Flat Rate Supplemental Wage Withholding, 42049-42058 [E6-11764]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 142 (Tuesday, July 25, 2006)]
[Rules and Regulations]
[Pages 42049-42058]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-11764]



[[Page 42049]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 31

[TD 9276]
RIN 1545-BD96


Flat Rate Supplemental Wage Withholding

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations amending the 
regulations that provide for determining the amount of income tax 
withholding on supplemental wages. These regulations apply to all 
employers and others making supplemental wage payments to employees. 
These regulations reflect changes in the law made by the American Jobs 
Creation Act of 2004.

DATES: Effective Date: January 1, 2007.
    Applicability Date: These regulations are applicable to payments 
made on or after January 1, 2007.

FOR FURTHER INFORMATION CONTACT: A. G. Kelley, (202) 622-6040 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 31 under sections 
3401 and 3402 of the Internal Revenue Code (Code). Section 904(b) of 
the American Jobs Creation Act of 2004 (Pub. L. 108-357, 118 Stat. 
1418) (AJCA) provided for mandatory income tax withholding at the 
highest rate of income tax in effect under section 1 of the Code to the 
extent an employee's total supplemental wages paid by the employer 
exceed $1,000,000 during the calendar year. The AJCA also provided that 
the supplemental wages paid by other businesses under common control 
would be taken into account in determining whether the employer has 
paid $1,000,000 of supplemental wages to an employee in the calendar 
year. In addition, section 904(a) of the AJCA provided that the rate 
for purposes of optional flat rate withholding on other supplemental 
wages (i.e., those supplemental wages not subject to mandatory flat 
rate withholding at the highest rate of income tax) would remain at 25 
percent, but could change if income tax rates change.
    Proposed regulations under sections 3401 and 3402 of the Code were 
published in the Federal Register on January 5, 2005 (70 FR 767, 2005-1 
C.B. 484). Written and electronic comments responding to the notice of 
proposed rulemaking were received. A public hearing was held on June 9, 
2005. After consideration of all the comments, the proposed regulations 
are adopted as amended by this Treasury decision.

Summary of Comments and Explanation of Provisions

    The final regulations reflect a balancing of two concerns: (1) In 
accordance with section 3402(a), procedures for withholding should have 
the goal of approximating the income tax liability of the employee 
receiving the wages; and (2) procedures for income tax withholding 
should not place undue administrative burdens on employers.

Definitions of Regular Wages and Supplemental Wages

    The final regulations have adopted the definitions of regular wages 
and supplemental wages provided in the proposed regulations with 
certain modifications discussed below. In response to comments on the 
proposed regulations, the final regulations also allow an employer to 
treat certain wage payments as regular wages or supplemental wages.
    The final regulations, like the proposed regulations, provide that 
supplemental wages include any wages paid by an employer that are not 
regular wages. Regular wages are defined as amounts paid by an employer 
for a payroll period either at a regular hourly rate or in a 
predetermined fixed amount. Wages that vary from payroll period to 
payroll period based on factors other than the amount of time worked, 
such as commissions, tips, and bonuses, are supplemental wages.
    The proposed regulations provided that a wage payment could qualify 
as a supplemental wage payment only if it was paid in addition to 
regular wages paid to the employee. Many commenters were concerned that 
the same type of compensation would be classified as regular or 
supplemental wages depending on whether the compensation was paid in 
addition to regular wages. Commenters also requested that payments of 
wages after the termination of employment be treated as supplemental 
wages if such payments would have been treated as supplemental wages 
prior to termination. Commenters suggested that characterizing the same 
type of compensation differently depending upon the circumstances upon 
which the payment was made unduly complicated payroll administration. 
Commenters also noted that the proposed regulations did not address the 
classification of wage payments if the employee received two or more 
types of payments that would normally be classified as supplemental 
wages, but received no regular wages.
    In response to these comments, the final regulations eliminate the 
rule that a payment can qualify as supplemental wages only if regular 
wages have been paid to the employee. Under the final regulations, 
payments that satisfy the basic definition of supplemental wages (i.e., 
all wage payments other than regular wage payments) will be 
supplemental wages regardless of whether the employee has received any 
regular wages in his or her working career with the employer. For 
example, if an employee's compensation from an employer consists of 
only income from the exercise of nonstatutory stock options and noncash 
fringe benefits, such wages will be supplemental wages for federal 
income tax withholding purposes. Similarly, if a retiree is receiving 
payments of nonqualified deferred compensation made by the employer or 
a rabbi trust, such payments will be supplemental wages regardless of 
whether the payments are made in addition to regular wage payments 
during either that calendar year or the employee's entire career with 
the employer.
    Commenters requested more flexibility for employers in determining 
whether particular types of payments are supplemental wages, such as a 
facts and circumstances test, or a default determination that amounts 
are supplemental wages where there is uncertainty regarding the correct 
classification of wages as regular or supplemental wages. Although the 
final regulations do not adopt these specific suggestions, the final 
regulations nonetheless address these concerns in other ways. As 
described below, the final regulations provide more guidance, compared 
to the proposed regulations, regarding the proper classification of 
certain types of payments as regular or supplemental wages. Also, the 
final regulations provide employers with a number of options regarding 
the treatment of certain payments that will simplify compliance with 
the requirement that the employer separately track the payment of 
supplemental wages prior to reaching the threshold for mandatory flat 
rate withholding. These features of the final regulations help to 
minimize uncertainties about the classification of particular wage 
payments.
    Commenters requested guidance on whether a number of specific types 
of payments were regular wages or supplemental wages, including shift 
differentials paid to employees on an

[[Page 42050]]

