representative (i.e., elective office)

• County commissioner

• State or local judge, or justice of the peace

• County or city attorney

• Marshal, sheriff, constable

• Registrar of deeds

• Tax collector or tax assessor

• Road commissioners

• Members of boards and commissions, such as school boards, utility districts, zoning boards, and boards of health

 

However, it may not always be clear whether a worker holds public office. In

Metcalf & Eddy v. Mitchell,

269 U.S. 514 (1926), the U.S. Supreme Court addressed the definition of an officer, and whether consulting engineers hired by states or subdivisions of states were independent contractors or "officers and employees" of a state. The Court ruled that an office is a public station conferred by the appointment of a government. The term "officer" includes the idea of tenure, duration, emolument and duties fixed by law, and where an office is created, the law usually determines its term, its duties, and its compensation. The Court concluded that the consulting engineers were not officers of the state or a subdivision of it, and were independent contractors. Public officials will generally have the characteristics of common-law employees.

Therefore, depending on the facts presented, a worker who is compensated for services performed for a government may be an independent contractor and not a public official or employee.

If there is some question as to whether a worker is a public official and employee, a critical factor to consider is whether there is a provision of the state constitution or a statute establishing the position. State statutes should be reviewed to determine whether they establish enough control for the individual to be classified as an employee under the common-law test. A statute may state that a specific position is that of a public official, in which case there is likely to be a right to control sufficient to make the individual an employee. Statutes may also specify the duties of a public office and generally establish the officer's superiors and subordinates, if any. Statutes establish an official's term of office and sometimes the compensation. They may require that a public official take an oath of office. Statutes often establish general and specific penalties for dereliction of duty. For instance, members of boards who are paid for each meeting they attend may face termination if they fail to attend a certain number of meetings.

Example. State A establishes the position of city attorney by statute, and indicates that the position holder is an officer and an employee. This statute defines the duties of the position. The city attorney is required to direct all litigation in which the city is a party, including prosecution of criminal cases; to represent the city in all legal matters in which the city or a city officer is a party; to attend meetings of the commissioners, advise commissioners, mayors, etc., on all legal questions, and approve all contracts and legal documents. A city manager appoints, supervises and controls the work of the city attorney. The city attorney must take an oath of office. These facts show the importance of state statutes in establishing a right of direction and control over a public official and thus classifying the individual as a common-law employee.

Elected Officials

For social security and Medicare purposes, elected officials (also referred to as "individuals in elective positions"), are subject to a degree of control that typically makes them employees under the common law, and therefore subject to these taxes. Elected officials are responsible to the public, which has the power to vote them out of office. Elected officials may also be subject to recall by the public or a superior official. Very few elected officials have sufficient independence to be considered independent contractors. Under IRC 3401, wages, for income tax withholding purposes, include all remuneration, other than fees paid to a public official. Because elected officials receive wages, not fees, they are employees for income tax withholding purposes, regardless of any determination for social security and Medicare purposes.

Home Care Service Recipients

A home care service recipient (HCSR) is an individual who receives home care services while enrolled in a program administered by a federal, state, or local government agency that provides funding for that individual's home care services. Home care services include health care and personal attendant care services rendered to the HCSR. Generally, the HCSR is considered the employer of the service provider under the common-law rules. The provision of home care services generally constitutes household employment.

The HCSR may request that the IRS authorize, under section 3504, an agent to act on his or her behalf to withhold, report, and pay the federal employment taxes with respect to the workers who provide home care services. See Revenue Procedure 70-6 and Form 2678, Employer/Payer Appointment of Agent. Special rules apply when a state or local government agency acts as the section 3504 agent. See Revenue Procedure 80-4 and Notice 2003-70. A state or local government agency acting as a section 3504 agent on behalf of a HCSR files an aggregate Form 941 and aggregate Form 940, attaching Schedule R (Form 941), Allocation Schedule for Aggregate Form 941 Filers, and Schedule R (Form 940), Allocation Schedule for Aggregate Form 940 Filers. Agencies must have an employer identification number separate from the one used to report taxes of its own employees for this purpose. The state agent may engage a reporting agent or subagent to perform the reporting and payment of employment taxes that the state agent would otherwise perform on behalf of the service recipient. See Notice 2003-70 for the correct reporting procedures.

Volunteer Firefighters

Compensation paid in an employer-employee relationship is taxable wages (unless an exclusion applies), regardless of whether the workers are termed "volunteers." In some cases, rather than receive salaries, firefighters may receive amounts intended to reimburse them for expenses. They may also receive other cash or in-kind benefits that may be wages. Unless these reimbursements are paid under an accountable plan, discussed in Chapter 3, these reimbursements are taxable as wages.

Amounts that are termed "reimbursements" but that are not paid under an accountable plan are treated as wages and subject to income and social security and Medicare taxes. Therefore, a per diem or fixed amount paid to a firefighter (or other worker), that does not reimburse actual, documented expenses, is includible in income and subject to income tax withholding, social security and Medicare.

The services of volunteers are generally not eligible for the exclusion from FICA for emergency workers, discussed in Chapter 5. IRC §3121(b)(7)(F)(iii) provides that services performed by employees on a temporary basis in the case of fires, storm, snow, earthquake, floor or other similar emergency are exempt from employment. Firefighters who are on call and work part-time or intermittently do not qualify for the emergency worker exclusion. This exception applies only for temporary workers who are hired because of an unforeseen emergency.

