Editor: Mary Van Leuven, J.D., LL.M.
In a recent Chief Counsel Advice memorandum (CCA 202202010), the IRS determined that an employer funding an international assignee's federal income tax obligations under a tax equalization policy may not seek a refund of excess withholding on that employee's compensation after the close of the calendar year during which the compensation was paid.
This IRS memorandum is notable because it is one of the few pieces of IRS guidance addressing the impact of global mobility tax compliance processes on an employer's federal income tax reporting and withholding obligations, and it appears to be the first published guidance to consider whether an overpayment of tax based on a hypothetical tax estimate is an "administrative error" that may be corrected by an employer after the close of the calendar year during which it was paid.
The IRS memorandum considers the scenario of a U.S. company sending an employee who is a U.S. citizen on an assignment to a foreign (host) country. Because there are both personal and economic costs to an employee who relocates to a host country, companies often provide these "assignees" with assignment allowances (such as cost-of-living adjustments, housing, and tuition for dependents) to mitigate the impact of an assignment on the assignee's pocketbook. However, these assignment allowances inflate an assignee's taxable earnings, and, in turn, increase the assignee's personal tax liability. Additionally, the assignee may be subject to tax in both the United States and the host country on this inflated income. Given the potential negative tax consequences for an assignee, many employers use a tax reimbursement policy known as tax equalization that attempts to approximate an assignee's personal out-of-pocket tax cost as if the assignee had not gone on assignment.
Tax equalization: Typical tax equalization policies divide an assignee's employment compensation into two categories. The first category, "assignment-related" compensation, includes assignment-related allowances. The company is responsible for all taxes on this income. The second category, "stay-at-home" compensation, includes amounts that would have been paid to the assignee regardless of whether the assignee was on an international assignment, such as base salary, annual bonus, vacation pay, and equity compensation. Tax equalization policies vary across organizations, but, in general, the assignee is responsible for the amount of tax that would have been incurred on this income had the assignee not relocated, and the company is responsible for any additional tax incurred on this income because of the assignment.
Hypothetical tax: Tax equalization is accomplished by collecting "hypothetical taxes" from an assignee. At the start of an assignment or tax year, the company estimates the amount of taxes the assignee would incur in the United States had the assignee not been on assignment. The assignee's salary is then reduced by this "estimated hypothetical tax" amount, which the company uses to fund the assignee's actual tax liability on equalized income. This estimated hypothetical tax amount is not considered "wages" or income for federal tax purposes, and, accordingly, it reduces the amount of wages reported to the IRS and the employee on Form W-2, Wage and Tax Statement.
The company meets the assignee's actual U.S. and host country tax liabilities by paying the taxes directly to the relevant tax authority and including the tax payment in the assignee's reportable compensation (a tax gross-up). For federal tax purposes, all wages (including assignment allowances and tax payments) reduced by any hypothetical tax amounts are reported by the employer on Form 941, Employer's Quarterly Federal Tax Return.
After the calendar year ends, a hypothetical tax return is prepared to determine the amount of taxes the assignee would have incurred had the assignee not been on assignment, and a reconciliation is performed between this "actual hypothetical tax" amount and "estimated hypothetical tax" that had reduced the employee's wages over the course of the year. If the actual hypothetical tax amount is lower than the estimated hypothetical tax amount, the company pays the assignee the difference, and the amount is included in the assignee's taxable compensation in the year paid. However, if the actual hypothetical tax amount is greater than the estimated hypothetical tax amount, the assignee is required to repay that amount to the employer.
Overpayment of tax is not an administrative error
When an employee repays an employer for wages received in error in the current year, the employer may offset the repayment against current-year wages and may be able to report the repayment as an adjustment on Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, to recover any employment taxes withheld on those repaid wages. However, when an assignee is required to repay an amount to the employer under a tax equalization program, the repayment represents a return of wages received in a prior year. The employer may wish to report the repayment as an adjustment on Form 941-X to recover any employment taxes withheld on those repaid wages and issue a Form W-2c, Corrected Wage and Tax Statement, to remove the overpaid tax from the assignee's wages and withholdings, but, as the IRS memorandum details, this approach is not consistent with federal income tax wage withholding rules.
When a company funds an assignee's tax obligations through direct payments to the IRS, the tax payments made on the assignee's behalf represent income and reportable wages to the assignee. For employment tax purposes, these payments are deemed to have been withheld by the company from the employee's wages and are therefore reportable on the assignee's Form W-2 as both wages and tax withholding on those wages in the tax year paid. Because these tax payments are properly considered wages in the year paid, a company may not correct an overpayment based on a hypothetical tax estimate in a subsequent year.
An exception to this general rule applies when the overpayment is due to an "administrative error." Although from the employer's perspective, an overpayment of tax based on a hypothetical tax estimate may seem like an "administrative error," as the IRS details, this term is defined for employment tax purposes as an error that results in the inaccurate reporting of the amount withheld. While an employer may have overpaid tax based on the hypothetical tax estimate, the company accurately reported that overpayment in the year paid. As the overpayment does not result in a difference between the amount the employer reported as withheld and the amount actually withheld from the assignee's wages, there is no administrative error to be corrected in a subsequent year. Therefore, the employer may not seek a refund of this overpayment.
Recovery of the employer portion of FICA tax
While the company cannot recover overwithheld federal income tax that was paid on behalf of an employee through Form 941-X, the same is not true of Federal Insurance Contributions Act (FICA) tax, for which a refund or credit can be claimed by the employer in a subsequent calendar year. Prior to claiming a refund or credit for FICA tax, the company must make reasonable efforts to first repay or reimburse the employee for the employee's portion of FICA tax and secure the employee's consent for the employer to pursue the refund claim.
Additionally, the company must file a Form W-2c and Form W-3c, Transmittal of Corrected Wage and Tax Statements,with the Social Security Administration to correct the reported FICA wages. While filing a Form 941-X and issuing a Form W-2c may be administratively burdensome, especially considering that an assignee's remuneration is likely to remain above the Old-Age, Survivors, and Disability Insurance threshold even after the wage repayment, there is still an opportunity for companies to recover significant tax costs with respect to the Medicare portion of the FICA tax, which is not subject to a cap.
Recovery of overpayment via the assignee's tax return
Although recovery of the overpayment of federal income tax is not possible via Form 941-X, the employer is not without recourse, as the normal tax equalization process requires that the employee return to the employer a refund of tax that was paid by the employer on the employee's behalf. Because during the assignment the company is responsible for the assignee's actual tax liabilities, any reduction in tax on the assignee's return reduces the assignee's tax burden that the company has assumed.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.