The United States Department of Labor defines backpay as the difference between what the employee was paid and what she actually received. The department recommends that employers resolve backpay as quickly as possible because failure to pay wages due is a violation of the Fair Labor Standards Act (FLSA). All wages are subject to taxes and backpay is no exception. But you must perform the deduction appropriately to ensure payroll tax compliance.
Apply backpay taxes in the year in which the wages were paid, not the year in which they were intended. The IRS treats all backpay as wages and requires that you use the tax rates for the year that the employee receives the payment.
Calculate federal income tax using the employee’s W-4 and IRS Circular E. Use the filing status and allowances shown on the W-4 and the Circular E’s withholding tax tables to figure the tax.
Calculate Social Security and Medicare taxes at their respective percentages. For years 1990 and later, Social Security tax is calculated at 6.2 percent of gross income and Medicare tax at 1.45 percent. Notably, for Social Security purposes, the tax year that backpay is credited as wages depends on whether it’s awarded under a statute. The latter means that the court or a government agency ordered the employer to pay back wages.
Statutes include state minimum wage laws, Equal Pay Act and the FLSA. If the backpay was not the result of a statute, then the Social Security Administration (SSA) applies it as wages in the year it was paid. Otherwise, it is credited to the year in which it should have been paid. Still, it’s important to remember that the actual tax deduction should be for the year the wages were paid.
Compute state income tax according to your state’s guidelines. Use the employee’s withholding conditions as shown on his state withholding allowance certificate and the state withholding tax tables to figure the taxes. Note that Alaska, Florida, Tennessee, Wyoming, Washington, Nevada, New Hampshire, South Dakota and Texas do not charge state income tax. Additionally, Pennsylvania does not have tax tables; instead it charges a flat rate–3.07 percent of gross wage for 2010. If local income tax or city income tax applies, you must withhold them at their respective rates. Contact your state department of revenue if you’re unsure of your state withholding taxes.
- Backpay should show on the employee’s W-2 for the year in which the wages were paid. If backpay was excluded from a previously filed W-2, file a corrected W-2c with the SSA adding the backpay to the wages previously filed.
- If the backpay is for a substantial amount, such as more than $500, you can issue it as a separate check from the employee’s regular paycheck to reduce taxes withheld.
- IRS Publication 957 helps you to understand how to report and pay backpay taxes.
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