Medical Residents

Medical residents are generally common-law employees of the hospitals for which they work, and therefore are subject to social security and Medicare taxes (unless they are excepted by a Section 218 Agreement). IRC 31.3121(b)(10)-2(d)(3)(iii), an employee whose normal work schedule is 40 hours or more per week is always considered a full-time employee. Therefore, medical residents generally do not qualify to exclude payments for their services from social security and Medicare taxes.

Identity of the Employer for Tax Purposes

In certain cases it is clear that the work in question is performed by employees, but it may not be clear which of two or more entities, organizations, or individuals is the employer. This situation may arise when workers are supplied or paid by one entity but work under the direction of another (for example, leased workers).

The term "employer" is defined in IRC §3401(c), for income tax withholding and reporting purposes, as the person for whom an individual performs any service, of whatever nature, as an employee. However, an exception is provided if the person for whom the individual performs the services does not have control of the payment of the wages. In this situation, the term "employer" means the person having legal control of the payment of the wages. See IRC §3401(d)(1) and Regulation Revenue Ruling 58-505 explains that for an individual to work in two capacities (employee and contractor), the services must not be interrelated. Stated differently, an individual does not work in two capacities when the same type of work, such as legal services, is divided into two components, one in an employee capacity, and one in an independent contractor capacity. The services and remuneration for the two activities must be separate.

Section 530 Relief

State and local government entities under examination by the IRS may be entitled to relief from employment tax for certain workers under Section 530 of the Revenue Act of 1978 ("Section 530"). If applicable, Section 530 terminates an entity's federal employment taxes, including social security and Medicare, income tax withholding, and any penalties attributable to the liability. See Revenue Procedure 85-18. This relief is not available for services covered by a Section 218 Agreement.

If the requirements for relief are met, the entity may obtain relief from liability for income tax withholding for prior years. However, Section 530 relief from income tax withholding will not apply with respect to wages paid after the date on which the entity is advised that the workers are covered under a Section 218 Agreement. This is because the entity would have begun withholding FICA taxes, which constitutes treatment of the workers as employees. See Revenue Procedure 85-18, section 3.03(C) and 3.04.

Section 530 provides relief for an entity that treated workers as nonemployees if the entity had a reasonable basis for the classification and acted consistently on that basis. To qualify for Section 530 relief, the entity must have a reasonable basis for treating the worker as an independent contractor. Section 530 provides three safe harbors for satisfying the reasonable basis requirement:

 

In addition, the entity must:

 

Tax Consequences for Workers

In some cases, a government entity may be entitled to relief under Section 530, but workers find, through a determination letter or some other means, that they have been misclassified and are employees. Section 530 does not extend relief to workers. It does not convert them from employees to independent contractors. Misclassified employees are liable for the employee share of social security and Medicare taxes rather than for SECA (self-employment) tax. (See Form 8919, Uncollected Social Security and Medicare Tax on Wages.) If they have been filing income tax returns as independent contractors, they should file amended returns for years for which the statute of limitations is open. As employees, they are not entitled to deduct employee business expenses on Schedule C. Because their employers are entitled to continue treating them as independent contractors, the workers will not be subject to income tax, social security or Medicare withholding, and will generally have to make estimated tax payments to cover their tax liabilities.

For more information about the requirements for Section 530 relief, see Publication 1976, Do You Qualify for Relief Under Section 530?

Note: Section 530 is not part of the Internal Revenue Code. It was originally intended as an interim relief measure, but was extended indefinitely in 1982.

Frequently Asked Questions

 

Chapter 5. Social Security and Medicare Coverage

As discussed in Chapter 3, cash or noncash compensation for services is subject to income, social security, and Medicare taxes unless certain exceptions apply. In addition to the exceptions for certain payments, state and local employees may be exempted from social security (and in some cases, Medicare) taxes based on coverage under a public retirement system. A public employee may be covered for social security and Medicare, Medicare only, or may be exempt from both. The flowchart in Chapter 1, "Social Security and Medicare Coverage of State and Local Employees," illustrates the process for determining the social security and Medicare coverage that applies to an employee. This chapter addresses various categories of employees and rules by which coverage is established, including the process for obtaining coverage under a Section 218 Agreement ("Agreement"). As a supplement to the social security coverage information provided in this publication, refer to the State and Local Government Employers page on the SSA website. Additional information is also available on the IRS FSLG home page.

All state and local government employees fall into one of three categories with respect to social security coverage:

 

Each of the three categories of employees is discussed below.

1) Employees Under Section 218 Coverage

State and local government employees can be covered for social security and Medicare through a Section 218 Agreement between the state and the SSA. This agreement may provide any of the following:

 

Each state's original Agreement incorporates the basic provisions, definitions, and conditions for coverage. Only the State Social Security Administrator can initiate a request for Section 218 coverage on behalf of an entity in the state. Additional coverage can be provided by modifications. Each modification, like the original Agreement, is binding upon all parties.

In order to establish an Agreement, authority must exist under state law (state enabling legislation) to enter into an Agreement and to extend coverage under an Agreement. The types and extent of coverage provided under an Agreement must be consistent with federal and state laws.