hourly basis, payments to retirees, sick pay, income from restricted 
stock awards, income from nonstatutory stock options exercised by 
former employees or retirees, amounts deferred under a retirement plan 
pursuant to a salary reduction agreement or a nonqualified deferred 
compensation plan, post-retirement or post-termination payments of 
wages that would have been treated as supplemental wages if paid prior 
to the termination of the employment relationship, and imputed income 
amounts for health insurance coverage for non-dependents. The final 
regulations have provided additional examples of supplemental wages and 
regular wages, including some of the items for which specific advice 
was requested. Other items that are not specifically included in the 
final regulations were considered to be either analogous to items 
covered or specifically covered by applicable rules.
    A commenter requested that employers be permitted to treat tips, 
overtime pay, commissions, third-party sick pay, and taxable fringe 
benefits as either supplemental wages or regular wages. The commenter 
indicated that many employers have systems in place that treat such 
payments as regular wages and wanted to continue with such systems. In 
addition, the commenter noted that tips are considered to represent a 
basic part of the compensation of many employees and that a tip credit 
is permitted against the minimum wage for Fair Labor Standards Act 
(FLSA) purposes. Also, many employees receiving overtime pay earn such 
pay each payroll period.
    In response to this comment, the final regulations permit employers 
to treat tips and/or overtime pay as regular wages. To provide 
employers with more flexibility, any such treatment is not required to 
be applied uniformly to all employees of the employer.
    The final regulations do not allow an employer to treat 
commissions, third party sick pay paid by agents of the employer, or 
taxable fringe benefits as anything other than supplemental wages. 
Commissions may vary considerably from pay period to pay period, have 
the essential characteristics of supplemental wages, and have 
historically been characterized in the existing regulations as 
supplemental wages. A longstanding regulation treats sick pay paid by 
an agent of the employer as supplemental wages and the final 
regulations have not amended that regulation in providing a definition 
of supplemental wages. Also, noncash fringe benefits have been treated 
as supplemental wages since withholding requirements with respect to 
noncash fringe benefits were set forth in response to the fringe 
benefit laws enacted by the Deficit Reduction Act of 1984. See 
Announcement 85-113, (1985-31 I.R.B. 31). With respect to supplemental 
wage payments below the threshold for mandatory flat rate withholding, 
employers may use the aggregate procedure, as described below, in 
determining the amount of withholding to produce similar withholding 
amounts as if the payments were classified as regular wages.

Procedures for Withholding on Supplemental Wages

    These regulations also interpret provisions of the AJCA relating to 
the taxation of supplemental wages.

Procedures for Withholding on Supplemental Wages of $1,000,000 or Less 
During a Calendar Year

    The final regulations continue to provide that, if an employee has 
not received cumulatively more than $1,000,000 of supplemental wages 
during the calendar year, generally there are two procedures available 
to an employer in withholding on a payment of supplemental wages: (1) 
The aggregate procedure and (2) optional flat rate withholding. Under 
the aggregate procedure, employers calculate the amount of withholding 
due by aggregating the amount of supplemental wages with the regular 
wages paid for the current payroll period or for the most recent 
payroll period of the year of the payment, and treating the aggregate 
as if it were a single wage payment for the regular payroll period.
    Optional flat rate withholding on supplemental wages (of $1,000,000 
or less cumulatively) allows employers to disregard the amount of 
regular wages paid to an employee as well as the withholding allowances 
claimed by an employee on Form W-4, ``Employee's Withholding Allowance 
Certificate,'' and use a flat percentage rate specified in the 
regulations in calculating the amount of withholding. The final 
regulations, like existing regulations and revenue rulings, continue to 
provide that optional flat rate withholding on supplemental wages is 
generally available only if (1) the employer has withheld income tax 
from regular wages paid the employee, and (2) the supplemental wages 
are either (a) not paid concurrently with regular wages or (b) 
separately stated on the payroll records of the employer.
    Commenters requested that employers be allowed to use optional flat 
rate withholding with respect to such payments to a former employee 
even if no other payments of wages were being made to the employee 
during that calendar year. Commenters believed that the requirement 
that income tax must have been withheld from the regular wages of the 
employee was unduly restrictive and noted that employers may have 
difficulty in obtaining Forms W-4 from individuals who were no longer 
employees.
    However, eliminating the requirement that income tax must have been 
withheld from regular wages paid to the employee in order for optional 
flat rate withholding to be available to the employer would exacerbate 
the problem of overwithholding on wages paid to employees. Therefore, 
the final regulations have retained the rule that income tax must have 
been withheld from the regular wages of the employee in order for 
optional flat rate withholding to be available to employers. The final 
regulations clarify that the income tax withholding requirement will be 
satisfied if income tax has been withheld from regular wages paid 
during the same year as the payment of supplemental wages or during the 
preceding calendar year. The final regulations continue to provide that 
if the supplemental wage payment is paid under the conditions 
permitting the use of optional flat rate withholding, the decision 
whether to use optional flat rate withholding rather than the aggregate 
procedure is discretionary with the employer.

Procedures for Withholding on Supplemental Wages in Excess of 
$1,000,000 Paid to One Employee in One Calendar Year

    The AJCA established different withholding rules for supplemental 
wages in excess of $1,000,000 received by an employee from an employer 
during a calendar year. The AJCA provided that, effective January 1, 
2005, employers must withhold from supplemental wages in excess of 
$1,000,000 at the highest income tax rate under section 1 of the Code.
    The final regulations provide that if the sum of a supplemental 
wage payment and all other supplemental wage payments paid by an 
employer to an employee during the calendar year exceeds $1,000,000, 
the withholding rate on the supplemental wages in excess of $1,000,000 
shall be equal to the maximum rate of tax in effect under section 1 for 
taxable years beginning in such calendar year. The maximum rate of tax 
in effect for taxable years beginning in 2005 is 35 percent. Thus, the 
mandatory flat rate for supplemental wages in excess of $1 million in a 
given taxable year is 35 percent and will

[[Page 42051]]

remain at 35 percent until income tax rates change.\1\
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    \1\ Under the sunset provision in section 901 of the Economic 
Growth and Tax Relief Reconciliation Act of 2001, the mandatory flat 
rate will change to 39.6 percent for taxable years beginning after 
December 31, 2010.
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Comments on Method for Withholding on Wages over $1,000,000

    Many commenters expressed concern that the mandatory flat rate 
withholding requirements would force them to identify whether every 
wage payment was a regular wage or a supplemental wage and to track all 
supplemental wages paid to determine whether mandatory flat rate 
withholding applied. Under prior law, treating any wage payment as a 
supplemental wage was optional for employers, and many employers 
withheld on supplemental wages under the aggregate procedure and thus 
were not required to identify whether payments were regular wages or 
supplemental wages. Commenters were concerned about the cost and burden 
of implementing a system to track whether payments were regular wages 
or supplemental wages, especially if only a few employees would have 
wages subject to mandatory flat rate withholding. While the IRS and 
Treasury Department appreciate the potential burden created by the need 
to distinguish between regular and supplemental wages in order to 
comply with the requirements of section 904(b) of the AJCA, section 
904(b) mandates flat rate withholding only for supplemental wages in 
excess of $1,000,000. The IRS and Treasury Department request 
additional comments on how any burden could be mitigated while taking 
into account the scope of section 904(b) and the rules provided in 
section 3402 of the Code which describe the circumstances under which 
employees provide withholding exemption certificates, and employers 
must follow them in implementing withholding. For example, the IRS and 
Treasury Department are interested in views on whether it should permit 
employers to withhold at the mandatory flat rate on any amount of total 
wages (both regular and supplemental) that exceeds $1,000,000.

