This Toolkit is designed to provide a concise guide to the basic requirements for compliance with Federal tax laws in major areas of interest to governmental organizations. The Toolkit consists of four parts:
A Public Employer’s Toolkit, which provides information to government entities and payroll officers working for government entities in meeting their federal employment tax obligations;
A Compliance Toolkit, which provides information to help government entities and their powers of attorney understand the enforcement process;
An International Withholding Issues Toolkit, addressing requirements and procedures for withholding tax from nonresident aliens.
If you are a new employer, or new to dealing with federal employment tax, the first place to go for information is IRS Publication 15, Employer’s Tax Guide (Circular E). This publication is revised each year and contains the basic information employers need to be able to collect adequate information so they can determine and pay their and their employees’ portion of employment tax liability, file correct tax returns, and withhold federal taxes, where necessary.
You may also want to consult the following Publications that include information specific to government entities:
Public Employer’s Tax Guide
Publication 963, Federal-State Reference Guide
Publication 15-A, Employer’s Supplemental Tax Guide
Publication 15-B, Employer’s Guide to Fringe Benefits
FSLG Taxable Fringe Benefits Guide
Publication 1281, Backup Withholding for Missing and Incorrect Names/TINs
The following list includes most federal tax forms and instructions you are likely to need to process payroll and file necessary returns with the IRS. You can download the forms and instructions from the links. Note: Some of the forms are information copies only and cannot be used for filing. A list of all IRS forms (in fillable format) and publications is available at http://www.irs.gov/.
Form W-3, Transmittal of Wage and Tax Statements.
This form is used to transmit the Form W-2 to the SSA.
Form W-4, Employee's Withholding Allowance Certificate.
This form must be furnished to each employee upon hiring to determine correct withholding. Employee may submit new certificate at any time.
Form W-9, Request for Taxpayer Identification Number and Certification ( with instructions).
This form must be furnished to each person who receives a payment from a government entity in order to verify the recipient’s taxpayer identification number. Examples of such payments are interest payments made by a government entity and payments made to persons who are not employees of the government entity.
Form 945, Annual Income Tax Withholding Return ( with instructions).
This form must be filed by each employer, including a government entity, to report withholding (including back up withholding) on payments other than wages. Examples of such payments made by a government entity are pensions, annuities, and IRAs.
Form 1096, Annual Summary and Transmittal of U.S. Information Returns.
This form is used to transmit Form 1099-MISC to the IRS.
You may be required to provide the following non-tax forms to new employees. They are available from other Federal agencies:
Form I-9, Employment Eligibility Verification.
Required for all new hires. This form can be obtained from U.S. Citizenship and Immigration Services.
Form SSA-1945, Statement Concerning Your Employment in a Job Not Covered by Social Security.
Employees covered under a public retirement system, as well as other categories of government workers, may not be covered by social security. State and local government employers are required to notify employees hired on or after January 1 2005, in jobs not covered by social security, of the effects of the Windfall Elimination Provision and the Government Pension Offset. The law requires newly hired public employees to sign Form SSA-1945, indicating that they are aware of a possible reduction in their future social security benefit entitlement. For more detailed information about this law, see http://www.socialsecurity.gov/form1945.
For further on-line information about employer responsibilities, visit the web page for Employment Taxes for Businesses.
The following information explains what a government entity can expect during a compliance check or an examination conducted by FSLG. It also provides information with regard to adequate record keeping by government entities, disclosure constraints on the IRS and consent by government entities authorizing the IRS to disclose tax information to third parties.
FSLG Compliance Program: Compliance Checks, Examinations, and the Difference Between Them – The purpose of a compliance check and an examination, and the difference between the two.
What Occurs During an Examination – What a government entity can expect during an examination, including the types of questions asked during an examination, the kinds of information requested, and possible outcomes of an examination.
What Occurs During a Compliance Check – What a government entity can expect during a compliance check, including the types of questions asked during a compliance check, the kinds of information requested, and possible outcomes of a compliance check, also includes sample compliance check opening and closing letters, pro forma information document requests, etc.
