Editor: Kevin D. Anderson, CPA, J.D.
At first glance, the computation of total W-2 wages under Sec. 199A appears daunting, in part because three possible methods are available to do so. Practitioners ask themselves, "Which method should I use?" or perhaps, "What are the benefits and drawbacks to each available method?" But the most important thing to first determine is the meaning of "total W-2 wages."
W-2 wages, as defined by the statute, means:
[W]ith respect to any person for any taxable year of such person, the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. [Sec. 199A(b)(4)(A)]
Employees of an individual or relevant passthrough entity are limited to employees as defined in Secs. 3121(d)(1) and (2). For purposes of Sec. 199A, this includes officers of an S corporation and common law employees.
Regs. Sec. 1.199A-1(b)(16) provides that W-2 wages "means W-2 wages of a trade or business (or aggregated trade or business) properly allocable to [qualified business income] as determined under [Regs. Sec.] 1.199A-2(b)." After reiterating the statutory definition, the writers of Regs. Sec. 1.199A-2(b) were kind enough to replace cross references with the referenced language by stating:
Thus, the term W-2 wages includes the total amount of wages as defined in section 3401(a) plus the total amount of elective deferrals (within the meaning of section 402(g)(3)), the compensation deferred under section 457, and the amount of designated Roth contributions (as defined in section 402A). [Regs. Sec. 1.199A-2(b)(2)(i)]
Wages paid to statutory employees (on Forms W-2, Wage and Tax Statement, where "Statutory Employee" is checked in box 13) should not be included in calculating W-2 wages under any of the three methods outlined below. Further, the taxpayer includes only those Forms W-2 that are for the calendar year ending with or within the tax year. Consider this last point in the context of an S corporation with a tax year ending Sept. 30, 2018. The S corporation will be required to include in its total wage computation for purposes of the W-2 wage limitation those forms filed for the calendar year ending Dec. 31, 2017.
When a taxpayer has a short tax year, the general rule that taxpayers include only the W-2 wages for the calendar year ending with or within the tax year does not apply. Instead, W-2 wages for the short tax year include only those wages actually paid, elective deferrals actually made, and compensation actually deferred under Sec. 457 during the short tax year for the taxpayer's employees for employment by the taxpayer. Using the third method for computing total W-2 wages, the tracking-wages method discussed below, is mandatory for a taxpayer with a short tax year.
Note that under each of the methods discussed below, qualified W-2 wages for purposes of Sec. 199A must have been filed on Form W-2 with the Social Security Administration within 60 days after the due date for that filing and must be with respect to employees of the taxpayer for employment by the taxpayer. A taxpayer may include any W-2 wages paid by another person and reported by the other person on Forms W-2 with the other person as the employer listed in box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the taxpayer for employment by the taxpayer. In those cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 must exclude those W-2 wages from the computation of its own Sec. 199A attributes.
As pointed out in Rev. Proc. 2019-11, there is a correlation between Form W-2 codes and those amounts potentially includible as W-2 wages. The revenue procedure notes that elective deferrals under Sec. 402(g)(3) and the amounts deferred under Sec. 457 correlate to box 12, codes D (elective deferrals under Sec. 401(k), including a SIMPLE 401(k)); E (elective deferrals under Sec. 403(b)); F (elective deferrals under Sec. 408(k)(6) for a SEP); G (elective deferrals in a Sec. 457(b) plan); and S (an employee salary reduction in a Sec. 408(p) SIMPLE plan). Designated Roth contributions are reported in box 12, codes AA and BB; however, since these are also included in box 1, "Wages, Tips, and Other Compensation," one will not find separate mention of these codes' inclusion in any of the three prescribed methods for calculating total wages. Essentially, only deferrals that currently reduce federal income tax withholding require adjustment. Since Roth contributions are always current wages subject to federal income tax withholding, they do not require adjustment.
Rev. Proc. 2019-11 offers a degree of flexibility in the computation of total W-2 wages by providing three methods, each adding progressively more complexity. The three available methods for the computation of W-2 wages are:
Unmodified box method: Under this method, the lesser of total box 1 or box 5 entries is the amount of total W-2 wages. While this undoubtedly is the easiest method, some taxpayers may find it more advantageous to pursue a more detailed level of analysis.
Modified box 1 method: Under this method, the taxpayer begins with box 1 wages and makes the following adjustments:
- Subtract amounts included in box 1 that are not wages for federal income tax withholding purposes, including amounts that are treated as wages for purposes of income tax withholding under Sec. 3402(o) (e.g., supplemental unemployment compensation benefits within the meaning of Rev. Rul. 90-72); and
- Add amounts that are reported in box 12 and properly coded D, E, F, G, or S.
In basic scenarios, this will move the total wage needle back to box 5 and should be strongly considered over the first method when elective deferrals under Sec. 401(k), 403(b), 408(k)(6), 457(b), or 408(p) are made.
Of course, the downside is the requirement that amounts that are not wages for federal income tax withholding purposes be subtracted from the total. Practitioners and taxpayers will need to consider to what extent remuneration paid and included in box 1 meets the 23 exceptions to the definition of wages outlined under Sec. 3401(a). Payroll departments should be able to provide an accumulator code report that discloses how each amount included in box 1 has been subjected to or not subjected to federal income tax withholding. Practitioners should review this carefully and use this as an opportunity to assist taxpayers in correcting any errors of over- or underreporting of wages subject to federal income tax withholding. Certainly, any taxpayer subject to the W-2 wage limitation who finds that wages subject to withholding are underreported will see an added incentive to correct the underreporting.
Tracking-wages method: Under this method, the taxpayer tracks total wages actually or constructively paid that are subject to federal income tax withholding and adds to this the amounts that are reported in box 12, properly coded D, E, F, G, or S.
Taxpayers who require employees to maintain detailed time records may find this method to be easier than the second method and more advantageous than the first. The employer will likely be able to perform a query for individuals performing services for a particular trade or business or trades or businesses, also making it easier to properly allocate W-2 wages among various trades or businesses.
Early preparation is key
It is also worth noting that the calculation of total W-2 wages is not per se a method of accounting that would ordinarily necessitate the filing of Form 3115, Application for Change in Accounting Method, to change the method. While the word "method" is used in reference to each of the three formulas for calculation, neither Rev. Proc. 2019-11, the statute, nor the regulations require that the same method of computation be used year after year.
Practitioners and taxpayers must be careful to give the computation of total W-2 wages proper consideration early in the tax compliance process. Failure to do so may result in a rushed or incomplete computation that does not fully explore opportunities for maximizing the Sec. 199A deduction or, worse, result in an overstated deduction.
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.