State and local government employees who are covered under an Agreement have the same benefits, rights, and responsibilities as employees who have mandatory social security coverage. The cost to the employer of providing social security protection for state and local government employees is the same as that for employees in mandatory coverage.

Coverage under an Agreement must be provided for groups of employees. An Agreement may be modified to increase, but not to decrease, the extent of coverage. (An exception applies to election worker services and solely fee-based positions; see Optional Section 218 Exclusions below.)

Termination of Agreements

Before legislation was enacted in 1983, states could terminate coverage for any group of employees covered under the state's Section 218 Agreement. A state did this by providing a two-year advance notice to the federal government. Once it was terminated, the coverage for this group of employees could not be reinstated. The 1983 Social Security Amendments rescinded this provision and prohibited states from terminating coverage on or after April 20, 1983, but permitted states to cover again any group terminated before this date.

Coverage Groups

Coverage under Section 218 Agreements can be extended only to groups of employees, referred to as coverage groups. Once an employee position is covered under a Section 218 Agreement, any employee filling that position is a member of the coverage group for social security and Medicare. There are two types of coverage groups: 1) an absolute, or non-retirement, coverage group (employees not in a retirement system); and 2) a retirement system coverage group. Each state decides, within federal and state law, which groups to include under its Agreement, and when their coverage begins. The state can choose to cover non-retirement system groups, retirement system groups, or both.

Absolute Coverage Groups (Non-Retirement System Groups)

An absolute coverage group includes the services of employees in positions not covered by a retirement system, except those whose services are mandatorily or optionally excluded from social security and Medicare coverage. They may also be referred to as non-retirement system groups or Section 218(b)(5) groups. A state may extend Section 218 coverage to an absolute retirement system group without considering the desires of the employees. An absolute coverage group may consist of any of the following:

 

Retirement System Coverage Group

A retirement system coverage group consists of employees working in positions covered by a public retirement system (FICA replacement plan), as provided in section 218(d)(4) of the Social Security Act (Act). Such a group may be provided social security and Medicare coverage under an Agreement only if approved by a referendum. The Act gives the state the option, for referendum purposes, of breaking down a retirement system into its components. If a retirement system covers positions of employees of one or more political subdivisions of the state, the state has the following choices. It may hold a referendum for:

 

The referendum for retirement system employees is conducted either on a majority vote basis (allowed in all states), or on a divided system basis (allowed in certain states).

Majority Vote Referendum

Under this type of referendum, social security and Medicare coverage may be extended to employees in positions covered by a retirement system only if a majority of the eligible employees vote in favor of such coverage. A majority of all of the eligible employees under the system (not a majority of the eligible employees casting votes), must vote in favor of coverage. All states are authorized by federal law to use the majority vote referendum procedures. Although the referendum itself is a state matter, federal law requires that the following conditions be met to establish coverage:

 

Divided System Retirement Referendum

In addition to the majority vote referendum procedure, certain states and all interstate instrumentalities are authorized to divide a retirement system based on whether the employees in positions under the retirement system want coverage. Under the divided vote referendum, only those employees who vote "yes" and all future employees who become members of the retirement system will be covered. Members who vote "no" are not covered as long as they maintain continuous employment in a position within the same public retirement system coverage group.

The states having this authority under Section 218(d)(6)(c) of the Act are:

 Alaska         Illinois         New Jersey      Tennessee

 

 California     Kentucky         New Mexico      Texas

 

 Connecticut    Louisiana        New York        Vermont

 

 Florida        Massachusetts    North Dakota    Washington

 

 Georgia        Minnesota        Pennsylvania    Wisconsin

 

 Hawaii         Nevada           Rhode Island

 

 

These "divided vote" states may choose between a divided system vote and a majority vote referendum.

States authorized to use the divided vote retirement system referendum to extend coverage may use either of two voting procedures:

 

The conditions for a divided vote referendum are the same as those given for the majority vote referendum with two exceptions: (1) the ballots are not secret, because the individuals choosing coverage must be identified, and (2) the individual must be in an employment relationship and a member of the retirement system when the vote is held (but not necessarily when the referendum notice was given).

At the discretion of the state, employees who become members of the retirement system after the referendum (division) date and before the execution of the modification extending coverage to the retirement system coverage group may be given a choice to receive coverage.

The referendum procedures must be conducted under the direction of the State Social Security Administrator.

Continuation of Coverage Rules

Once coverage is provided for state and local government employees, it generally continues unless an event occurs that results in termination of the coverage, such as a change in employer. The continuation rules are applied for each type of coverage group as follows:

Absolute Coverage Group: Social security and Medicare coverage for non-retirement system groups continues as long as the continuing governmental entity exists. This is true even if the positions are later placed under a retirement system. (This provision includes police and firefighter positions that were first covered as an absolute coverage group.)

Majority Vote Retirement System Group: Following a favorable majority vote referendum, services under the retirement system, including positions brought under the retirement system in the future, are compulsorily covered for social security under the State's Section 218 Agreement. Social security and Medicare coverage will continue as long as the continuing governmental entity exists, even though the positions are later removed from under the retirement system, the system is abolished, or the positions are placed under an additional retirement system.

Divided Vote Retirement System Group: If the use of procedure (2) above -- the original two-step referendum -- results in a favorable majority, then the entire "Yes" group and all future members of the retirement system are covered.

