Which Tax Year Should End-of-Year Employee Paychecks Be In?
You pay employees on January 4, 2019, for work done in the last week of December 2018 because that's your normal payday. Are these paycheck amounts taxable in the year of the work or the year of the paycheck? The tax year for a paycheck is important because it affects the taxable income for employees, as shown in employee gross pay on the W-2 forms for each year.
The paycheck date rules, even if the work was done and the pay was earned in a different year (but read the exception below). That's because the paycheck was available to the employees in January, but not in December.
The gross pay is taxable in 2019, not 2018. If you pay employees on the last day of December for this work, the paycheck date of December 31, 2018, and this would mean the pay is taxable income in 2018.
Why Is the Year of an Employee's Paycheck Important?
The year the paycheck is taxed affects the taxable income of the employee. If an employee had a big end-of-year bonus, for example, it could affect the employee's tax rate. In some years, there is an extra pay period, which can cause employees to receive what appears to be an "extra" paycheck. Informing the employee of the difference before payment gives the employee time to change the person's W-4 form to add more withholding to that paycheck.
The issue comes up when a pay period doesn't end on the last day of the year. If the pay period ends before the end of the year, there are few days in the first year that will be paid in the next year. If the pay period ends after the end of the year, there are a few extra days in the next year's pay.
An Exception: Constructive Receipt
If you make paychecks available to employees before the end of the year—through direct deposit, for example—the pay must be considered to be received (and taxable) in that year, even if the direct deposit check is dated in the following year.
The IRS says employees must have access to the paycheck "without substantial limitation or restriction." This is called "constructive receipt." Constructive receipt is an accounting term that refers to when income is considered to be in the possession of someone and when it is available to be spent. That is, when does the person have control over the money?
Post-Dated Checks and Constructive Receipt
In general, when a person receives a payment by mail, it could be considered that the person has constructive receipt of the funds. But that's not always true. A check might be post-dated. A post-dated check is a check that has a future date on it. If you receive a check in 2017 that is dated 2018, you can't cash it until the next year. Just because you have the check in your hand, because it's dated in the next year—and not cashable until then—the check would be included in the next year's taxes.
How Does This Rule Affect Employee W-2 Forms?
W-2 forms are the forms you give employees in January to provide information on their pay and amounts withheld for federal income taxes and FICA taxes (social security and Medicare).
The last paycheck dated in December is included in that year's W-2 earnings. The first paycheck in January is included in the new year's W-2 earnings.
After you prepare those W-2 forms, they must be distributed to employees and filed with the Social Security Administration. Here are the dates to remember: W-2 forms must be given to employees by the end of January, for the prior year's wages. You must also file W-2 forms with the Social Security Administration by January 31 (not February 28, as in previous years. If you are using payroll accounting software, the software should take care of the tax issue for the employee W-2s.
How Does Payroll Software Handle This Issue?
Patriot Software says, "The user [that's you, the business] would select the pay date which would include day, month and year. But to be clear, typically the deposit date of the paycheck is also the "pay date." If there is ever a delay for some reason in the deposit of the funds, the employee W2 will still reflect the pay date in payroll."
How Do I Handle This Issue?
Here are some suggestions:
- Don't get ahead of yourself and don't try to over-think it. Hand out paychecks when they are typically distributed. If you are trying to calculate payroll taxes yourself, it might be wise to consider getting payroll software.
- Inform employees. Let employees know which tax year their last paycheck will be in. It's always better to warn employees than have them find out later and be upset.
- You can get help from your CPA or other tax professional. If you are REALLY confused, you might want to consider getting a payroll service to help with these kinds of issues.