How to Handle Payroll Overpayments and Repayments

Overpayments are considered paid when received and must be included in the employee's income when received. If the employee repays the advance or overpayment during the same year they received it, the employer should exclude the amount from the employee's income when filing the W-2.

The employee should repay the net amount and the employer will need to submit proper amended federal and state returns. In these cases, it's also important to watch state and federal unemployment, as they may be overstated. If this happens, amendments may need to be filed for the affected quarters.

Let's look at an example:

ABC Company hires Mike on May 1, 2013 at a salary of $3,000 per month. Mike receives a sign-on bonus of $1,000 that he must repay if he leaves ABC within one year of hire. Mike resigns on December 2, 2013 and repays the sign-on bonus. Because he repaid the bonus in the same year it was originally paid, he owes only the net amount of $698.50. ABC will issue the net transaction on Mike's W-2.

Here's how Mike's W-2 would appear in this scenario:

	2013	2013	2013	2013
	Payments	Repayment	Net Payments	Form W-2
Federal Wages	20,000	1,000	19,000	19,000
Soc.Sec. Wages	20,000	1,000	19,000	19,000
Medicare	20,000	1,000	19,000	9,000
FIT Withheld	4,000	225	3,775	3,775
Soc. Withheld	1,240	62	1,178	1,178
Med. Withheld	290	14.50	275.50	275.50
Net Pay	14,470	698.50	13,771.50

Overpayments and repayments in subsequent years

Things get a bit more complicated when an overpayment isn't repaid until a subsequent year. This often happens with sign-on bonuses that need to be repaid. Again, overpayments are considered paid when received and must be included in the employee's income when received.

If the employee doesn't repay the advance or overpayment until a subsequent year, they'll need to repay the gross amount – the net amount they received plus any federal or state income tax. The employer can't collect federal or state income tax withheld in a prior year, so no correction can be made for income taxes withheld. The employee can, however, claim a deduction on their personal income tax return for the tax they repaid.

The employer can usually recover the Social Security taxes they remitted on the overpayment by filing a 941X. They'll also need to file a W-2C showing the reduced Social Security and Medicare wages and taxes collected. The exception to this is if the employee is over the FICA limit. In this case, the employer can recover Medicare tax but not Social Security.

Let's look at an example:

ABC Company hires Mike on May 8, 2012 at a salary of $3,000 per month. Mike also receives a sign-on bonus of $1,000 that he must repay if he leaves ABC within one year of hire. Mike resigns on January 31, 2013 and repays the sign-on bonus. Because the repayment took place in a different year than the original payment, Mike owes the net amount of $693.50, plus the $250 in federal tax that was withheld and remitted to the IRS. ABC will issue the gross transaction on Mike's W-2C. Mike will deduct the $250 from his 2013 income tax return.

	2012	2013	2013	2012
	Payments	Payments	Net Payments	Form W-2C
Federal Wages	24,000	3,000	1,000	n/a
Soc.Sec. Wages	24,000	3,000	1,000	(1,000)
Medicare	24,000	3,000	1,000	(1,000)
FIT Withheld	4,000	875	250	n/a
Soc. Withheld	1,008	186	42	(42)
Med. Withheld	290	14.50	275.50	275.50
Net Pay	18,702	18,875.50	693.50+$250

Recover net from current-year repayments and gross from subsequent-year repayments. Remembering this one simple rule will make life much easier when tax season rolls around.

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James Paille, CPP is the Director of Operations for Thomson Reuters myPay Solutions. He has been an executive manager in the payroll service industry for more than 30 years, specializing in managing multi-location offices. Jim is a member of the APA's Board of Directors and National Speakers Bureau, and chairs the CPP Certification Review Panel. He holds a Bachelor of Science in Accounting from St. John Fisher College in Rochester, NY.