As a result of procedure (1) -- the simplified one-step referendum -- all those retirement system members who voted "Yes" and all future retirement system members are covered for social security. If all current retirement system members vote against social security coverage (the "No" group), then only future retirement system members will be covered for social security and make up the "Yes" group.

Under a divided retirement system, employees carry the "no" or "yes" vote with them if they transfer to another position within the same retirement system coverage group. Social security coverage is not terminated because the positions are later covered under an additional retirement system.

If the divided vote retirement system is later abolished or positions are removed from coverage under it, the "Yes" group (those employees who voted "Yes" in the referendum and those subsequently hired retirement system members) continue to be covered for social security. New employees hired into positions after the removal from, or abolishment of, the former retirement system, are not covered for social security because they would not be considered new members of that former retirement system.

Section 218 Coverage Exclusions

When a state or local government entity voluntarily enters into the state's Section 218 Agreement with the Social Security Administration, it is important to determine which employee services will be excluded from social security coverage. If services are excluded, any employees performing these services are not covered by the Agreement.

Certain services -- known as mandatory exclusions -- are excluded from voluntary social security coverage by Section 218(c)(6) of the Social Security Act.

Other services, however, are optional exclusions under Section 218(c)(3), (5) and (8) and, therefore, may be covered under a voluntary Section 218 Agreement. Coverage under a Section 218 Agreement supersedes all other considerations. If optional exclusion services are covered under a Section 218 Agreement, these amounts are subject to social security and Medicare tax.

Mandatory Section 218 Exclusions

Federal law requires the exclusion of the following services from section 218 coverage under Section 218(c)(6) of the Social Security Act:

 

Caution:

Mandatory exclusions apply to

voluntary

social security coverage situations (through a Section 218 Agreement) and should not be confused with the different set of exclusions that applies to

mandatory

social security coverage situations.

Optional Section 218 Exclusions

Under a Section 218 Agreement, a state has the option to exclude from social security coverage the services listed below when they are performed by members of any coverage group, including retirement system coverage groups. If the Agreement does not specifically exclude these services, they are covered.

The following are positions and services that may be excluded at the option of the state:

 

Note: The definition of "part-time" under a Section 218 Agreement provisions may be different from the definition of "part-time" used to determine whether an individual is a qualified participant in a public retirement system (discussed in Chapter 6).

Example: A city provides social security coverage to some of its employees under a Section 218 Agreement, but excludes services performed in part-time positions. The Section 218 Agreement defines part-time positions as positions normally requiring less than 50 hours of service per month. The city must apply the definition in the Section 218 Agreement to determine which employees are excluded from social security coverage under the Agreement. Any employees excluded from coverage under the Agreement may then be subject to mandatory coverage.

 

Note: Effective July 2, 1991, elective and part-time positions, although optionally excluded under a Section 218 Agreement, must be covered under a qualifying public retirement system or else they will be covered for social security under the mandatory social security provisions.

Optional exclusions can be taken by the state in any combination and applied to both absolute and retirement system coverage groups. Any services a state excludes can be included later if permitted by federal and state law and the state's Agreement. Generally, if one of the types of work listed above has been included in a coverage group, it cannot later be removed from coverage, except for services performed by (1) election officials/workers, and (2) solely fee-based positions.

Optional exclusions apply only to voluntary social security coverage under a Section 218 Agreement; there are no optional exclusions from mandatory coverage.

Note: The 1972 Amendments to the Social Security Act allowed states a limited period to exclude services in part-time positions and services performed by students, in cases where this exclusion was not initially chosen. An additional window to make this election was provided by Public Law 105-277, enacted October 21, 1998, which allowed states a limited period to exclude the services of students employed by the public school, college or university where they are regularly attending classes. In those states exercising this option, the student exclusion was effective July 1, 2000. Where a state used either or both of these special one-time provisions for excluding services that had been covered previously, it cannot again cover these services under a Section 218 Agreement.

2) Employees Under Mandatory Social Security Coverage

Public Law 101-508 mandated full social security coverage beginning July 2, 1991, for state and local government employees who are not members of a qualifying public retirement system (also called a "FICA replacement plan") and who are not covered under a Section 218 Agreement, unless a specific exclusion applies under the law.

If an employee is mandatorily covered for social security, then becomes a member of a qualifying public retirement system, mandatory coverage ends; social security coverage would apply only if the position becomes covered by a Section 218 Agreement.

If an employee becomes a member of a public retirement system and is covered for social security under a Section 218 Agreement, the employee continues to be covered for social security and Medicare.

The determination of whether an employee is covered by mandatory social security is made on an individual basis. For example, a Section 218 Agreement may exclude part-time positions, and a public retirement system may exclude part-time employees for the same entity. If an employee is excluded from section 218 coverage because of work performed in a part-time position, (as defined under the Agreement), and is also excluded from membership in a public retirement system because of part-time status, that employee is subject to mandatory social security.

Example: A city has a Section 218 Agreement that excludes part-time positions requiring less than 18 hours of work a week. City cafeteria positions require employees to work only 3 hours per day, or 15 hours per week. The city's public retirement system does not allow membership for employees unless they work 25 hours or more per week. The cafeteria workers are subject to mandatory social security.

