With the fiscal cliff looming and new requirements under the Patient Protection and Affordable Care Act (PPACA) fast approaching in 2013, employee benefit professionals may need to quickly implement payroll and benefit changes. Favorable reductions in employee payroll taxes and favorable employee tax exclusions for employer-provided adoption and educational assistance expire at the end of 2012. Under PPACA, a new Medicare payroll tax and a new contribution limit to health care flexible spending accounts (FSAs) also become effective in 2013.
Given the current tax uncertainty, employers should be aware that extensions for educational assistance, adoption assistance and the 2 percent payroll tax decrease are possible if a new tax bill is enacted. However, even with a new tax bill, employers still will need to implement both the new contribution limit to health care FSAs and the new 0.9 percent Medicare payroll tax increase for high-income employees.
Social Security Payroll Taxes
The 2 percent payroll tax cut enjoyed in 2011 and 2012 will expire as of Jan. 1, 2013. This tax cut reduced the employee’s share of Social Security taxes from 6.2 percent to 4.2 percent on the first $110,100 of wages in 2012. Although the increase is on employee contributions, it also affects an employer’s withholding obligations. Furthermore, if an employer provides a "gross-up" to an employee (increasing pay to compensate for the tax), such a gross-up will be commensurately more expensive beginning in 2013.
Medicare Payroll Taxes for High-Income Earners
At the same time that the temporary 2 percent decrease in employee payroll taxes expires, a new 0.9 percent Medicare payroll tax increase applies (from 1.45 percent to 2.35 percent) under PPACA on wages over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. Although this increased tax rate is not an employer liability, employers must be prepared to withhold the additional 0.9 percent from wages for any employee with wages over dthe threshold.
Because this withholding is required on an employee’s wages over $200,000, which does not particularly correlate with an employee’s ultimate tax liability, many employees, particularly those who are married, may find that they are over-withheld or under-withheld, depending on the earnings of their spouse. For example, if a husband and wife each earn $200,000, with joint wages totaling $400,000, this couple will be under-withheld because their respective employers will withhold nothing. However, the additional 0.9 percent tax for them is owed on combined wages over $250,000, resulting in an under-withholding of $1,350 ($150,000 times 0.9 percent). In this case, the couple may owe under-withholding penalties unless they made tax withholding adjustments with their employers using IRS Form W-4 or make estimated tax payments.
Qualified Adoption Assistance
The income tax exclusion for amounts paid by an employer under a qualified adoption assistance program is also set to expire on Dec. 31, 2012. A qualified adoption assistance program allows an employer to reimburse an employee on a tax-free basis for as much as $12,650 in 2012 for expenses related to the adoption or attempted adoption of a child. Qualified adoption expenses include reasonable and necessary adoption fees, including court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging while away from home) and other expenses directly related to the legal adoption of an eligible child.
Flexible Spending Account Contributions
As dictated by PPACA, employee contributions to health care FSAs will be limited to $2,500 per year for plan years beginning in 2013. So depending on the fiscal year of the FSA plan, this lower contribution limit may start at the beginning of 2013 for some employees but start later in 2013 for other employees.
Prior to 2013, the tax code did not limit health care FSA contributions. This new limit must be documented in a flexible benefits plan by Dec. 31, 2014, regardless of the fiscal year of the flexible benefits plan, and this change must be retroactive to the beginning of the 2013 plan year.
Certain reimbursements for employer-provided educational assistance will expire at the end of 2012. Section 127 of the Internal Revenue Code allows an employer to reimburse an employee on a tax-free basis up to $5,250 for certain educational expenses provided through a non-discriminatory educational assistance program, including reimbursements for graduate school and programs that allow the employee to qualify for a new position. Even if employer-provided educational assistance programs no longer have tax subsidies in 2013, employers can still provide some type of tax-free educational reimbursements in a more limited manner if the educational reimbursements qualify as a business expense and meet certain requirements, such as enhancing the employee's performance but not qualifying the employee for a new position or career.
Action Steps for Employers
Given the current tax landscape, employers need to take the following two steps.
• Disseminate information. Employers need to advise employees of the $2,500 contribution limit on health care FSA contributions. This new limit should have been included in the employer’s 2013 open enrollment materials or other year-end employee communications. Employers also may want to advise employees of the ambiguity surrounding educational assistance and adoption assistance benefits for 2013 and the possibility of a 2 percent payroll tax increase.
• Tax and cost considerations. Employers should consider whether to take steps to alleviate some of the increased tax burden on employees. Although most employers will choose not to subsidize the increase in employee payroll taxes, employers that currently offer adoption assistance or educational assistance benefits may want to continue assisting employees with these expenses, especially for employees who are in the middle of education courses or an adoption placement at the end of 2012.
Moreover, employers could choose to continue reimbursing employees for adoption expenses on a taxable basis and choose to continue reimbursing employees for educational expenses on either a tax-free or taxable basis, depending on the specific courses selected by the employee and tax code requirements. In addition, to assist employees with the new limit on health care FSA contributions, an employer could consider increasing its subsidy toward the cost of employee health benefits. Finally, to assist high-income earners in sheltering some income from the increased Medicare tax, employers could consider accelerating and paying bonuses in 2012 that are normally paid in 2013.
With the uncertainty of the looming fiscal cliff, employers should be aware that tax extensions for educational assistance, adoption assistance and the 2 percent payroll tax decrease are possible if a new tax bill is enacted. However, even with a new tax bill, it is highly unlikely that either the new contribution limit to health care FSAs, or the new 0.9 percent Medicare payroll tax increase for high-income employees, will be altered or eliminated.
Diane Morgenthaler is a partner in the law firm of McDermott Will & Emery LLP, based in the firm’s Chicago office. She has designed and amended various types of retirement plans for private and public companies and for taxable and tax-exempt employers, including a master and prototype plan for an insurance industry client and various pension profit sharing, 401(k), cash balance, pension equity, age-weighted, money purchase and employee stock ownership plans. She is the immediate past national President of one of the largest U.S. employee benefit professional organizations, the Worldwide Employee Benefits Network.
Ruth Wimer is a partner in the law firm of McDermott Will & Emery LLP, based in the firm’s Washington, D.C., office. She focuses her practice on matters related to executive compensation, and she covers the gambit of compensation issues including employment taxes, stock options, section 162(m), section 83, deduction limitations, the entertainment disallowance and a wide variety of fringe benefits including health insurance. She spent nearly 30 years as a senior partner in the National Tax Department of a “Big Four” accounting firm, and prior to that she served as a tax law specialist with the Internal Revenue Service.
© 2012 Dermott Will & Emery LLP. All rights reserved. Republished with permission.
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