Basic Recordkeeping for Employment Taxes and Information Return Reporting – Suggestions about methods for maintaining employment tax records and vendor information. What records must be maintained by a government entity with respect to an employment tax exam.
Disclosure Laws – Constraints on the IRS with regard to disclosure of tax information of a government entity to third parties. Providing consent for disclosure to the IRS, including power of attorney provisions, third party contact procedures, etc.
Appeals Process – Information about IRS Appeals Office and procedure for requesting review by the Office of Appeals of an adverse determination made by FSLG after an examination.
Where To Find It – A list of topics and where to go to find more information.
Retirement plans established for the benefit of governmental employees generally function in ways similar to those covering private employers. However, in many cases, different sections of the Internal Revenue Code determine the tax treatment of these plans. Depending on the statutory basis for the plan and how it operates, employer and employee contributions may be subject to Federal income tax at the time of contribution, or tax-deferred until distributed; and they may be taxable or excluded from social security and Medicare taxes (FICA).
Public Retirement Systems (FICA Replacement Plans)
Effective July 2, 1991, Congress made social security coverage mandatory for state and local government employees who are neither covered by a Section 218 Agreement nor qualifying participants in a public retirement system. Under this provision, states can provide these mandatorily covered employees with membership in a public retirement system as an alternative to mandatory social security coverage. Employees may also be covered by both a public retirement system and social security under a section 218 Agreement.
A governmental retirement plan must meet certain minimum benefit or contribution standards to qualify as a public retirement system, and thereby serve as a “replacement” plan exempting the participants from mandatory social security coverage. These standards are based solely on meeting a minimum benefit level provided (defined benefit plan), or a minimum amount contributed (defined contribution plan) to the participant. Whether a plan meets the standard to exempt employees from mandatory FICA has no bearing on the rules discussed below, and a public retirement system is not necessarily a “qualified plan” within the meaning of Employee Retirement Income Security Act (ERISA). For a detailed discussion of the requirements for public retirement systems, see Chapter 6 of Publication 963, Federal-State Reference Guide.
Types of Public Employer Plans
The following types of retirement plans are discussed here (sections refer to the Internal Revenue Code)
Section 401(a) - Qualified Plan
Section 403(b) – Annuity for public schools and 501(c)(3) organizations
Section 457(b) – Nonqualified, eligible deferred compensation plans for state and local governments and tax-exempt organizations
Section 457(f) – Nonqualified, ineligible deferred compensation plans
Note: After May 6, 1986, state and local governments are not eligible to adopt Section 401(k) plans except for rural cooperatives, Indian tribal entities. Under grandfather provisions, plans established prior to that date may continue to operate and add new participants.
Almost all governmental plans are covered under one of these sections. They are discussed individually below.
Key Terms and Concepts
The following are some important terms that are used in discussing the features of public employer plans.
Constructive Receipt: Under the provisions of sections 451 and 457 of the Internal Revenue Code, generally all amounts employees receive are taxable when received or made available to the employee. However, numerous code sections provide exceptions to either defer or exempt amounts from current employee income. They are discussed below as they apply to governmental plans.
Employer Contributions: Amounts credited to individual employee retirement accounts paid in addition to salary; the employee does not have the option to receive these amounts in cash. These amounts are always tax deferred, because the employee does not have constructive receipt. Except for section 457(b) deferrals and section 457(f) contributions, employer contributions are exempt from FICA.
Tax-Deferred: Refers to amounts set aside or credited to the employee retirement account are not included in gross income at the time of the transaction. They are included in income when they are distributed to or constructively received by the employee. Generally, they are subject to withholding requirements at that time also.
Salary Reduction Agreement: An arrangement that provides for amounts recognized as a cash or deferred election because the employee either (a) elects to reduce cash compensation, or (b) elects to forego an increase in cash compensation.