Exclusions from Mandatory Social Security Coverage

Under Section 210(a) of the Social Security Act, the following categories of employees are not subject to mandatory social security coverage, even if they are not covered by a public retirement system:

 

Note: Coverage under a Section 218 Agreement always takes precedence over other employment circumstances. When considering whether the mandatory social security coverage and exclusion rules apply to a worker's services, first determine whether the services are covered by a Section 218 Agreement.

Election Officials and Election Workers

Prior to the 1967 Social Security Amendments, there was no specific provision for the exclusion of election officials or election workers. The Social Security Act was amended for years beginning with 1968 to allow states to modify their Agreements to exclude the services of election officials and election workers whose pay was below an annually determined threshold amount.

The Federal Insurance Contributions Act (FICA) tax exclusion for election officials and election workers is $1,600 for the calendar year beginning January 1, 2015, unless those wages are subject to social security and Medicare at a lower threshold under the state's Section 218 Agreement.

If the entity is covered by a Section 218 Agreement, the Agreement determines the treatment of election workers for FICA purposes. The Agreement may specify a lower threshold amount for election officials and election workers (for example, $50 a calendar quarter or $100 a calendar year). In these states, the social security and Medicare tax applies when the amount specified in the state's Agreement is met. States may modify the Agreement to exclude the services of election officials and election workers paid less than the threshold amount mandated by law. Such modifications are effective in the calendar year the modification is mailed or delivered to the Social Security Administration.

If the Section 218 Agreement does not exclude election workers from coverage, or does not provide a threshold for coverage, social security and Medicare taxes apply from the first dollar paid. If the entity is not covered under a Section 218 Agreement, the rules for mandatory social security and Medicare under Section 210(a)(7)(F) of the Social Security Act apply.

The election official/worker thresholds under mandatory social security for calendar years prior to 2016 are as follows:

 2013-2015   $1,600

 

 2009-2012   $1,500

 

 2008        $1,400

 

 2006-2007   $1,300

 

 2002-2005   $1,200

 

 2000-2001   $1,100

 

 1995-1999   $1,000

 

 1978-1994   $  100

 

 

For calendar years 1968 through 1977, the threshold was $50 per calendar quarter.

Generally, Form W-2 is required for these workers; however, if the worker received only wages for election work and the total is less than $600 total for the year, Form W-2 is not required and no withholding of social security or Medicare tax is required. The amount paid is includible in the gross income of the worker. Revenue Ruling 2000-6 provides reporting procedures for payments to election officials and election workers in several different situations.

Contact your State Social Security Administrator concerning the status of election officials and election workers under the state's Section 218 Agreement. Additional information and threshold amounts can be found on the SSA website.

Fee-Based Public Officials

A fee-based public official receives and retains remuneration directly from the public. An individual who receives payment for services from government funds in the form of wages or salary is not a fee-based public official, even if the compensation is called a fee.

Beginning in 1968, services performed in positions compensated solely by fees are excluded from coverage under Section 218 Agreements unless the state specifically covers these services. If a state covered these positions before 1968, it may modify its Agreement to exclude these positions prospectively. The exclusion is effective the first day of the year following the year in which the modification is mailed or delivered by other means to SSA. If a state covered and later excluded these positions, the state cannot again cover these positions.

Fee-Basis Exclusion--Positions Compensated Solely by Fees

Services in positions compensated solely by fees are excluded from coverage under Section 218 Agreements (except where the state specifically included these services) and are covered as self-employment and subject to self-employment tax (SECA).

Fee-Basis Exclusion--Position Compensated by Salary and Fees

Generally, a position compensated by a salary and fees is considered a fee-basis position if the fees are the principal source of compensation, unless a state law provides that a position for which any salary is paid is not a fee-basis position.

If the state law does include this provision, none of the compensation, including the salary, is covered wages under the state's Section 218 Agreement. In this case, the salary payment, while excluded under the Agreement, is subject to mandatory social security if the official is not a qualified participant in a public retirement system.

Police Officers and Firefighters

Beginning August 16, 1994, all states were allowed to extend Section 218 social security and Medicare or Medicare-only coverage to police officer and firefighter positions covered under a retirement system through a referendum procedure conducted by the state. (Prior to August 16, 1994, only 23 states, and all interstate instrumentalities, were specifically authorized by Congress to do so.) Those states were:

 Alabama      Kansas        North Carolina   Tennessee

 

 California   Maine         North Dakota     Texas

 

 Florida      Maryland      Oregon           Vermont

 

 Georgia      Mississippi   Puerto Rico      Virginia

 

 Hawaii       Montana       South Carolina   Washington

 

 Idaho        New York      South Dakota

 

 

As noted earlier, all states may use the majority vote referendum procedure. Some states are also authorized under the Act to use the divided retirement system referendum, discussed earlier. (Interstate instrumentalities may use the majority or divided retirement system referendum procedures.) As with other retirement system employees, before referendums can be held and coverage extended to police officer and firefighter positions already covered by a retirement system, there must first be authority to provide such coverage under state law (state statutes and/or the enabling act) and the federal-state agreement (via a modification to the state's Section 218 Agreement).

Generally, state statutes and court decisions establish the definition of police officer and firefighter positions. For social security purposes, the terms do not include services in positions that, although connected with police and firefighting functions, do not meet the definitions of police officer and firefighter positions.

Note: Police officers and firefighters are not considered emergency workers for purposes of the mandatory exclusion from social security and Medicare coverage for such workers. This exclusion applies only to services of an employee who was hired because of an unforeseen emergency to do work in connection with that emergency on a temporary basis to provide emergency assistance in fires or other disasters such as severe ice storm, earthquake, volcano eruption or flood.