Special Rules for Determining Applicability of Mandatory Flat Rate 
Withholding

    A commenter also requested that an employer be permitted to treat 
any supplemental wage payment as subject to mandatory flat rate 
withholding whenever it is anticipated the employee's supplemental 
wages for the year are approaching the $1,000,000 threshold. To address 
these concerns, the final regulations and the revenue procedure provide 
employers with a number of options in determining whether supplemental 
wages in excess of $1,000,000 have been paid to an employee during the 
calendar year.
    One commenter suggested that guidance was needed as to the 
calculation of the amount of noncash fringe benefits to be included in 
supplemental wages for purposes of determining whether the $1,000,000 
threshold for mandatory flat rate withholding has been reached. With 
respect to the determination of the amount of supplemental wages for 
purposes of the mandatory flat rate withholding, the regulations are 
not intended to require different calculations of the amount of wages 
than would normally apply in determining the amount of wages subject to 
withholding. Thus, currently applicable procedures for the calculation 
of noncash fringe benefits of an employee (see Announcement 85-113, 
which provides employers with special accounting rules that they may 
use to determine the amount of noncash fringe benefits that are wages 
subject to income tax withholding) will continue to apply in 
determining the amount of supplemental wages for purposes of the 
mandatory flat rate withholding. If the noncash fringe benefit amounts 
are not wages subject to income tax withholding, then they are not 
included in regular wages or supplemental wages.
    A commenter suggested that specific guidance was needed concerning 
whether disqualifying dispositions of shares of stock acquired pursuant 
to the exercise of statutory stock options are taken into account as 
supplemental wages for purposes of determining whether the $1,000,000 
threshold has been reached. Such income is not wages subject to federal 
income tax withholding. The final regulations specifically provide that 
income from disqualifying dispositions of shares of stock acquired 
pursuant to the exercise of statutory stock options is not included in 
supplemental wages.
    A commenter also requested that, for purposes of determining 
whether an employee has received $1,000,000 of supplemental wages, an 
employer should be allowed to treat amounts included in Box 1 of Form 
W-2, ``Wage and Tax Statement'' as ``wages, tips, other compensation'' 
as supplemental wages. Items reportable in Box 1 of Form W-2 include 
items that are not subject to income tax withholding. Nevertheless, in 
the interest of making the rules administrable for employers, the 
regulations provide that employers can treat such amounts as 
supplemental wages.
    A commenter requested that, in determining whether the employee has 
received $1,000,000 of supplemental wages, employers should be allowed 
to take into account the gross amount of a supplemental wage payment 
including any pretax deductions that are attributable to such 
supplemental wages. However, pretax deductions, including salary 
reduction deferrals, are not includible in gross income for the taxable 
year and are not wages subject to income tax withholding. Therefore, 
the IRS and Treasury Department have not adopted this proposal.
    Mandatory flat rate withholding applies only to the excess of 
supplemental wages over $1,000,000 received by an employee from an 
employer, taking into consideration all payments of supplemental wages 
made by an employer to an employee. Therefore, the new mandatory flat 
rate withholding on supplemental wages in excess of $1,000,000 can 
apply to all of a payment or only a portion of the payment.
    The proposed regulations provided that if a particular supplemental 
wage payment results in an employee exceeding the $1,000,000 
supplemental wage threshold, mandatory flat rate withholding will apply 
to the extent that the payment, together with other supplemental wage 
payments previously made to the employee during the year, is in excess 
of $1,000,000. Because this provision could result in an employer 
having to treat two portions of a single supplemental wage payment 
under different withholding regimes, commenters requested that 
employers be permitted to elect to treat the entire amount of the 
payment that results in supplemental wage payments to the employee 
exceeding $1,000,000 as subject to mandatory flat rate withholding. 
Commenters also requested that to avoid having the mandatory flat rate 
withholding apply only to the portion of a supplemental wage payment 
that exceeds $1,000,000, employers be allowed to apply the mandatory 
rate only to payments after the payment which causes the employee to 
have received $1,000,000 or more of supplemental wages.
    The IRS and Treasury Department concluded this latter approach 
could not be reconciled with the statute. Section 904(b) of the AJCA 
provides that ``if the supplemental wage payment, when added to all 
such payments previously made by the employer to the employee during 
the calendar year, exceeds $1,000,000, the rate used with respect to 
such excess shall be equal to

[[Page 42052]]

the maximum rate of tax * * *.'' Accordingly, the final regulations 
continue with the rule that, if a supplemental wage payment results in 
the total supplemental wage payments to the employee from the employer 
during the calendar year exceeding $1,000,000, the amount of that 
payment in excess of $1,000,000 (when added to the supplemental wage 
payments previously made in the calendar year) is subject to mandatory 
flat rate withholding. The final regulations, however, permit employers 
to treat the entire amount of the payment that results in the employee 
receiving total supplemental wages of more than $1,000,000 as subject 
to mandatory flat rate withholding. This treatment can apply on an 
employee-by-employee basis.
    A commenter requested that guidance be provided as to the 
calculation of supplemental wages for purposes of determining the 
applicability of mandatory flat rate withholding in a situation where 
salary reduction deferral amounts are deferred from either gross 
regular wage payments or gross supplemental wage payments to the 
employee. The commenters requested flexibility in allocating such 
deferrals. However, in order to apply mandatory flat rate withholding 
on a consistent basis, payments of wages must be correctly identified 
as either regular wages or supplemental wages. Therefore, the final 
regulations provide that, in determining the amount of supplemental 
wages paid, salary deferral amounts are allocated to the gross regular 
wage payments or to the gross supplemental wage payments from which 
they are actually deducted. For example, if an employee had a valid 
salary reduction agreement deferring 10 percent of all salary and 
bonuses, and the employee had received wage payments based on 
$1,500,000 of gross salary and $1,000,000 of gross bonuses prior to 
reduction for the deferrals (and no other wages), the employer would 
allocate $150,000 to the gross regular wage payment and $100,000 to the 
gross supplemental wage payment. Thus, for purposes of the mandatory 
flat rate withholding, the example employee has received $900,000 of 
supplemental wages.

