Relevant factors for employees other than full-time employees For employees who are not full-time employees, the employee's normal work schedule and number of hours worked per week are relevant factors in evaluating the service aspect of the employee's relationship with the employer. As an employee's normal work schedule or actual number of hours worked approaches 40 hours per week, it is more likely that the service aspect of the relationship is predominant. The regulations provide that certain other factors suggest that the service aspect of the relationship is predominant. For example, status as a professional employee (as defined in the regulations) suggests that the service aspect of the relationship is predominant, especially if the employee is required to be licensed under State or local law to work in the field in which the employee performs services. In addition, eligibility for certain employment benefits suggests that the service aspect of the relationship is predominant. Administrative safe harbor In conjunction with the issuance of the final regulations, the IRS has provided a safe harbor under which half-time undergraduate students and half-time graduate or professional students enrolled at an institution of higher education are generally eligible for the student exception. 189 For purposes of the safe harbor, the term "graduate or professional student" does not include a postdoctoral student, postgraduate fellow, medical resident, or medical intern. In addition, the safe harbor does not apply to full-time employees, professional employees, or employees who receive or are eligible for certain employment benefits. Employees who are not eligible for the safe harbor (other than full-time employees) may qualify for the student exception based on consideration of all the facts and circumstances. Application of FICA exceptions containing dollar limits 191 Some FICA exceptions are subject to dollar limits. For example, cash remuneration of less than a specified amount ($1,400 for 2005) paid to an employee in a year for domestic service in a private home is exempt from FICA.190 Similarly, cash remuneration of less than $150 paid to an employee in a year for agricultural labor may be exempt from FICA. The FICA rules provide that, in cases in which a FICA exception is subject to a dollar limit, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit and, thus, may be exempt from FICA. Otherwise, once the total payments to the employee reach the limit, the employer must withhold the employee share of FICA that was not withheld from previous payments, in addition to withholding FICA with respect to current payments. Withholding the employee share of FICA from payments made before the limit is reached may result in erroneous 192 189 Rev. Proc. 2005-11, 2005-02 I.R.B. 1. Safe harbor guidance under Rev. Proc. 98-16, 1998-1 C.B. 403, applies for periods before the new regulations apply. withholding; however, it avoids the need to withhold additional FICA amounts once the limit is reached. 193 The IRS has established procedures for situations in which FICA taxes are erroneously withheld from an employee's pay. Under these procedures, the employer generally repays the employee for the erroneously withheld amount. In addition, if the employer has paid the erroneously withheld amount to the IRS, the employer may take credit for the amount in determining future taxes that must be paid to the IRS. Reasons for Change As indicated in legislative history, the student exception to FICA is intended to be narrow, applying to employment that is part-time or intermittent and involves nominal earnings. However, it appears that the student exception may be viewed by certain taxpayers as applying more broadly to include situations that are similar to full-time employment. Although recent IRS regulations help to clarify the scope of the student exception, clear statutory standards would make the exception more administrable. In addition, the original intent of the exception can be implemented more effectively through a dollar limit. 193 The proposal codifies the IRS regulations that clarify the scope of the present-law student exception. In addition, the proposal amends the student exception so that it does not apply to individuals whose earnings subject to the exception exceed an annual dollar limit. The proposal also applies for purposes of determining wages for Social Security and Medicare purposes. Codification of regulations The proposal codifies the regulations relating to the definition of "school, college, or university." Thus, the student exception applies to services performed for an organization only if: (1) its primary function is the presentation of formal instruction; (2) it normally maintains a regular faculty and curriculum; and (3) it normally has a regularly enrolled body of students in attendance at the place where its educational activities are regularly carried on. 196 194 The proposal applies also for purposes of the other student exceptions under FICA and FUTA and for purposes of coverage under the Social Security Act. 195 No inference is intended that the regulations are inconsistent with the student exception under present law. 196 As under present law, the student exception may also apply to services performed as a student in the employ of an organization that is organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of the school, college, or The proposal also codifies the regulations relating to student status, including whether: (1) the student is enrolled and regularly attending classes in pursuit of a course of study at the school, college, or university for which the services are performed; and (2) the services are incident to and for the purpose of pursuing a course of study at the school, college, or university. Under the proposal, the Secretary of Treasury has explicit authority to provide rules for determining student status, including criteria such as those provided in the regulations. Thus, for example, it is expected that, under the proposal, as under the regulations, services of a full-time employee are not incident to and for the purpose of pursuing a course of study, so the student exception does not apply to a full-time employee. Annual dollar limit Under the proposal, the student exception applies to an individual for a year only if the individual's earnings from the school, college, or university are less than the amount needed to receive a quarter of FICA coverage for the year ($920 for 2005). Thus, if an individual's earnings exceed the limit, the individual's earnings are subject to FICA, regardless of whether the individual otherwise meets the requirements for the student exception. If the limit is exceeded, all of the individual's earnings are subject to FICA, including earnings up to the limit, thus enabling the individual to receive at least one quarter of coverage for the year. Under the proposal, the rules and procedures relating to the withholding of the employee share of FICA that apply under present law in the case of FICA exceptions that are subject to dollar limits apply also for purposes of the student exception. For example, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit. Effective Date The proposal relating to codification of the regulations is effective on the date of enactment. The proposal relating to a dollar limit on the student exception is effective with respect to wages for services performed in calendar years beginning after the date of enactment. Discussion As indicated by its legislative history, the present-law student exception is intended to apply to situations in which the employment is part-time or intermittent, the total amount of earnings is only nominal, and the tax involved and the related Social Security benefit rights are inconsequential. Over time, however, it appears that the exception has been applied to situations beyond those intended, such as: (1) employees performing services on a full-time or close to full-time basis; (2) professional services that have an educational component, but that primarily further the work of the employer rather than the education of the employee; and (3) services performed in the employ of an organization other than a school, college, or university. university, if the organization is operated, supervised or controlled by or in connection with such school, college, or university. Uncertainty as to the proper scope of the student exception results in part from a lack of clear standards for applying the exception. The regulations provide standards that enable the IRS and taxpayers to determine more accurately whether the exception applies. The proposal to codify the regulations is likely to make the exception more administrable and improve compliance. The proposal to apply a dollar limit to the student exception is also consistent with the original intent of the student exception to apply in situations in which total earnings are nominal and benefit rights inconsequential. Under the proposal, the exception is limited to students whose earnings are too small to provide a quarter of coverage for Social Security benefit purposes. This will relieve employers and employees from having to pay small amounts of FICA taxes that do not result in a quarter of coverage, while enabling students whose earnings are high enough to result in at least one quarter of coverage to receive Social Security credit. The use of a dollar limit also provides a clearer standard for applying the student exception, which makes the exception easier for the IRS and taxpayers to apply. For example, if an individual's pay rate and work schedule are such that the individual's earnings will exceed the limit, it is unnecessary to determine whether the individual's services are performed as an incident to and for the purpose of pursuing a course of study. Administrative issues may arise as to the proper FICA treatment of amounts paid to an employee before the limit is reached, particularly with respect to whether the employer may withhold the employee share of FICA. The proposal addresses such issues by applying the rules and procedures that apply in similar situations under present law. The proposal has the effect of increasing FICA taxes for some employers and employees, as well as increasing revenues for the Social Security and Medicare programs. The proposal also results in additional wages for Social Security and Medicare purposes. In many cases, credit for wages earned while a student will have little, if any, effect on an individual's eligibility for Social Security benefits or Medicare coverage. However, in some cases, particularly employees with short work histories, these earnings may establish eligibility for disability or death benefits. To the extent that the proposal expands eligibility for Social Security benefits or Medicare coverage, it may also increase the long-term costs of the Social Security and Medicare programs. In many cases, a school, college, or university provides employment to students in part as a form of financial aid. In such cases, application of FICA as a result of the proposal may be viewed as a cutback on an education-related tax benefit. However, legislative history does not indicate that the student exception is intended as an education-related tax benefit. In addition, the student exception creates inappropriate disparities in the FICA tax treatment of students employed by the school, college, or university where they attend classes and students employed by other employers. The proposal reduces these disparities. E. Apply Employment Taxes to Sales Incentive Payments Made by Manufacturers (secs. 3121, 3306, and 3401) Present Law Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act ("FICA"), the tax under the Federal Unemployment Tax Act ("FUTA”), and the requirement that employers withhold income taxes from wages paid to employees ("income tax withholding"). 197 FICA tax consists of two parts: (1) old age, survivor, and disability insurance (“OASDI”), which correlates to the Social Security program that provides monthly benefits after retirement, disability, or death; and (2) Medicare hospital insurance (“HI”). The QASDI tax rate is 6.2 percent on both the employee and employer (for a total rate of 12.4 percent). The OASDI tax rate applies to wages up to the OASDI wage base ($90,000 for 2005). The HI tax rate is 1.45 percent on both the employee and the employer (for a total rate of 2.9 percent). Unlike the OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages. Under FUTA, employers must pay a tax of 6.2 percent of wages up to the FUTA wage base of $7,000. An employer may take a credit against its FUTA tax liability for contributions to a State unemployment fund and certain other amounts. Employers are required to withhold income taxes from wages paid to employees. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee. Employment taxes apply to all compensation for employment (including commissions and other sales incentives) unless an exception applies. Generally all amounts received in connection with the performance of services are considered compensation, even if paid by a person other than the person for whom services are performed. 198 In addition, if compensation is paid to an employee by a person other than the employer, the payor is generally responsible for complying with the applicable employment tax requirements, regardless of whether an employment relationship exists between the employee and the payor. In such circumstances, 199 197 Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax withholding). 198 See, e.g., Treas. Reg. sec. 1.61-2T(a)(5) (fringe benefits treated as provided by the person for whom services performed, regardless of whether actually provided by that person) and Treas. reg. sec. 1.83-6(d) (rules for transfers of property by a shareholder to an employee of a corporation in consideration of services performed for the corporation). 199 Sec. 3401(d)(1) (for purposes of income tax withholding, if the employer does not have control of the payment of wages, the person having control of the payment of such wages is treated as the employer); Otte v. United States, 419 U.S. 43 (1974) (the person who has the control of the payment of wages is treated as the employer for purposes of withholding the |