What You Need to Know About Excess Tax Withholding
March 08, 2023
One of the most common questions I am asked is whether it is permissible for companies to allow employees to request additional withholding on their stock awards. It seems like a simple yes or no question, but the answer is quite a bit more complicated.
I’m asked this question often enough that I decided it would be handy to have an article I could point members to that will hopefully address all their questions. So I wrote one: “ Excess Tax Withholding: What You Need to Know.” Everything you ever wanted to know about excess tax withholding in about 2,000 words. This blog covers a few highlights from the article. You can also check out my video "Your Guide to Excess Tax Withholding."
Why do employees request additional withholding?
The tax withholding that a company collects is merely an estimate of the employee’s tax liability. For many employees, their actual tax liability for their stock plan transactions may be significantly more than the flat rate that is normally applied to supplemental payments. No one wants to have to write a big check to the IRS at the end of the year. Moreover, where the withholding collected by the company is insufficient, employees could be subject to tax penalties.
Can companies allow employees to request additional withholding on their stock plan transactions?
The short answer is that it depends but even if you can allow it, you probably don’t want to because it’s likely to be a big hassle.
The IRS allows employees to request additional withholding on their stock plan transactions but A) only if they have received $1 million or less in supplemental payments during the year, and B) only if you agree to calculate their withholding using their Form W-4, rather than using the optional flat rate that applies to supplemental payments. Withholding at the W-4 rate is hard; you probably have better things to do with your time.
When employees have received more than $1 million in supplemental payments during the year, the company must withhold at the highest individual tax rate. No other withholding rate is permitted.
Is there official guidance from the IRS on this question?
There sure is! The IRS is concerned enough about excess withholding that they issued Information Letter 2012-0063 to address the topic (or maybe they just get as many questions about it as I do). They managed to cover the topic in about 500 fewer words than I did.
The IRS’s letter is pretty clear that they don’t want employees to request a different withholding rate without going through the W-4 process. Here is a quote from the letter:
If the employer is using the optional flat rate withholding method, the employer must withhold at the optional flat rate and cannot take into account requests by the employee that the rate be increased or lowered.
Why wouldn’t the IRS want extra withholding?
The IRS is worried employees will request additional withholding on their supplemental payments to circumvent having the appropriate amount of taxes withheld on their regular wages. The IRS doesn’t want employees to be able to purposely complete their Form W-4 in a manner that results in insufficient withholding on their regular wages and make up for this insufficiency by requesting additional withholding on their stock plan transactions. This sort of scheme constitutes tax fraud.
I sense your skepticism that any employees would do this, but I assure you that there have been incidents in which the IRS felt they had a strong enough case against individual taxpayers that they pursued enforcement.
Didn’t the FASB change the rules several years ago to make additional tax withholding permissible?
The FASB’s authority is limited to US accounting principles. The FASB doesn’t have any authority to stipulate which tax withholding procedures are permissible; they can only stipulate how to account for transactions in which taxes are withheld.
The FASB did amend ASC 718 back in 2016 to allow shares to be withheld to cover tax payments up to the maximum individual tax rate without triggering liability treatment. But this doesn’t mean that you can do so without following the process prescribed in US tax regulations. Also, as noted in my article, there are still some accounting traps to be wary of when withholding additional taxes.
What are the penalties to the company for over withholding?
State laws govern the amounts companies are permitted to deduct from employee paychecks. When companies deduct monies for which they don’t have a legal obligation or basis, they could have a liability to effected employees under state laws.
In this situation, where the withholding is at the request of employees, it seems unlikely that employees would pursue claims against the company (or, if they did, that they would be successful in their pursuit).
My general take on this question is that occasionally accommodating a request for additional withholding without requiring the employee to submit a new Form W-4 is unlikely to result in any penalties to the company. A few transactions here or there aren’t likely to be uncovered during an audit and, even if they are discovered, it’s not clear that the company would be subject to penalty.
I am more concerned about companies systematically allowing all or most employees to circumvent the process for requesting additional withholding that is prescribed by the IRS. A systematic or automated process is likely to be noticed during an audit. My sense is that most tax audits involve some amount of negotiation between the company and the auditor. If nothing else, systematically circumventing the IRS’s prescribed process here might be the sort of thing that would annoy an IRS auditor and might make the auditor less willing to negotiate on other matters that are uncovered in the audit.
In addition, the more employees that you allow to request additional withholding, the greater the chances that one of them will figure out that this is a nifty way to avoid having sufficient taxes withheld on their regular pay. I don’t think it’s wise for the company to take on the risk of inadvertently helping employees commit tax fraud.
But isn’t it true that many/most companies allow employees to request additional tax withholding?
I’ve heard this from a couple of different sources lately but I’m not aware of any factual basis for this opinion. Not only that, NASPP data indicates the exact opposite:
- Just over 60% of respondents to the NASPP/Deloitte Tax 2022 Equity Administration Survey do not allow employees to request additional withholding in any circumstances.
- Those that allow employees to request additional withholding typically only allow it in very limited circumstances.
- Only 3% allow all employees to request additional withholding and notify employees that they have this choice.
Over 300 companies answered this question in the survey, which makes this data more reliable than mere anecdotal data.
What about outside directors? Can we withhold taxes for them upon request?
Nope, nope, and nope. That is a whole separate blog entry, see “Say No to Withholding Taxes for Outside Directors."