Differential Pay for Active Military Duty

In Revenue Ruling 2009-11, the IRS ruled that the differential pay that employers pay to their employees while on active duty in the United States uniformed services for more than 30 days is subject to income tax withholding, but is not subject to Federal Insurance Contributions Act (“FICA”) or Federal Unemployment Tax Act (“FUTA”) taxes.  Because the individuals are scheduled to be on active military duty for an extended period of time, rather than being temporarily absent, the differential wage payments are not wages for purposes of FICA and FUTA taxes.

The ruling provides that employers may use the aggregate procedure or optional flat rate withholding to calculate the amount of income taxes required to be withheld on these payments, and that these payments must be reported on Form W-2.

Under the aggregate procedure, an employer adds the differential wage payment to the employee’s regular wages, if any, for the payroll period and treats the aggregate of the two as if it constituted a single wage payment for the payroll period. The withholding method used by the employer with respect to regular wages is then used to calculate the withholding on this single wage payment and the employer takes into consideration the Form W-4, Employee’s Withholding Allowance Certificate, submitted by the employee.

Alternatively, the employer may determine the income tax withholding on the differential wage payment using optional flat rate withholding, if certain requirements are satisfied. Optional flat rate withholding may be used provided that (1) the differential wage payment is either not paid concurrently with regular wages or is separately stated on the payroll records of the employer, and  (2) income tax has been withheld from the regular wages paid to the employee during the calendar year of the differential wage payment or the preceding calendar year.

The rate used for optional flat rate withholding is provided in § 31.3402(g)-1(a)(7)(iii)(F) of the Regulations. For 2009, the rate for optional flat rate withholding is scheduled to be 25 percent, but this rate could change if income tax rates change. The determination of the amount of tax to be withheld under optional flat rate withholding 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.

If the amount of the differential pay, when added to all other supplemental wages paid by the same employer to the employee during the calendar year exceeds $1,000,000, a special rule applies. Treas Reg §31.3402(g)-1(a)(2) requires that the rate used in determining the amount of withholding on the excess shall be equal to the highest rate of tax applicable under section 1 of the Code. Under current law, that rate is 35 percent.

This revenue ruling is effective for differential wage payments made after

December 31, 2008 (the effective date of 3401(h) under the Heroes Earnings

Assistance and Relief Tax Act of 2008).