This post covers a multitude of issues surrounding employee compensation, with a particular emphasis on how to calculate the compensation and what types of compensation is taxable income to employees. It begins with coverage of guidelines for determining if an employer can designate someone as an employee or contractor and proceeds to guidelines for differentiating between salaried and hourly employees. Then it covers a number of general compensation-related topics, such as activities for which wages must be paid, the standard work week, and payments made to temporary work agencies. The rest sections then covers a variety of compensation types, as well as business expenses that can be reported as gross income to employees for tax purposes. It comes with case example and calculations [computation] i.e.; Computing Pay under the Hourly Rate Plan, Computing Pay under the Piece Rate Plan and more.
I hope this post a worth reading information for the cost accountants, tax preparers, tax planners, payroll clerks, controllers [and CFO], and those who are searching for answers to daily payroll-related questions about compensations, its calculation and income tax treatment.
Defining Employee and Contractor Status
A key issue is whether someone is an employee or a contractor, since the reporting of income to the tax office [IRS for U.S. people] varies considerably for each one, as well as the tax withholding requirements of the employer. The defining test of an employee is when the company controls not only the types of work done by the employee, but also how the work shall be done. An employer also controls the work of a contractor, but not how the work is done. Other supporting evidence that an individual is a contractor is the presence of a contract between the parties, whether the contractor provides similar services to the public, and whether the contractor is paid based on the completion of specific tasks, rather than on the passage of time.
An employer may be tempted to categorize employees as contractors even when it is evident that this is not the case, since the employer can avoid matching some payroll taxes by doing so. However, taking this approach leaves an employer liable for all the Income, Social Security, and Medicare taxes that should have been withheld. Consequently, strict adherence to the rules governing the definition of an employee and contractor should be followed at all times.
Wage Exemption Guideline
One should be aware of the general rules governing whether an employee is entitled to an hourly wage or a salary, since this can avoid complaints from employees who wish to switch their status from one to the other. The key guidelines for designating a person as being eligible for a salary are:
- Administrative – Those in charge of an administrative department, even if they supervise no one, and anyone assisting management with long-term strategy decisions.
- Executive – Those who manage more than 50 percent of the time and supervise at least two employees.
- Professional – Those who spend at least 50 percent of their time on tasks requiring knowledge obtained through a four-year college degree (including systems analysis, design, and programming work on computer systems, even if a four-year degree was not obtained). The position must also allow for continued independent decision making and minimal close supervision.
Wage Payments Guideline
There are a number of special activities falling within the standard work day for which an employee earning an hourly wage must be compensated. The most frequently encountered activities are:
- Employer-mandated charitable work.
- Employer-mandated meal times when employees are required to stay in their work locations.
- Employer-mandated training programs.
- Employer-mandated travel between work locations.
- Employer-mandated work activities.
- Rest periods equal to or less than 20 minutes.
Special activities falling outside the standard work day for which an employee earning an hourly wage must be compensated include the following items:
- Attendance at an employer-mandated training session.
- Emergency work for the employer.
- Equipment start-up or shut-down work.
- Maintenance work.
- Overlapping work related to shift-change problems.
Workers Paid by a Temporary Agency
It is common to ask a temporary agency to send workers to a company to complete work on a short-term basis. The temporary agency is considered the employer of these workers if it screens and hires them and can fire them. Under these conditions, the temporary agency is liable for all tax withholdings from their pay. The company paying the temporary agency for these services is only liable for prearranged fees paid to the agency, and is not responsible for their payroll taxes.
Determining Work Week
The work week is a fixed period of 168 consecutive hours that is recurring on a consistent basis. The beginning and ending start and stop times and dates can be anything management desires, but it should be consistently applied.
Whatever the work week is defined to be, it should be listed in the employee manual to avoid confusion about which hours worked fall into which work week, not only for payment purposes but also for the calculation of overtime. It is unwise to alter the stated work week, since it may be construed as avoidance of overtime payments.
EXAMPLE: A company may have a history of experiencing large amounts of overtime at the end of a month in order to make its delivery targets, so company management elects to change the work week from Monday through Sunday to Wednesday through Tuesday right in the middle of the final week in a month, thereby reducing much of the overtime hours that employees would otherwise earn to regular hours.
Note: This would be a highly suspect change of work week that might be construed by the government as being intended to avoid wage payments.
The minimum wage is the minimum amount of wage per hour that must be paid to all employees, with some restrictions by type of industry. The minimum wage is usually set by the Central government [ federal for U.S.], though it can be overridden by local law with a higher minimum wage requirement.