Police and Firefighter Positions Not Covered Under a Retirement System

If police officer and firefighter positions are not covered under a retirement system, these positions are mandatorily covered for social security and Medicare unless the positions were already covered under a Section 218 Agreement as part of a non-retirement system coverage group.

Foreign Students, Teachers and Apprentices

Individuals admitted to the United States under an F-1, J-1, M-1 or Q-1 visa are generally exempt from both social security and Medicare taxes. Wages earned within the United States are subject to income tax, whether or not the workers are U.S. citizens. Nonresident students who are not U.S. citizens, permanent residents or resident aliens for tax purposes may be able to take advantage of treaty exemptions to exclude a portion of their U.S. source income from withholding. For more information on specific treaty provisions, contact the IRS or SSA. The following IRS publications have additional information on social security and Medicare coverage for foreign workers:

 

3) Employees With No Social Security Coverage

The final category of workers includes those who are not subject to any voluntary or mandatory social security coverage at all. This can only occur where the workers are covered by a qualifying public retirement system ("FICA replacement plan") and are not covered by a Section 218 Agreement. Employers of these workers will not withhold social security taxes or show any "social security wages" on Form W-2; they are generally covered for Medicare. Public retirement systems are the subject of Chapter 6.

Identifying Covered Employment

In addition to determining whether specific employees are members of a social security coverage group, questions may arise as to whether certain positions constitute employment. These determinations may be based on decisions regarding specific issues to which either federal or state law is applicable. It is important to know whether federal or state law is applied in making a determination on a specific issue. Generally, questions involving interpretation or application of state law are resolved by the authorized legal officers of the state in accordance with applicable state and local laws, regulations and the state court decisions. Jurisdiction for some of the major questions is indicated in the table below:

Federal Law:

Does an employer-employee relationship exist?

Who is the employer?

Are the earnings wages?

What are emergency services?

What are student services?

State Law:

Who is an officer of a state or political subdivision?

Is an entity a political subdivision?

Is a function governmental or proprietary?

Is a position under a retirement system?

Which employees are eligible for membership in a retirement system?

Who is an employee for purposes of retirement system participation?

Although federal law determines whether earnings are wages subject to social security and Medicare, state laws have a bearing on the issue of employment, such as whether a position is that of a public official of a state. Where this is the case, an opinion of the state legal officer may be requested. The state's opinion will be given weight in making the decision, but it will not be determinative of the issue. Before contacting IRS or SSA, contact the State Social Security Administrator for guidance.

The federal courts provide the ultimate determination of how social security and tax laws will apply in a given situation.

Note: Federal Circuit Court decisions are binding only in the circuit in which they are issued. For a map of federal Circuit Court jurisdictions, see the interactive map at http://www.uscourts.gov/court_locator.aspx.

Identity of the Employer for Social Security Coverage Purposes

Because entities have different social security and retirement plan situations, it is important to determine which of two or more entities, organizations, or individuals is the employer. In some cases, certain individuals, referred to as "leased workers," are supplied or paid by one entity but work under the direction of another. Generally, if there is a provision in a statute or ordinance that creates a position and the individual is hired or elected under this authority, the individual is an employee of the state or political subdivision to which the provision applies. If there is no such authority, the employer is the entity that has the right to control the worker in the performance of the work, i.e., the common-law employer.

The employing entity is responsible for withholding and paying social security and Medicare taxes on its employees' wages, as well as reporting to SSA the amount of wages paid. These withholding, paying and reporting requirements apply to wages of individuals subject to mandatory social security and Medicare, as well as to wages of individuals covered under a Section 218 Agreement. See Publication 15.

Indian Tribal Governments and Section 218

Indian Tribal Governments, while treated as states for other purposes, are not treated as states for social security and Medicare tax purposes under Internal Revenue Code (IRC) section 7871. Thus, Indian tribal governments do not enter into Section 218 Agreements with SSA and may not participate in a public retirement system as an alternative to paying social security and Medicare tax under the provisions of IRC section 3121(b)(7)(F).

Mandatory Medicare Coverage

Prior to April 1, 1986, state and local government employees could only be covered for Medicare through a voluntary Section 218 Agreements between the state and the federal government. This changed with the enactment of the Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1985, which mandated that all state and local employees hired or rehired after March 31, 1986, must be covered for Medicare, and pay Medicare taxes regardless of their membership in a retirement system. Employees covered by social security under a Section 218 Agreement are automatically covered for Medicare. Public employees already covered under a Section 218 Agreement are covered under Medicare and subject to the tax. Employees who are not covered by social security, but are subject to the Medicare-only portion of FICA, are referred to as Medicare Qualified Government Employees (MQGE). Reporting procedures for MQGE employees are covered in Chapter 3.

Employees who have been in continuous employment with the employer since March 31, 1986, who are not covered under a Section 218 Agreement nor subject to the mandatory social security and Medicare provisions, remain exempt from both social security and Medicare taxes, provided they are members of a public retirement system. (See Continuing Employment Exception, below.)

The flowchart "Social Security and Medicare Coverage for State and Local Government Employees" in Chapter 1 shows how to determine whether Medicare coverage applies.

