IRC Section 3121: Defining Wages and Employment Status

The Federal Insurance Contributions Act, or FICA, mandates contributions from both employees and employers to fund Social Security and Medicare. These payroll taxes are a familiar deduction on most workers’ pay stubs. The rules governing what compensation is subject to these taxes are outlined in the Internal Revenue Code (IRC), which provides the framework for compliance. IRC Section 3121 defines what the government considers “wages” and what constitutes an “employment” relationship for FICA taxation. These distinctions determine how much tax is owed and who is responsible for paying it.

Defining Wages for FICA Tax

The tax code establishes a broad definition of “wages” for FICA purposes, including all remuneration for employment and the cash value of non-cash compensation. This means nearly every form of payment an employee receives from an employer is a taxable wage unless a specific statutory exception applies. The name given to the payment is immaterial if it is compensation for services.

The most common form of wages is regular salaries and hourly pay. These payments are fully subject to FICA taxes, whether an employee earns a fixed annual salary or is paid based on the number of hours worked. The method of calculation does not alter the payment’s status as remuneration.

Beyond standard pay, other compensation is also classified as wages. Bonuses are considered wages regardless of whether they are for performance, signing, or part of a collective bargaining agreement. Commissions paid to salespeople are also included.

Other payments related to the employment relationship are also captured by this definition. Severance pay provided to employees upon termination is a taxable wage. Vacation pay, sick pay, and other forms of paid time off also constitute wages as part of the overall compensation package.

Compensation Excluded from FICA Wages

While the definition of wages is expansive, the code provides several specific exclusions. These statutory exceptions identify employer-provided payments and benefits that are not considered wages for FICA tax purposes, which reduces the amount of compensation subject to tax. For a payment to be excluded, it must meet the precise conditions laid out in the law.

Common exclusions from FICA wages include:

• Employer contributions to an employee’s qualified retirement plan, such as a 401(k) or 403(b). This exclusion applies to the employer’s contribution, while employee contributions are still subject to FICA taxes.
• Payments made by an employer under a plan for accident and health insurance, including premiums for medical, dental, and disability coverage for employees and their dependents.
• De minimis benefits, which are non-cash benefits so small and infrequent that accounting for them is unreasonable, like occasional office snacks.
• Working condition fringe benefits, which are items or services provided to an employee that would have been deductible as a business expense if the employee had paid for them.
• Payments made on account of an employee’s disability after the employee has been absent from work for six consecutive calendar months.
• Qualified transportation fringes up to a certain monthly limit, educational assistance programs meeting IRC Section 127 requirements, and dependent care assistance programs under IRC Section 129.

Determining an Employment Relationship

The obligation to pay FICA taxes hinges on the existence of an “employment” relationship. For workers not in a specific statutory category, the determination is based on the common law control test. This test examines the facts of the working relationship to determine whether the person paying for the services has the right to control the manner and means by which the work is accomplished.

The IRS groups the factors for the common law test into three main categories.

Behavioral Control

This category looks at whether the business has the right to direct and control the work being done. This includes evaluating who provides instructions on when, where, and how to work. If the business provides detailed training and instructions on the methods to be used, it suggests an employer-employee relationship.

Financial Control

This category examines the business aspects of the worker’s job. Factors include whether the worker has a significant investment in the equipment they use, can realize a profit or loss, and how they are paid. An independent contractor is more likely to have their own tools and risk a financial loss, whereas an employee is paid a regular wage and has business expenses reimbursed.

Relationship of the Parties

This category considers how the worker and the business perceive their interaction. This involves looking for written contracts that describe the intended relationship, though the substance of the relationship outweighs the contract’s language. The presence of employee-type benefits, the permanency of the relationship, and the extent to which the services are a key aspect of the business are also considered.

Special Categories of Workers and Services

Beyond the common law test, the tax code defines specific categories of workers treated as employees for FICA purposes, known as “statutory employees.” For these rules to apply, the service contract must imply the work will be performed personally. This group includes:

• Agent-drivers or commission-drivers who distribute beverages (other than milk) or meat, vegetable, fruit, or bakery products.
• Full-time life insurance salespersons whose principal business activity is selling life insurance or annuity contracts for one company.
• Individuals who work from home on materials or goods supplied by a business that must be returned to the business, as long as the business provides specifications for the work.
• Traveling or city salespersons who work full-time for one principal to solicit orders from wholesalers, retailers, or contractors.

Conversely, the tax code also carves out “statutory non-employees.” These are workers treated as independent contractors for all federal tax purposes. The two primary groups are qualified real estate agents and direct sellers. To qualify, their pay must be directly related to sales rather than hours worked, and they must operate under a written contract stating they will not be treated as an employee for federal tax purposes.

Finally, several types of services are exempt from the definition of “employment,” meaning payments for these services are not subject to FICA taxes. A common example is the service performed by a child under the age of 18 in the employ of their parent’s sole proprietorship. Another exemption applies to students enrolled and regularly attending classes at a school, college, or university where they are also employed, provided the work is incidental to their education.