To determine if an employer is paying at least the minimum wage, summarize all forms of compensation earned during a work week and divide it by the number of hours worked. The most common forms of compensation include base wages, commissions, shift differentials, piece-rate pay, and performance bonuses.
Example: The Lie Dharma Company, which specializes in making rush deliveries, pays its delivery staff at a rate of $8.00 per delivery made. In the last week, one employee completed 25 deliveries, which entitled him to $200 in wages. However, the minimum wage of $5.15 for the 40 hours worked should have entitled him to a base wage of $206.00, so the company must pay him an additional $6.00 in order to be in compliance with the law.
Note: If the calculation results in an average rate that drops below the minimum wage, then the employer must pay the difference between the actual rate paid and the minimum wage.
Computing Pay under the Hourly Rate Plan
The hourly rate plan is by far the most common method for calculating wages for hourly employees. This simply involves multiplying the wage rate per hour times the number of hours worked during the work week.
Example: Samuel Chow works the second shift at a manufacturing facility, where he earns an extra $0.25 per hour as a shift differential, as well as a base wage of $12.50 per hour. He works a standard 40 hours in the most recent work week. The calculation of his total wages earned is:
($12.50 base wage + $0.25 shift differential) × 40 hours = $510.00 weekly pay
Note: It can be complicated by adding shift differentials, overtime, and other forms of bonus pay to the base wage rate [the overtime calculation is covered in a later section].
Computing Pay under the Piece Rate Plan
The piece-rate pay plan is used by companies that pay their employees at least in part based on the number of units of production completed. To calculate wages under this method: multiply the rate paid per unit of production by the number of units completed in the work week.
Note: An employer who uses this approach must still pay its staff for overtime hours worked; to calculate this, divide the total piece-rate pay by the hours worked, and then add the overtime premium to the excess hours worked. An employer can avoid this extra calculation by computing wages earned during an overtime period by using a piece rate that is at least 1.5 times the regular piece rate.
Example: Janet Company makes miniature dolls, and pays its staff a piece rate of $0.75 for each doll completed. One worker completes 320 dolls in a standard 40 hour work week, which entitles her to pay of $240.00 (320 dolls × $0.75 piece rate). The worker then labors an extra five hours, and produces an additional 42 dolls.
To calculate her pay for this extra time period: First calculates her regular piece-rate pay, which is $31.50 (40 dolls × $0.75 piece rate). Then calculates the overtime due by calculating the standard wage rate during the regular period, which was $6.00 per hour ($240.00 total pay divided by 40 hours), resulting in a premium of $3.00 per hour.
The employee’s overtime pay is therefore $15.00 ($3.00 overtime premium × five hours)
Determining Pay of Salaries for Partial Periods
Many salaried employees begin or stop work partway through a pay period, so the payroll staff must calculate what proportion of their salary has been earned. This calculation also arises when a pay change has been made that is effective as of a date partway through the person’s pay period.
To determine the amount of a partial payment: calculate the salaried employee’s hourly rate and then multiply this rate by the number of hours worked. A common approach for determining the hourly rate is to divide the total annual.
Example: The Lie Dharma Company pays its employees on the 15th and last day of each month, which amounts to 24 pay periods per year. One employee, Shirley Wang, has been hired partway through a pay period at an annual salary of $38,500. She starts work on the 20th of the month, and there are seven business days left in the pay period.
The payroll staff first determines her hourly rate of pay, which is $38,500 divided by 2,080 hours, or $18.51. They then calculate the number of hours left in the pay period, which is eight hours a day times seven working days, or 56 hours.
Ms. Wang’s pay for her first pay period will be $18.51 times 56 hours, or $1,036.56.
Dtermining Overtime Pay
Overtime is a pay premium of 50 percent of the regular rate of pay that is earned by employees on all hours worked beyond 40 hours in a standard work week.
Note: This calculation can vary for individual country, states, even city, so be sure to check with the local provincial or city agency that tracks wage law issues to see if there are variations.
When calculating overtime, the employer does not have to include in the 40 base hours such special hours as vacations, holidays, sick time, or jury duty.
Example: Burke is a welder who works 47 hours during a standard work week at an hourly wage of $22.00 per hour. The overtime premium he will be paid is 50 percent of his hourly wage, or $11.00. The calculation of his total pay is as follows:
47 hours × regular pay rate of $22.00/hour = $1,034.00
7 hours × overtime premium of $11.00/hour = 77.00
Total pay = $1,111.00
An employee earns a commission when he or she secures a sale on behalf of a business. The commission may be earned at the point when an invoice is issued or when cash is received from the customer.