Mandatory Employee Contributions: Amounts deducted from employee salary and credited to a retirement account.
Employer “Pick-Up” Contributions: Section 414(h)(2) allows state or local government entities with section 401(a) plans to treat certain contributions designated as employee contributions, but which are “picked up” (paid) by the employer, to be treated as employer contributions, and therefore as exempt from income tax. This does not include contributions made under a salary reduction agreement. For purposes of FICA, the term “salary reduction” relates to amounts treated as an employer contribution under Code §414(h)(2) that would have been included in wages for FICA tax purposes, but for the employer contribution.
For more information on the requirements to treat contributions as employer pick-ups, see the article in the January 2007 FSLG Newsletter. For more information on pick-up contributions and FICA, see the article in the July 2007 FSLG Newsletter.
Section 401(a) Qualified Plans
Generally, any public employer may set up a 401(a) plan. Under this plan:
Employer contributions not made pursuant to a salary reduction agreement, but including employer “pick-up” contributions, are deferred from income tax until distribution, and exempt social security and Medicare tax.
Employer contributions made under a salary reduction agreement are deferred from income tax, but are subject to FICA tax.
Employee contributions pursuant to a salary reduction agreement are subject to income tax and FICA.
Section 403(b) Plans
Plans under IRC section 403(b), also called tax-sheltered annuities, are available to certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers. To maintain a section 403(b) plan, a governmental employer must be a public school of a state, political subdivision of a state, or an agency or instrumentality of one or more of these. Many public school employees are covered by 403(b) plans in addition to social security coverage under section 218.
403(b) plans resemble “qualified” (i.e., 401(k)) plans in many respects. Eligible participants may defer amounts from income tax up to an annual limit ($16,500 in 2009). This amount may be increased for certain employees with more than 15 years service. In addition, additional tax-deferred “catch-up” contributions may be made to employees age 50 or older.
Employer contributions (within dollar limitations) are tax-deferred and exempt from FICA.
Employee elective contributions to 403(b plans that are considered employer contributions pursuant to a salary reduction agreement are deferred from income tax, but taxable for FICA.
For more information on catch-up contributions to 403(b) plans, see Publication 571.
Section 457(b) Plans
Section 457 addresses nonqualified plans. Many public employees participate in nonqualified, or section 457, plans. These plans can be established by state and local governments or tax-exempt organizations. If they meet the requirements of IRC section 457(b), they are considered “eligible” plans; if not they are considered “ineligible” and are governed by IRC section 457(f).
Governmental 457(b) plans must be funded, with assets held in trust for the benefit of employees. Plan assets and income of all other eligible plans must remain the property of the employer.
Plans eligible under 457(b) may defer amounts from income tax up to an annual limit ($16,500 in 2009). In addition, “catch-up” contributions may be made to employees age 50 or older. Social security and Medicare taxes generally apply to all employer and employee contributions. For further information regarding social security and Medicare tax withholding and reporting on amounts deferred into eligible deferred compensation plans, see Notice 2003-20 and the IRS.gov Employee Plans site.
Employer contributions to 457(b) plans are tax deferred up to annual limits. They are subject to FICA when no longer subject to substantial risk of forfeiture.
Substantial risk of forfeiture. The rights of a person to compensation are subject to substantial risk of forfeiture if such person's rights to such compensation are conditioned upon the future performance of substantial services by any individual.
Section 1.83-3(c)(1) of the regulations provides that whether a risk of forfeiture is substantial or not depends upon the facts and circumstances
“A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied.”
Section 1.83-3(c)(2) of the regulations point out that requirements that the property be returned to the employer if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.
Employee elective contributions are deferred from income tax. They are subject to FICA. However, see IRS Notice 2003-20, VI B, “Timing of social security and Medicare taxes.”