Continuing Employment Exception

Services performed after March 31, 1986, by an employee who was hired by a state or political subdivision employer before April 1, 1986, are exempt from mandatory Medicare tax if the employee is a member of a qualifying public retirement system and all of the following requirements are met:

 

In general, the following employment changes are considered continuous employment and qualify the employee for the exception:

 

The following are

not

considered continuous employment for this purpose:

 

See

Revenue Ruling 86-88

,

Revenue Ruling 88-36

, (in the Appendix) and

Revenue Ruling 2003-46

for more information about the continuing employment exception.

The Centers for Medicare & Medicaid Services (CMS) is the federal agency that administers the Medicare program. For more information, see the CMS website.

Services Not Subject to Mandatory Medicare Coverage

The following are not subject to mandatory Medicare tax even though the services are performed by an employee hired after March 31, 1986. (Note: These are the same services that are excluded from mandatory social security coverage, discussed earlier.)

 

See the sections on

Mandatory Exclusions

and

Optional Exclusions

in this chapter for more details on these exclusions.

Voluntary Medicare Coverage

A Section 218 Agreement can be executed to provide Medicare-only coverage for employees who are qualified participants in a public retirement system and not covered under a Section 218 Agreement and not subject to the mandatory Medicare provisions. Contact your State Social Security Administrator for further information. (A list of State Administrators is available at http://www.ncsssa.org.)

Frequently Asked Questions

 

Chapter 6. Social Security and Public Retirement Systems

Effective July 2, 1991, Congress made social security coverage mandatory for state and local government employees who are neither covered by a Section 218 Agreement nor qualified participants in a public retirement system (also referred to as a "FICA replacement plan"). States can provide employees with membership in a public retirement system as an alternative to mandatory social security coverage.

As a supplement to the social security and public retirement systems information provided in this publication, refer to the FSLG web site.

This chapter provides information about the requirements a retirement system must meet to qualify as an alternative to social security coverage.

Public Retirement Systems (FICA Replacement Plans)

A public retirement system, as defined in Internal Revenue Code (IRC) section 3121(b)(7)(F) and Regulation

Note: A "public retirement system" for this purpose is not required to be a qualified plan within the meaning of the Employee Retirement Income Security Act of 1974 (ERISA). The ERISA provisions relate to the tax treatment of contributions and benefits of employee plans, and are irrelevant to the coverage issues addressed here. To avoid confusion, this publication does not use the term "qualified" to refer to public retirement systems. For mandatory coverage purposes, the employee may be a member of any type of retirement system, including a system that is nonqualified under ERISA (for example, a section 457 plan), as long as the plan provides the minimum level of benefits required for a public retirement system. These requirements are discussed below and in Regulation Revenue Procedure 91-40.

For purposes of determining whether mandatory coverage applies for an employee holding more than one position, social security is NOT a public retirement system.

Example: An individual holds two positions with the same political subdivision. The wages earned in one position are subject to social security and Medicare tax pursuant to a Section 218 Agreement; the other position is not covered. The social security system is not a retirement system for this purpose. Thus, mandatory social security coverage applies to service in the other (non-218) position unless the employee is a member of a public retirement system with respect to that position. See Regulation 414(i).

A defined contribution plan that satisfies the definition of a retirement system under Regulation 401(a), 403(b), or 457. Contributions from both the employer and the employee may be used to make up the 7.5 percent. Matching contributions by the employer may be taken into account for this purpose. A plan with only employee contributions would also satisfy the minimum benefit requirement, provided the contributions constitute at least 7.5 percent of compensation. However, the 7.5 percent cannot include any earnings on the account.

Definition of Compensation

For a defined contribution plan, the definition of "compensation" used to determine whether the benefit is sufficient must include at least the employee's base pay, provided that the definition of "base pay" is reasonable. Thus, for example, a defined contribution retirement system may disregard any of the following: overtime pay, bonuses, or single-sum amounts received on account of death or separation from service, amounts received under a bona fide vacation, compensatory time or sick pay plan, or amounts received under severance pay plans. Any compensation in excess of the social security contribution wage base for that year ($118,500 in 2015) may also be disregarded for this purpose.

Example: A political subdivision maintains an elective defined contribution plan that is a retirement system within the meaning of IRS regulations. The plan is on a calendar year. In 2014, an employee contributes to the plan at a rate of 7.5 percent of base pay. Assume that the employee compensation will reach the social security maximum contribution base in October. The employee is a qualified participant in the plan for the entire plan year, even if the employee ceases to contribute to the plan after reaching the maximum contribution base. See Regulation 31.3121(b)(7)-2(c)(2)(iv).

Reasonable Interest Rate Requirement

Generally, a defined contribution retirement system must credit the employee's account with earnings at a reasonable rate, under all the facts and circumstances. Alternatively, employees' accounts may be held in a separate trust subject to general fiduciary standards and credited with actual earnings of the trust fund. Whether the interest rate is reasonable is determined after reducing the rate to adjust for the payment of any administrative expenses. See Regulation Revenue Procedure 91-40 and the IRS regulations to determine whether a defined benefit retirement system meets this requirement.

Who Is a Qualified Participant?

For an employee to be excluded from mandatory social security coverage, the employing entity must maintain a retirement system within the meaning of IRC section 3121(b)(7)(F), and the employee must also be a qualified participant in that system, as defined in IRC section 3121(b)(7)(F) and Regulation 3121(b)(7)(F).