Taking Into Account Payments by Agents of Employers in Determining 
Applicability of Mandatory Flat Rate Withholding

    In determining whether the supplemental wages paid by an employer 
to an employee in a given taxable year exceed $1,000,000, the proposed 
regulations provided that an employer (the first employer) must 
consider wage payments made to the employee by any other person treated 
as a single employer with the first employer under section 52(a) or 
52(b). Furthermore, if an employer enlists a third party to make a 
payment to an employee on the employer's behalf, the payment will be 
considered as made by the employer even though it may have been 
delivered to the employee by the third party.
    Commenters expressed the view that employers should not be required 
to count supplemental wage payments made by third party agents in 
determining whether the $1,000,000 supplemental wage threshold has been 
met. Although the AJCA did not specifically address whether 
supplemental wage payments made by employers through agents must be 
considered in determining the applicability of mandatory flat rate 
withholding, requiring that such wages be taken into account is 
consistent with the purpose of the legislation to impose income tax 
withholding on a basis that is more consistent with income tax 
liability. Failure to consider payments made by agents of an employer 
would create an inconsistency in the application of mandatory flat rate 
withholding based on the type of payment systems that employers choose 
to put in place. Thus, the final regulations retain the rule of the 
proposed regulations requiring that payments made by agents of the 
employers must be considered in determining the applicability of 
mandatory flat rate withholding (with the exception of certain payments 
discussed below).
    A commenter requested that common law employers be allowed to 
disregard payments made by agents if the payments would be unlikely to 
trigger the mandatory flat rate withholding. The commenter noted the 
administrative burden imposed if a third party agent were required to 
coordinate every payment with the employer to determine whether the 
employee has received $1,000,000 of supplemental wages. The commenter 
requested that agents be allowed to presume that mandatory flat rate 
withholding does not apply until year-to-date payments that they 
themselves make to a particular worker exceed $100,000. Also, the 
commenter requested that employers be allowed to presume that the 
mandatory flat rate withholding does not apply until year-to-date 
payments that the employer makes to a particular worker, without regard 
to payments made by a third party payer, exceed $500,000.
    In order to provide relief with respect to payments made by agents, 
the final regulations provide a de minimis rule exception. An agent 
making total wage payments, including regular and supplemental wages, 
of less than $100,000 to an individual in any calendar year may 
disregard other supplemental wages from the common law employer or any 
other agent of the employer that would subject the employee to 
mandatory flat rate withholding. Similarly, an employer may disregard 
supplemental wage payments made by an agent to an employee in 
determining whether the employee has reached the $1,000,000 threshold 
if the agent has made total wage payments of less than $100,000 to the 
employee during the calendar year. If an agent does reach the $100,000 
threshold of wages paid to a single employee in a calendar year, then 
the employer, in determining the applicability of mandatory flat rate 
withholding, must take into account all supplemental wages paid by the 
agent in determining whether mandatory flat rate withholding applies to 
a wage payment made after the agent reaches the $100,000 threshold. 
Similarly, with the payment that reaches the $100,000 threshold, the 
agent who has made $100,000 of wage payments to an employee during a 
calendar year, is required to take into account all wages paid by the 
employer and any other agent of the employer who has reached the 
$100,000 threshold in determining the applicability of mandatory flat 
rate withholding. This de minimis rule is subject to an anti-abuse 
rule, in that it does not apply to the employer in situations where the 
employer has created an arrangement or arrangements with five or more 
agents if a principal effect of the arrangement or arrangements is to 
reduce applicable mandatory flat rate withholding with respect to an 
employee. Application of the de minimis rule is optional. An employer 
may take into account all supplemental wages paid by agents, regardless 
of how small the payments are from any particular agent, in determining 
whether the employee has received $1,000,000 of supplemental wages 
during the calendar year. Similarly, an agent is not required to apply 
the de minimis rule.

Rates Applicable for Purposes of Optional Flat Rate Withholding

    The final regulations change the optional flat rate withholding on 
supplemental wages to provide that the 20 percent rate applies only to 
supplemental wages paid prior to January 1, 1994. The rate of 28 
percent

[[Page 42053]]

applies to supplemental wages paid after December 31, 1993, and on or 
before August 6, 2001. The Revenue Reconciliation Act of 1993, as 
amended by the Economic Growth and Tax Relief Reconciliation Act of 
2001, provides that the supplemental withholding rate shall not be less 
than the third lowest rate of tax applicable under section 1(c) of the 
Code for wages paid after August 6, 2001, and before January 1, 2005. 
Consistent with this amendment, the regulations provide that the rate 
of 27.5 percent applies to supplemental wages paid after August 6, 
2001, and on or before December 31, 2001, the rate of 27 percent 
applies to wages paid after December 31, 2001, and on or before May 27, 
2003, and the rate of 25 percent applies to wages paid after May 27, 
2003, and on or before December 31, 2004.
    One commenter suggested that optional flat rate withholding for 
wages paid after December 31, 2002, and on or before May 27, 2003, 
should be 25 percent. The law in effect at the time as enacted by the 
Economic Growth and Tax Relief Reconciliation Act of 2001 provided that 
the supplemental withholding rate ``shall not be less than the third 
lowest rate of tax applicable under section 1(c) of the Internal 
Revenue Code of 1986.'' The commenter stated that the optional flat 
rate withholding should be 25 percent because the Jobs and Growth Tax 
Relief Reconciliation Act of 2003 provided that the third lowest rate 
of tax under section 1(c) of the Code after December 31, 2002, would be 
25 percent. However, this provision changing the third lowest rate of 
income tax rate to 25 percent was not enacted into law until May 28, 
2003. Thus, at the time of payments of supplemental wages made after 
December 31, 2002, and prior to May 28, 2003, the third lowest rate of 
tax under section 1(c) was 27 percent. As noted in the preamble to the 
proposed regulations, the IRS and Treasury Department believe that the 
27 percent rate for this period is consistent with the general 
principle that the employment taxation of wage payments is determined 
based on the rates in effect at the date the wages are paid. United 
States v. Cleveland Indians Baseball Co., 532 U.S. 200 (2001). 
Therefore, the final regulations continue to provide that the optional 
flat rate withholding for wages paid after December 31, 2002, and prior 
to May 28, 2003, was 27 percent.
    For 2006, the optional flat rate withholding for supplemental wages 
of $1,000,000 or less in a given taxable year is 25 percent. The 
optional flat rate withholding will remain at 25 percent until income 
tax rates change.\2\
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    \2\ Under current law, section 1(i)(2) will not be applicable to 
taxable years beginning after December 31, 2010, pursuant to the 
sunset provisions contained in section 901 of the Economic Growth 
and Tax Relief Reconciliation Act of 2001 (Pub. L. 107-16; 115 Stat. 
150). See also section 107 of Public Law 108-27 (117 Stat. 755). 
Absent legislative action, the optional flat rate will change to 28 
percent in 2011.
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Application of Mandatory Flat Rate Withholding Regardless of Employee's 
Personal Income Tax Liability