Section 457(f) Plans
Nonqualified state or local government plans that do not meet the tests of 457(b) are ineligible, or 457(f), plans. There is no limit on the annual deferrals on these plans, but to defer taxation all amounts must be subject to substantial risk of forfeiture (see above). Distributions are generally subject to social security and Medicare taxes at the later of the time 1) when the services giving rise to the related compensation are performed, or 2) when there is no substantial risk of forfeiture of the rights to the amounts.
Employer contributions to 457(f) plans are includible in income in the year they are no longer subject to any substantial risk of forfeiture. They are subject to income tax withholding in the year they are actually or constructively paid.
Note: IRC §457(f)(1)(A) requires that the contributions be included in the gross income of the participant in the first taxable year in which there is no substantial risk of forfeiture, whereas, IRC §3402(a)(1) requires withholding of federal income tax when the contributions are actually or constructively paid. Thus, while the contributions must be reported as income taxable wages on Form W-2 in the first year in which there is no substantial risk of forfeiture, there may be no income tax withholding requirement at that time. Contributions to funded plans (not meeting the requirements of §457(b)) are constructively paid in the “taxable year in which amounts attributable to employer contribution amounts first become nonforfeitable.”
IRC 547(e)(11)(A)(i) provides exceptions to the above treatment may apply to plans involving bona fide vacation, sick leave, involuntary severance pay, disability or death benefits. For information on the treatment of severance pay plans, see Notice 2007-62.
457(f) contributions are subject to FICA at the later of:
When the services are performed, or
When there is no substantial risk of forfeiture and when the amounts are reasonably ascertainable.
Form W-2 Reporting
Box 1: Income taxable contributions.
Box 12: Elective salary reduction deferrals to §§401(k), 403(b), 408(k)(6), 408(p); elective deferrals and employer contributions (including nonelective deferrals) to §457(b) unless subject to substantial risk of forfeiture.
Box 14: Employer may enter the following: (a) nonelective employer contributions made on behalf of an employee, (b) voluntary after-tax contributions that are deducted from an employee’s pay, (c) required employee contributions, and (d) employer matching contributions.
Resources for Further Information
See also the following IRS web pages:
Federal, state and local governmental entities often act as withholding agents, and pay income to nonresident aliens. This discussion covers:
The persons responsible for withholding (withholding agents),
The types of income subject to withholding, and
The information return and tax return filing obligations of withholding agents.
The discussion includes the rules that generally apply to payments of U.S. source income to nonresident aliens.
Withholding of Tax
Generally, a nonresident alien is subject to U.S. tax on its U.S. source income. Most types of U.S. source income received by a nonresident are subject to U.S. tax at a rate of 30%, unless a lower amount is prescribed by a tax treaty. An in-depth discussion of tax treaties is beyond the scope of this article, and we recommend reviewing Publication 901, U.S. Tax Treaties.
The tax is generally withheld from the payment made to the nonresident alien. Nonresident alien (NRA) withholding is descriptively used to refer to withholding required under section 1441 of the Internal Revenue Code. Generally, NRA withholding describes the withholding regime that requires withholding on a payment of U.S. source income.
For general information about withholding, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.
Withholding is required at the time you make a payment of an amount subject to withholding.
You are required to report payments subject to NRA withholding on Form 1042-S and to file a tax return on Form 1042. Form 1042 is due March 15 of the following year. Note: Form 1042 has unique requirements to deposit tax; these differ from Form 941 tax deposits.
A withholding agent is the person responsible for withholding on payments made to a nonresident alien. You are a withholding agent if you have control, receipt, custody, disposal, or payment of any item of income of a nonresident alien that is subject to withholding.
Liability for tax
As a withholding agent, you are personally liable for any tax required to be withheld. This liability is independent of the tax liability of the nonresident alien to whom the payment is made. If you fail to withhold and the NRA fails to satisfy his or her U.S. tax liability, then both you and the nonresident alien are liable for tax, as well as interest and any applicable penalties. The applicable tax will be collected only once. If the nonresident alien satisfies the U.S. tax liability, you may still be held liable for interest and penalties for your failure to withhold.