Example 1: A state-owned hospital maintains a non-elective defined contribution plan that is a retirement system within the meaning of IRS regulations. Under the terms of the plan, employees must be employed on the last day of a plan year in order to receive any allocation for the year. Employees may not be treated as qualified participants in the plan before the last day of the year.

Example 2: The situation is the same as in Example 1, except that under the terms of the plan, an employee who terminates service before the end of a plan year receives a pro rata portion of the allocation he or she would have received at the end of the year, e.g., based on compensation earned since the beginning of the year. If the pro rata allocation available on a given day would meet the minimum retirement benefit requirement with respect to compensation from the beginning of the plan year through that day (or some later day), the employee is treated as a qualified participant in the plan on that day.

Example 3: A political subdivision maintains an elective defined contribution plan that is a retirement system within the meaning of IRS regulations. The plan operates on a calendar year. It has two open seasons--in December and June--when employees can change their contribution elections. In December, an employee elects not to contribute to the plan. In June, the employee elects (beginning July 1) to contribute a uniform percentage of compensation for each pay period to the plan for the remainder of the plan year. The employee is not a qualified participant in the plan during the period January-June, because no allocations are made to the employee's account during that time. If the level of contributions during the period of July-December meets the minimum retirement benefit requirement with respect to compensation during that period, however, the employee is treated as a qualified participant during that period.

Example 4: Assume the same facts as in Example 3, except that the plan allows participants to cancel their elections in cases of economic hardship. In October, the employee suffers an economic hardship and cancels the election, effective November 1. If the contributions during the period July-October are high enough to meet the minimum retirement benefit requirement with respect to compensation during that period, the employee is treated as a qualified participant during that period. In addition, if the contributions during the period July-October are high enough to meet the requirements for the entire period July-December, the employee is treated as a qualified participant in the plan throughout the period July-December, even though no allocations are made to the employee's account in the last two months of the year. There is no requirement that the period used to determine whether an employee is a qualified participant on a given day remain the same from day to day, as long as the period begins on or after the beginning of the plan year and ends on the date the determination is being made. See Regulation 31.3121(b)(7)-2(d)(1)(i).

Part-Time, Seasonal, Temporary Employees

Special rules apply to part-time, seasonal and temporary employees for purposes of determining whether they are qualified participants in a public retirement system. To be exempt from mandatory social security coverage, these employees must not only be qualified participants; they must be fully vested in their benefits. This means the benefits cannot be forfeited. If a part-time, seasonal or temporary employee (as defined below) is not a qualified participant in a public retirement system with benefits fully vested from the first day of employment, that employee is subject to mandatory social security and Medicare tax until the employee becomes fully vested.

The special vesting requirement is considered to be met if a part-time, seasonal or temporary employee in a defined contribution plan has the right to receive a single sum payment of at least 7.5 percent of the compensation the employee earned while covered under the retirement system (plus interest) when the employee separates from employment.

Part-Time Employees

For purposes of applying the qualified participant test, part-time employees are those who normally work 20 hours or less per week. (This definition of "part-time" should not be confused with a definition of "part-time" that may be used for a Section 218 Agreement.) If mandatory coverage applies, part-time positions cannot be excluded; but part-time positions may be excluded from coverage under a Section 218 Agreement, at the option of the state. Contact the State Social Security Administrator to determine the definition of part-time positions under the state's Section 218 Agreement.

A special rule provides that a teacher employed by a post-secondary educational institution (e.g., a community or junior college, post-secondary vocational school, college, university or graduate school) is not considered part-time if the teacher normally teaches classroom hours of one-half or more of the number of classroom hours normally considered to be full-time employment.

Example: A community college treats a teacher as a full-time employee if the teacher is assigned to work 15 classroom hours per week. A new teacher is assigned to work eight classroom hours per week. Because the assigned classroom hours of the teacher are at least one-half of the hours designated by the school as constituting full-time employment, the teacher is not a part-time employee. See Regulation 1.3121(b)(7)-2(d)(2)(iii)(A).

Seasonal Employees

For purposes of applying the qualified participant test, a seasonal employee is any employee who normally works on a full-time basis less than five months in a year. Thus, for example, individuals who are hired by a political subdivision during the tax return season in order to process incoming returns and work full-time over a three-month period are seasonal employees. See Regulation 31.3121(b)(7)-2(d)(2)(iii)(C).

Individuals Employed in More Than One Position

If an employee is not covered by a Section 218 Agreement, but is a member of a retirement system with respect to one full-time position, the employee is generally treated as a member of a retirement system with respect to any other position with the same employer.

Example: An individual is employed full-time by a county and is a qualified participant in its retirement plan with regard to that employment. In addition to this full-time employment, the individual is employed part-time in another position with the same county. The part-time position is not covered by the county retirement plan. Nevertheless, if the individual is a qualified participant in the retirement plan with respect to the full-time position, the part-time position is excluded from mandatory social security coverage. See Regulation

 

• The employee's service in the other positions is or was covered by the same retirement system;

• All service aggregated for purposes of determining whether an employee is a part-time, seasonal or temporary employee (and related compensation) is aggregated under the system for all purposes in determining benefits (including vesting); and

• The employee is treated at least as favorably as a full-time employee under the retirement system for benefit accrual purposes.