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Date: November 24, 2010

Bulletin Number: 1037

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Subject

Taxation of Recovered Salary Overpayments

Purpose

To describe the new process for withholding taxes and reporting wages when an overpayment originated in a prior calendar year.

Affected Employees

All employees.

Effective Date

November 24, 2010

Background

According to Internal Revenue Code Section 1341 as explained in IRS Publication 525, the repayment of wages in the current year that were originally overpaid in a prior year can not reduce the tax liability of the current year. The Federal, Social Security, Medicare, State and Local taxable wages cannot be reduced by the amount of this repayment for the purposes of determining tax withholdings.  This is because the IRS considers the employee to have had the use and benefit of these wages in the prior year, and therefore repayment of those wages in the current year is not relevant in determining taxable wages in the current year. 

The IRS does, however, consider that since tax and wage information is used in determining future social security benefits, adjustments must be made when wages are recovered from a prior year overpayment.  The IRS states that if an overpayment for a prior year is recovered, it must be recognized that an overpayment of SS/Med taxes occurred in that year.  The IRS requires that the employer make adjustments to SS/Med wage and tax reporting for that prior year and issue a refund of SS/Med taxes for that prior year.

However, since the IRS considers wages to be subject to Federal Tax Withholdings at the time they are received, no prior year adjustment for Federal taxes is permissible when there is a recovery of an overpayment from a prior year.

As a result, new procedures for recovering overpayments are required to comply with these regulations.  

Overview of New Approach

Whenever an overpayment is recovered, it is essential that the year the overpayment originated be reported in PayServ.  To accomplish this, the Office of the State Comptroller (OSC) has created several new earnings codes which will identify the year the overpayment originally took place.  Agencies will discontinue using the current overpayment earnings codes for all new overpayment recoveries and will select the appropriate new earnings code based on the year the overpayment originated. 

A transition period will occur between now and the end of the calendar year to allow agencies and OSC to change all existing overpayment records to the new earnings codes. By December 31, 2010, there will be no unsatisfied recoveries using the current earnings codes in the system. Beginning with the first check in January 2011, the attributes of the new earnings codes will be updated to reflect the proper taxation requirements. OSC can then rely on the new earnings codes to ensure that PayServ will withhold taxes in compliance with regulations, make the necessary changes to tax filing, and issue Form W-2Cs (Corrected Wage and Tax Statement) and credit statements to employees as appropriate.

Details on New Process

New Process

OSC will establish the following earn codes:

  • Q10 – Overpayment 2010
  • Q09 – Overpayment 2009
  • Q08 – Overpayment 2008
  • Q07 – Overpayment 2007
  • Q06 – Overpayment 2006 and Before

For instructions on updating employee records refer to bulletin #1038.

For the remainder of 2010 the PayServ earnings code attributes for all of these codes will be the same as the existing overpayment earnings codes. 

Beginning with the first pay check in January, the PayServ earnings code attributes of Q06 – Q10, 10X, 10Y and 10Z will be changed to reflect the prior year taxation requirements.  As always, the recovery will reduce the employee’s total gross pay in the employee’s pay check.  But, taxable gross pay, the amount used for calculating withholdings, will not be reduced by the amount of the repayment. 

Also beginning with the first check in January, new earnings codes will be established for overpayments that originated in 2011 – Q11, 11X, 11Y and 11Z. The attributes of these earnings codes will be set up to allow for the repayment to reduce the base for calculating Federal, Social Security, Medicare, State and Local tax withholding and taxable wages reported on the Form W-2 (Wage and Tax Statement) for the current calendar year.  Each new year hereafter, OSC will change the attributes of the earnings code representing the year that is ending, and create a new earnings code representing the new year. 

Tax Reporting and Refunds

Beginning with the first pay check in 2011, overpayment recoveries using a prior year code (Q10, Q09, Q08, Q07, Q06, 10X, 10Y and 10Z) will not reduce the taxable wages for employees.  However, employees may receive a refund for SS/Med taxes paid in a prior year and may be able to take the amount repaid as a tax deduction or credit when they file their Federal individual tax return in the year of repayment. 

Social Security and Medicare Taxes
OSC will request SS/Med tax refunds for any prior year overpayment that is recovered within the statute of limitations.  Internal Revenue Code, Section 6513 addresses that employers are allowed to amend their quarterly SS/Med filings for up to three years, three months and fifteen days after the end of the tax year.  While agencies should continue any reasonable efforts to collect an overpayment, OSC will request refunds only for those that fall within the statute of limitations.

Each year/quarter OSC will submit a Form 941X (Employer’s Quarterly Tax Return) to the IRS for prior years requesting a refund of both employee and employer share of SS/Med taxes for any repayments of prior year wages using the new overpayment earnings codes. OSC will process an SS/Med refund to the employee through Time Entry using the earn code TF7.  A separate check will be produced.  The employee will not need to file an amended tax return.

It is essential that employees be made aware that OSC is requesting an SS/Med refund on their behalf and must sign a Form AC 3206 (Prior Year Social Security and Medicare Tax Refund Certification) giving OSC consent to request the refund and confirm that they will not file a claim on their own. Specific agency instructions are provided in the “Details on New Process” section under the heading “Impact on Employee” in this bulletin. 

Federal Withholding Tax
Refunds cannot be made for Federal, State and Local taxes.  The employee, in some cases, may be eligible for a tax deduction or credit when filing a tax return for the current year if wages from a prior year are repaid.  As part of year end processing, OSC will issue a Credit Statement to any employee who repaid prior year wages through a new overpayment earnings code.  Please refer to Payroll Bulletin 837 (Change in Procedures for Correcting W-2C’s due to AC230s) for additional information regarding Credit Statements.   Employees with questions related to this potential tax deduction should contact their tax advisor. 

Note:  If only a portion of the original overpayment is recovered in the calendar year, the employee will receive a Form W-2C, a Credit Statement and/or a refund related to that portion of the recovery only.  If it takes more than one year to recover an overpayment, the employee will receive W-2Cs, Credit Statement and or refunds over the course of several years covered under the statute of limitation.

Impact on Employee

In the first check in January 2011, employees with overpayment recoveries underway will experience a decrease in their net pay due to an increase in their tax withholdings.  Agencies should inform their employees of this impact prior to the end of the calendar year and encourage them to consider increasing their bi-weekly recovery amount before the end of the year.

As new overpayments are established after January 1, 2011, agencies should make it clear to employees that there will be a negative tax impact if the overpayment originated in a prior year.  Similarly, if the overpayment is from the current year, agencies should explain to employees that there is an advantage to paying off the overpayment before the end of the calendar year. 

Agencies should also make it clear to employees that the IRS acknowledges that a repayment of a prior year overpayment indicates that an overpayment of prior year SS/Med taxes also occurred.  The agency should inform the employee that he or she will receive a refund for the SS/Med taxes associated with this repayment.  Agencies should require the employee to sign Form AC 3206 (Prior Year Social Security and Medicare Tax Refund Certification) giving OSC consent to request the refund and confirm that they will not file a claim on their own.  Agencies should keep a copy of this form for their records. 

Attachment A provides language that can be used by agencies to explain the tax impact of the recovery of prior year overpayments.  The language should be used in concert with any other communications the agency issues to ensure that employees are provided due process regarding the recovery of overpayments.

Questions

Questions may be directed to the Tax Compliance Mailbox.