Wage Continuation Plan: Tax Rules and Requirements

A wage continuation plan, also referred to as an accident and health plan, is an arrangement established by an employer to provide continued compensation to employees who are unable to work because of personal sickness or injury. These payments are distinct from a regular salary, which is paid for active services rendered to the company. Payments might cover a percentage of the employee’s normal wages and can sometimes include contributions to maintain health insurance coverage.

This arrangement is separate from workers’ compensation, which specifically covers work-related injuries, as a wage continuation plan provides a benefit for non-work-related health issues that cause an employee to miss work.

Tax Treatment for Employees

When an employee receives payments from a wage continuation plan, those amounts are considered part of their gross income and are subject to federal income tax. The employer is responsible for withholding the appropriate amount of income tax from these payments.

A specific rule applies to the payroll taxes for Social Security and Medicare, collectively known as FICA taxes. Payments made under a wage continuation plan are subject to FICA taxes for a limited duration. This period covers the calendar month the employee last worked and the subsequent six calendar months. After this six-month window closes, any further payments from the plan are exempt from FICA taxes for both the employee and the employer.

To illustrate this “six-month rule,” consider an employee who last worked on March 15th. The six-month period would begin on April 1 and end on September 30. Any wage continuation payments made to this employee from March 15th through September 30th would have FICA taxes deducted. Payments received on or after October 1st would not be subject to FICA withholding.

The reporting of these payments on the employee’s annual Form W-2, Wage and Tax Statement, reflects this treatment. The total amount of payments will be included in the taxable wages reported in Box 1. The portion of the payments subject to FICA will be included in Box 3 for Social Security wages and Box 5 for Medicare wages.

Employer Tax and Withholding Obligations

Payments made through a properly established wage continuation plan are considered an ordinary and necessary business expense. This allows the employer to deduct the full amount of the payments from their business income, reducing their overall tax liability.

The employer shares the responsibility for FICA taxes on these payments, mirroring the employee’s obligation. For the first six calendar months after an employee last performed services, the employer must pay its matching share of Social Security and Medicare taxes on the wage continuation payments. Once this six-month period has passed, the employer’s obligation to pay FICA taxes on these specific payments ceases.

The tax treatment of these payments under the Federal Unemployment Tax Act (FUTA) also mirrors the rules for FICA taxes. Payments are subject to FUTA taxes for the same limited duration, after which they become exempt. The employer must manage the withholding of federal income tax on all payments and the required FICA taxes during the initial six-month period.

Requirements for a Formal Plan

For a wage continuation arrangement to be recognized by the IRS and receive favorable tax treatment, it must be a formal plan. An informal or ad-hoc practice of paying sick employees may not qualify. The IRS has specific criteria that must be met for the plan to be considered valid.

• The plan must be in writing. This written document serves as the foundation of the plan, outlining its terms and conditions and providing clear evidence of the employer’s intent.
• The plan must be communicated to the employees who are covered by it. Employees need to be aware of the plan’s existence, its benefits, and the procedures for making a claim.
• The plan must establish clear and definite rules regarding eligibility and the calculation of payment amounts.
• The plan must be for the exclusive benefit of the employees or their dependents and cannot be structured to disproportionately benefit owners or highly compensated employees.

Meeting these formal requirements is a prerequisite for the employer to claim deductions and for certain tax exemptions to apply.

Administering and Reporting Payments

Proper administration and reporting are necessary once a formal wage continuation plan is implemented. The employer’s quarterly payroll tax filing, Form 941, must also reflect these payments correctly. The total compensation paid to employees, including wage continuation payments, is reported on this form.

When payments are made after the six-month FICA-exempt period, the employer must still report them as wages but will adjust for the FICA-exempt portion on the form. This ensures that the employer does not overpay its share of Social Security and Medicare taxes.

Accurate record-keeping is fundamental to this process. The employer needs to track the date an employee last worked and the six-month period for each individual receiving benefits. This allows for the correct application of FICA taxes and ensures compliance with IRS reporting requirements. Failure to properly administer and report these payments can lead to penalties and interest charges.