The commission calculation may be quite complex, involving a percentage of the dollar amount sold, a fixed fee per sale, a bonus override for the sale of specific items, or perhaps a commission sharing arrangement with another member of the sales force. In any case, commissions are considered regular wages for tax withholding purposes, so all normal income tax withholdings.
Example: Mr. Lie Dharma is a salesperson for the Royal Bali Fiddle Company. His basic compensation deal is a six percent commission on all sales at the time they are invoiced, plus $25 each for any fiddle that is currently overstocked. He sells two of the Melodic series fiddles for $600 each, and also sells three of the overstocked Kid’s Mini model for $450 each. His compensation is as follows:
2 × $600 Melodic series fiddles = $1,200 × 6% commission = $72.00
3 × $450 Kid’s Mini series fiddles = $1,350 × 6% commission = $81.00
Bonus on sales of overstocked Kid’s Mini model = $75.00
Total = $228.00
Tips are paid directly to employees by customers for services performed. Employees who receive tips must report them to the employer by the tenth day of the month after the month in which the tips were received, except when total tips for the month are less than $20. This information may need to be reported to the employer on certain Form [e.g: Employee’s Report of Tips to Employer].
The employer is required to withhold income, Social Security, and Medicare taxes from employee tips. These deductions are frequently made from employee base wages rather than tips, since employees do not usually contribute their tip income back to the employer so taxes can be withheld from it.
Back Pay and Its Tax Treatment
Back pay is frequently paid to an employee as part of an arbitration award, perhaps related to an unjustified termination or an incorrectly delayed wage increase. Whatever the reason, it should be treated as regular wages for tax withholding purposes. However, some recent court cases have more tightly defined the types of back pay awards that are subject to withholding, so one should consult with a lawyer to determine the correct treatment.
Business Expense Reimbursements
If an employee submits substantiation of all expenses for which reimbursement is requested, then the corresponding payment from the employer to the employee is not considered income to the employee.
Meals and entertainment present a special situation from the employer’s perspective. Only 50 percent of these costs are allowed as tax deductions on the employer’s tax return, though all of the expense claimed by employees can be reimbursed to them without it being listed as income to them. Also, meal expenses incurred by the company on behalf of an employee are not wages to the employee if they are incurred for the employer’s convenience and are provided on the employer’s premises.
Health insurance costs, including expenses incurred for an employee’s family, are not considered employee wages, but must be recorded as wages in Subchapter S corporations for those employees who own more than two percent of the business.
If an employee lives away from home for less than one year on company business, the living costs paid to the employee for this period are not considered taxable income. However, once the duration exceeds one year, the employee is considered to have permanently moved to the new location, rendering all such subsequent payments taxable income to the employee.
Such fringe benefits as tickets to entertainment events, free travel, and company cars should be recorded as employee gross income. The amount of incremental gross income added should be the fair market value of the fringe benefit, minus its cost to the employee, minus any deductions allowed by law.
Club dues are taxable income to the employee, except for that portion of the dues that are business related, which must be substantiated. Clubs that fall into this category are: airline and hotel clubs, as well as golf, athletic, and country clubs.
Note: The portion of the club dues that are personal income to the employee can be treated as a wage expense to the employer for tax purposes.
Example: Marck Robinson is a member of an airline club, which allows him access to club facilities at a variety of airports around the country. He estimates that he uses these facilities 70 percent of the time while he is traveling on company business. He can substantiate this estimate with travel records. The annual cost of the membership is $400. Accordingly, only 30 percent of the cost, or $120, is recognizable as his personal income.
The reimbursement of an employee’s educational expenses by the employer is not income to the employee if the education being reimbursed is related to his or her current job and will either maintain or improve the person’s skills for conducting that job. However, the payments are income if the education is to promote the person or shift him or her into an unrelated position requiring different skills.
An employer can change the reportable income situation somewhat by creating an educational assistance plan (EAP). This is a written plan that an employer creates on behalf of its employees. For this plan, employees are considered to be current staff, long-term leased staff, former staff who have retired, were laid off, or who left due to disability, or a sole proprietor or business partner.
Employee Achievement Awards
Employee achievement awards can be excluded from employee gross income, but only if the awards are tangible property given in recognition of length of service with the business or for safety achievement, and awarded as part of a meaningful presentation.