    Commenters requested that the final regulations provide an 
exception from mandatory flat rate withholding when the employee 
receiving the supplemental wage amount will be eligible to take an 
offsetting income tax credit or an offsetting income tax deduction, but 
no exception from the definition of wages for income tax withholding 
purposes applies. Commenters noted that some foreign countries impose 
foreign income tax but not foreign income tax withholding on 
supplemental wage payments made to United States employees who are 
based in and working in those foreign countries. If an employer is not 
required by foreign law to withhold foreign income tax from a 
supplemental wage payment, the exception from wages provided by section 
3401(a)(8)(A)(ii) of the Code does not apply. However, the payment may 
be subject to foreign income tax and the employee may be eligible for a 
foreign income tax credit that could offset any liability for United 
States income tax. The commenters requested that the regulations 
provide an exception for United States residents or citizens who are 
working overseas and receive supplemental wage payments that are 
subject to foreign income tax, but not foreign income tax withholding.
    Another commenter noted that an employee may be required by the 
terms of a divorce decree to pay the entire amount of a bonus to a 
former spouse and may be eligible to take an alimony deduction with 
respect to the transfer to the former spouse. This commenter suggested 
that the IRS and Treasury Department create an administrative exception 
from mandatory flat rate withholding that would apply if the employee 
submits a Form W-4 establishing that the employee will be entitled to 
an offsetting income tax deduction with respect to the supplemental 
wage payment.
    In enacting the requirement for mandatory flat rate withholding, 
Congress made clear its intent to override the withholding that would 
apply pursuant to the employee's elections on the Form W-4 with 
withholding at a specific statutorily prescribed rate. To provide 
exceptions for tax credits or deductions that an employee would expect 
to receive would require the employer to give the employee's Form W-4 
or some other document from the employee precedence over the statutory 
mandate. Moreover, although the commenters are suggesting limiting the 
exceptions to circumstances in which specific credible claims for 
credits or deductions can be made, implementation of such proposals 
would require the employer to vet claims made by individual employees 
about their tax circumstances. The IRS and Treasury Department decline 
to adopt the suggestions made by the commenters because they are 
contrary to statutory intent and would require the employer to assume a 
role in assessing employees' tax circumstances that employers cannot 
and should not be asked to perform.

Effective Date of Regulations

    Many commenters stated that making the changes to their payroll 
systems necessary to comply with mandatory flat rate withholding would 
take time and require testing. Of particular concern was the 
coordination of payments by agents. In response to these comments, the 
final regulations will be effective with respect to wages paid on or 
after January 1, 2007. This will give employers time to implement any 
programming and coordination required by the final regulations.
    A commenter also asked for permanent relief from mandatory flat 
rate withholding and related reporting and withholding penalties and 
interest if the employer (or third party payer) makes reasonable, good 
faith efforts to comply with the new requirements. Because Congress 
established this withholding as mandatory, it would be inconsistent 
with the statute to provide permanent relief from liability for the 
mandatory flat rate withholding.

Special Analyses

    It has been determined that these final regulations are not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply, and therefore,

[[Page 42054]]

a Regulatory Flexibility Analysis is not required. Pursuant to section 
7805(f) of the Code, the proposed regulations preceding these 
regulations were submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on the impact on small 
business.

Drafting Information

    The principal author of these regulations is A. G. Kelley, Office 
of Division Counsel/Associate Chief Counsel (Tax Exempt and Government 
Entities). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 31

    Employment taxes, Income taxes, Penalties, Pensions, Railroad 
retirement, Reporting and recordkeeping requirements, Social security, 
Unemployment compensation.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 31 is amended as follows:

PART 31--EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

0
Paragraph 1. The authority citation to part 31 is amended by adding an 
entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 31.3402(n)-1 also issued under 26 U.S.C. 6001, 6011 and 
6364. * * *


0
Par. 2. Section 31.3401(a)-1 is amended by revising paragraph 
(b)(8)(i)(b)(2) to read as follows:


Sec.  31.3401(a)-1  Wages.

* * * * *
    (b) * * *
    (8) * * *
    (i) * * *
    (b) * * *
    (2) Payments made by agents subject to this paragraph are 
supplemental wages as defined in Sec.  31.3402(g)-1, and are therefore 
subject to the rules regarding withholding tax on supplemental wages 
provided in Sec.  31.3402(g)-1. For purposes of those rules, unless the 
agent is also an agent for purposes of withholding tax from the 
employee's regular wages, the agent may deem tax to have been withheld 
from regular wages paid to the employee during the calendar year.
* * * * *

0
Par. 3. Section 31.3401(a)-4 is amended by revising paragraph (c) to 
read as follows:


Sec.  31.3401(a)-4  Reimbursements and other expense allowance amounts.

* * * * *
    (c) Withholding rate. Payments made under reimbursement or other 
expense allowance arrangements that are subject to income tax 
withholding are supplemental wages as defined in Sec.  31.3402(g)-1. 
Accordingly, withholding on such supplemental wages is calculated under 
the rules provided with respect to supplemental wages in Sec.  
31.3402(g)-1.
* * * * *

0
Par. 4. Section 31.3402(g)-1 is amended by:
0
1. Revising paragraph (a).
0
2. Adding a sentence at the beginning of paragraph (b)(1).
0
3. Revising paragraph (b)(2).
    The revisions and addition read as follows:


Sec.  31.3402(g)-1  Supplemental wage payments.

    (a) In general and withholding on supplemental wages in excess of 
$1,000,000--(1) Determination of supplemental wages and regular wages--
(i) Supplemental wages. An employee's remuneration may consist of 
regular wages and supplemental wages. Supplemental wages are all wages 
paid by an employer that are not regular wages. Supplemental wages 
include wage payments made without regard to an employee's payroll 
period, but also may include payments made for a payroll period. 
Examples of wage payments that are included in supplemental wages 
include reported tips (except as provided in paragraph (a)(1)(v) of 
this section), overtime pay (except as provided in paragraph (a)(1)(iv) 
of this section), bonuses, back pay, commissions, wages paid under 
reimbursement or other expense allowance arrangements, nonqualified 
deferred compensation includible in wages, wages paid as noncash fringe 
benefits, sick pay paid by a third party as an agent of the employer, 
amounts that are includible in gross income under section 409A, income 
recognized on the exercise of a nonstatutory stock option, wages from 
imputed income for health coverage for a non-dependent, and wage income 
recognized on the lapse of a restriction on restricted property 
transferred from an employer to an employee. Amounts that are described 
as supplemental wages in this definition are supplemental wages 
regardless of whether the employer has paid the employee any regular 
wages during either the calendar year of the payment or any prior 
calendar year. Thus, for example, if the only wages that an employer 
has ever paid an employee are payments of noncash fringe benefits and 
income recognized on the exercise of a nonstatutory stock option, such 
payments are classified as supplemental wages.
    (ii) Regular wages. As distinguished from supplemental wages, 
regular wages are amounts that are paid at a regular hourly, daily, or 
similar periodic rate (and not an overtime rate) for the current 
payroll period or at a predetermined fixed determinable amount for the 
current payroll period. Thus, among other things, wages that vary from 
payroll period to payroll period (such as commissions, reported tips, 
bonuses, or overtime pay) are not regular wages, except that an 
employer may treat tips as regular wages under paragraph (a)(1)(v) of 
this section and an employer may treat overtime pay as regular wages 
under paragraph (a)(1)(iv) of this section.
    (iii) Amounts that are not wages subject to income tax withholding. 
If an amount of remuneration is not wages subject to income tax 
withholding, it is neither regular wages nor supplemental wages. Thus, 
for example, income from the disqualifying dispositions of shares of 
stock acquired pursuant to the exercise of statutory stock options, as 
described in section 421(b), is not included in regular wages or 
supplemental wages.
    (iv) Optional treatment of overtime pay as regular wages. Employers 
may treat overtime pay as regular wages rather than supplemental wages. 
For this purpose, overtime pay is defined as any pay required to be 
paid pursuant to federal (Fair Labor Standards Act), state, or local 
governmental laws at a rate higher than the normal wage rate of the 
employee because the employee has worked hours in excess of the number 
of hours deemed to constitute a normal work week or work day.
    (v) Optional treatment of tips as regular wages. Employers may 
treat tips as regular wages rather than supplemental wages. For this 
purpose, tips are defined as including all tips which are reported to 
the employer pursuant to section 6053.
    (vi) Amount to be withheld. The calculation of the amount of the 
income tax withholding with respect to supplemental wage payments is 
provided for under paragraph (a)(2) through (a)(7) of this section.
    (2) Mandatory flat rate withholding. If a supplemental wage 
payment, when added to all supplemental wage payments previously made 
by one employer (as defined in paragraph (a)(3) of this section) to an 
employee during the calendar year, exceeds $1,000,000, the rate used in 
determining the amount