Determination of amount to withhold
You must withhold on the gross amount subject to NRA withholding. You cannot reduce the gross amount by any deductions. If the determination of the source of the income or the amount subject to tax depends on facts that are not known at the time of payment, you must withhold an amount sufficient to ensure that at least 30% of the amount subsequently determined to be subject to withholding is withheld. In no case, however, should you withhold more than 30% of the total amount paid; if this is done because of error or inaccurate estimate of income, the excess should be refunded to the recipient.
Persons Subject to NRA Withholding
NRA withholding applies only to payments made to nonresident aliens. It does not apply to payments made to U.S. persons. Usually, you determine the payee’s status as a U.S. or foreign person based on the documentation that person provides.
A nonresident alien is an individual who is not a U.S. citizen or a resident alien.
A resident alien is an individual that is not a citizen or national of the United States and who meets either the green card test or the substantial presence test for the calendar year. Generally, resident aliens are taxed in the same way as U.S. citizens.
Green card test - An alien is a U.S. resident if the individual was a lawful permanent resident of the United States at any time during the calendar year. This is known as the “green card test” because these aliens hold immigrant visas (also known as “green cards”).
Substantial presence test - An alien is considered a U.S. resident if the individual meets the substantial presence test for the calendar year. Under this test, the individual must be physically present in the United States on at least:
31 days during the current calendar year, and
183 days during the current year and the 2 preceding years, counting all the days of physical presence in the current year, but only 1/3 the number of days of presence in the first preceding year, and only 1/6 the number of days in the second preceding year.
Generally, the days the alien is in the United States as a teacher, student, or trainee on an “F, J, M, or Q” visa are not counted toward the substantial presence test. This exception is for a limited period of time. A discussion of students, scholars, teachers, researchers, exchange visitors, and cultural exchange visitors temporarily in the United States on “F, J, M, or Q” visas is beyond the scope of this article. This topic is discussed in another IRS article, Foreign Students and Scholars.
For more information on resident and nonresident status, the tests for residence, and the exceptions to them, please see Publication 519, Tax Guide for Aliens.
Exceptions to 30% Withholding Rule
Generally, you must withhold 30% from the gross amount paid to a nonresident alien unless you can reliably associate the payment with valid documentation that establishes either of the following.
The payee is a U.S. person.
The payee is a nonresident alien person that is the beneficial owner of the income and is entitled to a reduced rate of withholding.
The nonresident alien may provide you with one of the following forms. They deal with various exceptions to the general withholding rules. You may link to these forms for further information. See Publication 515.
Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding
Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States
Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Withholding
Form W-8EXP, Certificate of Foreign Government or Other Organization for United States Tax Withholding
Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual
Source of Income
Generally, income is from a U.S. source if it is paid for personal services rendered within the United States. This is considered U.S. sourced income. Payments to a nonresident alien for personal services rendered outside the U.S. are determined to be foreign-sourced income, and are considered non-taxable and non-reportable.
Scholarships, fellowships, and grants are sourced according to the residence of the payer. Those made by entities created or domiciled in the United States are generally treated as income from sources within the United States. Scholarship, fellowship and grant income are reportable on a Form 1042S to the nonresident alien. Those made by entities created or domiciled in a foreign country are treated as income from foreign sources, and are considered nontaxable and nonreportable.
The source of pension payments is determined by the portion of the distribution that constitutes the compensation element (employer contributions) and the portion that constitutes the earnings element (the investment income). The compensation element is sourced the same as compensation from the performance of personal services. The portion attributable to services performed in the United States is U.S. source income, and the portion attributable to services performed outside the United States is foreign source income. The earnings portion of a pension payment is U.S. source income if the trust is a U.S. trust.
The information contained in this article is not to be considered an official position of the Internal Revenue Service. If you would like to obtain official written advice on an issue, please visit our website, www.irs.gov, download IRS Revenue Procedure 2007-1, and follow the instructions contained in this revenue procedure.