Example: Julianne Kwok continues to receive achievement awards for every quarter during which she works in a meat packing plant without being injured. Every quarter, she is paid a bonus of $50 during a formal achievement ceremony.
Note: This payment is taxable gross income to her, because it is a cash award instead of a tangible award.
The value of group term life insurance paid for by the employer is excluded from income for the first $50,000 of life insurance purchased. The excess value of life insurance coverage over this amount must be included in employee income. This income is only subject to Social Security and Medicare taxes.
Example: $80,000 of group term life insurance is purchased for a 54-year-old employee, who contributes $2 per month to this benefit. The first $50,000 of this amount is excluded from the employee’s gross income. To calculate the value of the remaining $30,000, divide it by 1,000 and multiply the result by $0.23 (as taken from the above table for the 50-54 age bracket), which yields a fair value of $6.90 per month. Then subtract her $2.00 monthly contribution to arrive at a net monthly value received of $4.90. Next, multiply the monthly value of $4.90 by 12 in order to obtain the full-year value of the life insurance, which is $58.80. The $58.80 should be reported as her gross income.
Note: The above scenario does not apply if the employer is the beneficiary of the life insurance. This would not be a benefit to the employee, and therefore its fair value should not be included in his or her gross income.
Some organizations will pay employees for a fixed amount of time off for a meal break if they exceed a set number of hours worked in a day. For example: If employees work more than 10 hours in a day, they are awarded an extra half-hour of pay, as long as they turn in a receipt as evidence of having purchased a meal. This extra amount is typically paid at an overtime pay rate.
If an employer gives time off for a meal break partway through a shift, such as lunch, this does not have to be paid time as long as the employees are relieved from all work responsibilities during the time period. If they are required to be on call during this period, then the employer would otherwise have had to pay someone else to take that position, so they should receive compensation for this type of meal break.
Though it may be company policy to automatically deduct some amount of time from the reported working time of its nonexempt employees to account for a lunch break, there should be a system in place that verifies the actual absence of employees from their places of work. This is necessary in case employees claim they had to work through their lunch breaks and were not compensated for this effort.
Employers may ask employees to move to a different company location. If the employer pays a third party or reimburses the moving employee for actual costs incurred, there is no reportable income to the employee. In the U.S., this only applies if the employee’s new workplace is at least 50 miles further from his/her residence than the old workplace, and the employee must work out of the new location for at least 39 weeks during the 12-month period following the move. Otherwise, the move transaction will have the appearance of being a simple compensation by the employer of the employee, who happens to use the funds to move to a new location while still working at the same place of work.
Note: If the employer pays the employee a fixed amount in order to complete the move and if the actual expenses incurred are less than the payment, then the difference is reported as income to the employee.
An employer may offer resumé assistance, counseling, and so on to employees it has terminated. The value of these services are not recorded as income for the affected employees, but only if the employer receives a substantial business benefit from providing the services and the services would have been reimbursable business expenses to the employees if they had paid for them directly. These rules will usually apply, since a business can claim a business benefit from the morale of the remaining employees, who can see that terminated employees are being well taken care of. If these rules do not apply, then the employer must withhold taxes on the fair market value of the services.
Note: If the services are provided in exchange for severance pay, then the employer must withhold taxes on them. This latter situation arises when employees ask that the services be provided in an attempt to mask the offsetting compensation, so they can avoid paying payroll taxes.
Personal Use of Company Vehicles
A number of taxation rules apply if an employee drives a company vehicle for personal use. The basic rule is that personal use of this asset is taxable income to the employee. The following rules apply:
- If the vehicle is a specialty one, such as a garbage truck, then there is an assumption that no personal use will occur, so using this type of vehicle will never result in taxable income to the employee.
- If the employer requires the employee to use the vehicle to commute to work; an enforced company policy prohibits the vehicle from all other personal use; and the employee is not a highly compensated employee, director, or officer; then the employee will be charged with $1.50 of taxable income for each commute in each direction.
- If the employee can substantiate the amount of business use to which the vehicle was put, including dates, miles, and the purpose of each trip, all remaining miles are assumed to be for personal use.
Example: The president of Lie Dharma Inc. drives a company-owned Mercedes. The value of the car is clearly beyond $15,000, so he must record as personal income the proportion of his personal use of the car multiplied by its annual lease value of $28,000. The proportion of his personal use was 78 percent, so the company must record 78 percent of $28,000, or $21,840, as his gross income associated with his use of the car.