[[Page 42055]]

of withholding on the excess (including any excess which is a portion 
of a supplemental wage payment) shall be equal to the highest rate of 
tax applicable under section 1 for such taxable years beginning in such 
calendar year. This flat rate shall be applied without regard to 
whether income tax has been withheld from the employee's regular wages, 
without allowance for the number of withholding allowances claimed by 
the employee on Form W-4, ``Employee's Withholding Allowance 
Certificate,'' without regard to whether the employee has claimed 
exempt status on Form W-4, without regard to whether the employee has 
requested additional withholding on Form W-4, and without regard to the 
withholding method used by the employer. Withholding under this 
paragraph (a)(2) is mandatory flat rate withholding.
    (3) Certain persons treated as one employer--(i) Persons under 
common control. For purposes of paragraph (a)(2) of this section, all 
persons treated as a single employer under subsection (a) or (b) of 
section 52 shall be treated as one employer.
    (ii) Agents. For purposes of paragraph (a)(2) of this section, any 
payment made to an employee by a third party acting as an agent for the 
employer (regardless of whether such person shall have been designated 
as an agent pursuant to section 3504) shall be considered as made by 
the employer except as provided in paragraph (a)(4)(iii) of this 
section.
    (4) Treatment of certain items in determining applicability of 
mandatory flat rate withholding--(i) Optional treatment of compensation 
not subject to income tax withholding. For purposes of paragraph (a)(2) 
of this section, employers may determine whether an employee has 
received $1,000,000 of supplemental wages during a calendar year by 
including in supplemental wages amounts includible in income but not 
subject to withholding that are reported as wages, tips, other 
compensation on Form W-2.
    (ii) Allocation of salary reduction deferrals. In allocating salary 
reduction deferral amounts excludable from wages for purposes of 
determining whether the employer has paid $1,000,000 of supplemental 
wages under paragraph (a)(2) of this section, employers must allocate 
such salary reduction deferral amounts to the type of compensation 
(i.e., gross amounts of regular wage payments or gross amounts of 
supplemental wage payments) actually being deferred.
    (iii) Optional de minimis exception for certain payments by agents. 
For purposes of paragraph (a)(2) of this section, if an agent makes 
total wage payments (including regular wages and supplemental wages) of 
less than $100,000 to an individual during any calendar year, an 
employer or other agent may disregard such payments in determining 
whether the individual has received $1,000,000 of supplemental wages 
during the calendar year, and such agent need not consider whether the 
individual has received other supplemental wages in determining the 
amount of income tax to be withheld from the payments. An employer may 
not avail itself of this exception if the employer is making payments 
to the employee using five or more agents and a principal effect of 
such use of agents is to reduce the applicability of mandatory flat 
rate withholding to the employee. For purposes of paragraph (a)(2) of 
this section, if an agent makes total wage payments of $100,000 or more 
to an individual during any calendar year, the entire amount of 
supplemental wages paid by the agent during the calendar year to the 
employee must be taken into account (by other agents of the employer 
that make total wage payments to the employee of $100,000 or more, by 
the agent, and by the employer for which the agent is acting) in 
determining whether the employee has received $1,000,000 of 
supplemental wages.
    (iv) Treatment of supplemental wage payment exceeding $1,000,000 
cumulative threshold. In the case of a supplemental wage payment that, 
when added to all supplemental wage payments previously made by the 
employer to the employee in the calendar year, results in the employee 
having received in excess of $1,000,000 supplemental wages for the 
calendar year, the employer is required to impose withholding under 
paragraph (a)(2) of this section only on the portion of the payment 
that is in excess of $1,000,000 (taking into account all prior 
supplemental wage payments during the year). However, an employer may 
subject the entire amount of such supplemental wage payment to the 
withholding imposed by paragraph (a)(2) of this section.
    (5) Withholding on supplemental wages that are not subject to 
mandatory flat rate withholding. To the extent that paragraph (a)(2) of 
this section does not apply to a supplemental wage payment (or a 
portion of a payment), the amount of the tax required to be withheld on 
the supplemental wages when paid shall be determined under the rules 
provided in paragraphs (a)(6) and (7) of this section.
    (6) Aggregate procedure for withholding on supplemental wages--(i) 
Applicability. The employer is required to determine withholding upon 
supplemental wages under this paragraph (a)(6) if paragraph (a)(2) of 
this section does not apply to the payment or portion of the payment 
and if paragraph (a)(7) of this section may not be used with respect to 
the payment. In addition, employers have the option of using this 
paragraph (a)(6) to calculate withholding with respect to a 
supplemental wage payment, if paragraph (a)(2) of this section does not 
apply to the payment, but if paragraph (a)(7) of this section could be 
used with respect to the payment.
    (ii) Procedure. Provided this procedure applies under paragraph 
(a)(6)(i) of this section, the supplemental wages, if paid concurrently 
with wages for a payroll period, are aggregated with the wages paid for 
such payroll period. If not paid concurrently, the supplemental wages 
are aggregated with the wages paid or to be paid within the same 
calendar year for the last preceding payroll period or for the current 
payroll period, if any. The amount of tax to be withheld is determined 
as if the aggregate of the supplemental wages and the regular wages 
constituted a single wage payment for the regular payroll period. The 
withholding method used by the employer with respect to regular wages 
would then be used to calculate the withholding on this single wage 
payment and the employer would take into consideration the Form W-4 
submitted by the employee. This procedure is the aggregate procedure 
for withholding on supplemental wages.
    (7) Optional flat rate withholding on supplemental wages--(i) 
Applicability. The employer may determine withholding upon supplemental 
wages under this paragraph (a)(7) if three conditions are met--
    (A) Paragraph (a)(2) of this section does not apply to the payment 
or the portion of the payment;
    (B) The supplemental wages are either not paid concurrently with 
regular wages or are separately stated on the payroll records of the 
employer; and
    (C) Income tax has been withheld from regular wages of the employee 
during the calendar year of the payment or the preceding calendar year.
    (ii) Procedure. The determination of the tax to be withheld under 
paragraph (a)(7)(iii) of this section is made without reference to any 
payment of regular wages, without allowance for the number of 
withholding allowances claimed by the employee on Form W-4, and without 
regard to whether the employee has requested additional withholding on 
Form W-4. Withholding

[[Page 42056]]

under this procedure is optional flat rate withholding.
    (iii) Rate applicable for purposes of optional flat rate 
withholding. Provided the conditions of paragraph (a)(7)(i) of this 
section have been met, the employer may determine the tax to be 
withheld--
    (A) From supplemental wages paid after April 30, 1966, and prior to 
January 1, 1994, by using a flat percentage rate of 20 percent;
    (B) From supplemental wages paid after December 31, 1993, and on or 
before August 6, 2001, by using a flat percentage rate of 28 percent;
    (C) From supplemental wages paid after August 6, 2001, and on or 
before December 31, 2001, by using a flat percentage rate of 27.5 
percent;
    (D) From supplemental wages paid after December 31, 2001, and on or 
before May 27, 2003, by using a flat percentage rate of 27 percent;
    (E) From supplemental wages paid after May 27, 2003, and on or 
before December 31, 2004, by using a flat percentage rate of 25 
percent; and
    (F) From supplemental wages paid after December 31, 2004, by using 
a flat percentage rate of 28 percent (or the corresponding rate in 
effect under section 1(i)(2) for taxable years beginning in the 
calendar year in which the payment is made).
    (8) Examples. For purposes of these examples, it is assumed that 
the rate for purposes of mandatory flat rate withholding for 2007 is 35 
percent, and the rate for purposes of optional flat rate withholding 
for 2007 is 25 percent. The following examples illustrate this 
paragraph (a):

    Example 1. (i) Employee A is an employee of three entities (X, 
Y, and Z) that are treated as a single employer under section 52(a) 
or (b). In 2007, X pays regular wages to A on a monthly payroll 
period for services performed for X, Y, and Z. The regular wages are 
paid on the third business day of each month. Income tax is withheld 
from the regular wages of A during the year. A receives only the 
following supplemental wage payments during 2007 in addition to the 
regular wages paid by X--
(A) A bonus of $600,000 from X on March 15, 2007;
(B) A bonus of $2,300,000 from Y on November 15, 2007; and
(C) A bonus of $10,000 from Z on December 31, 2007.
    (ii) In this Example 1, the $600,000 bonus from X is a 
supplemental wage payment. The withholding on the $600,000 payment 
from X could be determined under either paragraph (a)(6) or (7) of 
this section because income tax has been withheld from the regular 
wages of A. If X elects to use the aggregate procedure under 
paragraph (a)(6) of this section, the amount of withholding on the 
supplemental wages would be based on aggregating the supplemental 
wages and the regular wages paid by X either for the current or last 
payroll period and treating the total of the regular wages paid by X 
and the $600,000 supplemental wages as a single wage payment for a 
regular payroll period. The withholding method used by the employer 
with respect to regular wages would then be used to calculate the 
withholding on this single wage payment, and the employer would take 
into consideration the Form W-4 furnished by the employee.
    (iii) In this Example 1, the $2,300,000 bonus from Y is a 
supplemental wage payment. To calculate the withholding on the 
$2,300,000 supplemental wage payment from Y, the $600,000 of 
supplemental wages X has already paid to A in 2007 must be taken 
into account because X and Y are treated as the same employer under 
section 52(a) or (b). Thus, the withholding on the first $400,000 of 
the payment (i.e., the cumulative supplemental wages not in excess 
of $1,000,000) is computed separately from the withholding on the 
remaining $1,900,000 of the payment (i.e., the amount of the 
cumulative supplemental wages in excess of $1,000,000). With respect 
to the first $400,000, the withholding could be computed under 
either paragraph (a)(6) or (a)(7) of this section, because income 
tax has been withheld from the regular wages of the employee. If Y 
elected to withhold income tax using paragraph (a)(7) of this 
section, Y would withhold on the $400,000 component at 25 percent 
(pursuant to paragraph (a)(7)(ii)(F) of this section), which would 
result in $100,000 tax withheld. The remaining $1,900,000 of the 
bonus would be subject to mandatory flat rate withholding at the 
maximum rate of tax in effect under section 1 for 2007 (35%) without 
regard to the Form W-4 submitted by A. The amount withheld from the 
$1,900,000 would be $665,000. The withholding on the first component 
and the withholding on the second component then would be added 
together to determine the total income tax withholding on the 
supplemental wage payment from Y. Alternatively, under paragraph 
(a)(4)(iv) of this section, Y could treat the entire $2,300,000 
bonus payment as subject to mandatory flat rate withholding at the 
maximum rate of tax (35%), in which case the amount to be withheld 
would be 35 percent of $2,300,000, or $805,000.
    (iv) The $10,000 bonus paid from Z is also a supplemental wage 
payment. To calculate the withholding on the $10,000 bonus, the 
$2,900,000 in cumulative supplemental wages already paid to A in 
2007 by X and Y must be taken into account because X, Y, and Z are 
treated as a single employer. The entire $10,000 bonus would be 
subject to mandatory flat rate withholding at the maximum rate of 
tax in effect under section 1 for 2007. The income tax required to 
be withheld on this payment would be 35 percent of $10,000 or 
$3,500.

    Example 2. Employees B and C work for employer M. Each employee 
receives a monthly salary of $3,000 in 2007. As a result of the 
withholding allowances claimed by B, there has been no income tax 
withholding on the regular wages M pays to B during either 2007 or 
2006. In contrast, M has withheld income tax from regular wages M 
pays to C during 2007. Together with the monthly salary check paid 
in December 2007 to each employee, M includes a bonus of $2,000, 
which is the only supplemental wage payment each employee receives 
from M in 2007. The bonuses are separately stated on the payroll 
records of M. Because M has withheld no income tax from B's regular 
wages during either the calendar year of the $2,000 bonus or the 
preceding calendar year, M cannot use optional flat rate withholding 
provided under paragraph (a)(7) of this section to calculate the 
income tax withholding on B's $2,000 bonus. Consequently, M must use 
the aggregate procedure set forth in paragraph (a)(6) of this 
section to calculate the income tax withholding due on the $2,000 
bonus to B. With respect to the bonus paid to C, M has the option of 
using either the aggregate procedure provided under paragraph (a)(6) 
of this section or the optional flat rate withholding provided under 
paragraph (a)(7) of this section to calculate the income tax 
withholding due.

    Example 3. (i) Employee D works as an employee of Corporation R. 
Corporations R and T are treated as a single employer under section 
52(a) or (b). R makes regular wage payments to Employee D of 
$200,000 on a monthly basis in 2007, and income tax is withheld from 
those wages. R pays D a bonus for his services as an employee equal 
to $3,000,000 on June 30, 2007. Unrelated company U pays D sick pay 
as an agent of the employer R and such sick pay is supplemental 
wages pursuant to Sec.  31.3401(a)-1(b)(2). U pays D $50,000 of sick 
pay on October 31, 2007. Corporation T decides to award bonuses to 
all employees of R and T, and pays a bonus of $100,000 to D on 
December 31, 2007. D received no other payments from R, T, or U.
    (ii) In chronological summary, D is paid the following wages 
other than the regular monthly wages paid by R:
(A) June 30, 2007--$3,000,000 (bonus from R);
(B) October 31, 2007--$50,000 (sick pay from U); and
(C) December 31, 2007--$100,000 (bonus from T).
    (iii) In this Example 3, each payment of wages other than the 
regular monthly wage payments from R is considered to be 
supplemental wages for purposes of withholding under Sec.  
31.3402(g)-1(a)(2). The amount of regular wages from R is irrelevant 
in determining when mandatory flat rate withholding on supplemental 
wages must be applied.
    (iv) Because income tax has been withheld on D's regular wages, 
income tax may be withheld on $1,000,000 of the $3,000,000 bonus 
paid on June 30, 2007, under either paragraph (a)(6) or (7) of this 
section. If R elects to use optional flat rate withholding provided 
under paragraph (a)(7)(ii)(F) of this section, withholding would be 
calculated at 25 percent of the $1,000,000 portion of the payment 
and would be $250,000.
    (v) Income tax withheld on the following supplemental wage 
payments (or portion of a payment) as follows is required to be

[[Page 42057]]

calculated at the maximum rate in effect under section 1, or 35 
percent in 2007--
(A) $2,000,000 of the $3,000,000 bonus paid by R on June 30, 2007; 
and
(B) all of the $100,000 bonus paid by T on December 31, 2007.
    (vi) Pursuant to paragraph (a)(4)(iii) of this section, because 
the total wage payments made by U, an agent of the employer, to D 
are less than $100,000, U is permitted to determine the amount of 
income tax to be withheld without regard to other supplemental wage 
payments made to the employee. Income tax withholding on the $50,000 
in sick pay may be determined under either paragraph (a)(6) or (7) 
of this section. If U elects to withhold income tax at the flat rate 
provided under paragraph (a)(7)(ii)(F) of this section, withholding 
on the $50,000 of sick pay would be calculated at 25 percent of the 
$50,000 payment and would be $12,500. Alternatively, U may choose to 
take account of the $3,000,000 in supplemental wages paid by the 
employer during 2007 prior to payment of the $50,000 sick pay, and 
withholding on the $50,000 of sick pay could be calculated applying 
the mandatory flat rate of 35 percent, resulting in withholding of 
$17,500 on the $50,000 payment.

    Example 4. (i) Employer J has decided it wants to grant its 
employee B a $1,000,000 net bonus (after withholding) to be paid in 
2007. Employer J has withheld income tax from the regular wages of 
the employee. Employer J has made no other supplemental wage 
payments to B during the year. The rate for mandatory flat rate 
withholding in effect in the year in which the payment is made is 35 
percent, and the rate for optional flat rate withholding in effect 
is 25 percent.
    (ii) This Example 4 requires grossing up the supplemental wage 
payment to determine the gross wages necessary to result in a net 
payment of $1,000,000. If the employer elected to use optional flat 
rate withholding, the first $1,000,000 of the wages would be subject 
to 25 percent withholding. However, any wages above that, including 
amounts representing gross-up payments, would be subject to 
mandatory 35 percent withholding. The withholding applicable to the 
first $1,000,000 (i.e., $250,000) would thus be required to be 
grossed-up at a 35 percent rate to determine the gross wage amount 
in excess of $1,000,000. Thus, the wages in excess of $1,000,000 
would be equal to $250,000 divided by .65 (computed by subtracting 
.35 from 1) or $384,615.38. Thus the total supplemental wage 
payment, taking into account income tax withholding only (and not 
Federal Insurance Contributions Act taxes), to B would be 
$1,384,615.38, and the total withholding with respect to the payment 
if Employer J elected optional flat rate withholding with respect to 
the first $1,000,000, would be $384,615.38.

    (9) Certain noncash payments to retail commission salesmen. For 
provisions relating to the treatment of wages that are not subject to 
paragraph (a)(2) of this section and that are paid other than in cash 
to retail commission salesmen, see Sec.  31.3402(j)-1.
    (10) Alternative methods. The Secretary may provide by publication 
in the Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of 
this chapter) for alternative withholding methods that will allow an 
employer to meet its responsibility for the mandatory flat rate 
withholding required by paragraph (a)(2) of this section.
    (b) Special rule where aggregate withholding exemption exceeds 
wages paid--(1) Procedure. This rule does not apply to the extent that 
paragraph (a)(2) of this section applies to the supplemental wage 
payment. * * *
    (2) Applicability. The rules prescribed in this paragraph (b) 
shall, at the election of the employer, be applied in lieu of the rules 
prescribed in paragraph (a) of this section except that this paragraph 
shall not be applicable in any case in which the payroll period of the 
employee is less than one week or to the extent that paragraph (a)(2) 
of this section applies to the supplemental wage payment.
* * * * *

0
Par. 5. Section 31.3402(j)-1 is amended by adding a new sentence at the 
beginning of paragraph (a)(2) to read as follows:


Sec.  31.3402(j)-1  Remuneration other than in cash for service 
performed by retail commission salesman.

    (a) * * *
    (2) Section 3402(j) and this section are not applicable with 
respect to wages paid to the employee that are subject to withholding 
under Sec.  31.3402(g)-1(a)(2). * * *
* * * * *
0
Par. 6. Section 31.3402(n)-1 is revised and the authority citation at 
the end of the section is removed to read as follows:


Sec.  31.3402(n)-1  Employees incurring no income tax lia