Employers who offer military differential pay should also offer tips for dealing with the tax rules
When U.S. Naval Reserve Lt. Marc J. Soss was called to active duty last year, his employer gave him more than a goodbye. Because Soss earned much more as a tax attorney than as a military officer, his law firm offered him a stipend for six months to help fill the gap between his military pay and his regular salary.
The firm also gave Soss money it received from a Florida grant program for private-sector employers who pay workers called to active duty. Soss, who left his family in Sarasota, Fla., to serve in Afghanistan, says that “it was very generous” of his firm to supplement his military pay. He returned to the law firm in May after 14 months of military duty.
The payments that Soss received from his employer, called military differential pay, are strictly voluntary. The law that protects the civilian jobs and benefits of employees called to active duty—the Uniformed Services Employment and Reemployment Rights Act of 1994, or USERRA—doesn’t require employers to pay anything to employees called to active duty with the Reserves or the National Guard.
But many employers offer military differential pay. Some even continue to pay full salary, whether it’s for two weeks of regular training or two years in a war zone.
Employers’ reasons for offering military differential pay can range from patriotism or a wish to ease soldiers’ financial burdens to a desire to retain employees after their military duty ends.
“If your human capital strategy is based on recruiting and retaining employees, military differential pay is an effective method for developing loyal employees,” says Air Force Maj. Rob Palmer, spokesman for the National Committee for Employer Support of the Guard and Reserve (ESGR), a Department of Defense agency that promotes cooperation between service members and their civilian employers.
Although paying a military differential is generally a minimal administrative task for employers, it can present some unusual circumstances for employees, particularly at tax time. HR can make sure that employees called to active duty understand that they will be taxed on military differential payments. And those taxes can be easy to overlook throughout the year because federal tax withholding is not permitted on military differential pay.
A Variety of Calculations
More than 580,000 Guard and Reserve members have been called to active duty since the terrorist attacks in September 2001. (Each state’s National Guard can be mobilized by a governor in peacetime for state emergencies or by the president in times of war. Each military branch has a Reserve that can be mobilized only by the president.)
It’s uncertain how many of the 80,000-plus Reserve and National Guard members on active duty as of late April were receiving differential pay. Soss estimates about 10 percent.
In a Society for Human Resource Management Weekly Online Survey conducted in April, 45 percent of the randomly selected HR professionals who responded said their organizations offer military differential pay, 10 percent said they pay full salary and benefits for part of the employee’s time on active duty, 6 percent said they do so for the entire period of activation, and 35 percent said they provide no direct compensation support to employees called to active duty.
According to a 2003 Mercer Human Resource Consulting survey, 68 percent of 201 employers provided military differential pay, 8 percent paid full salary, and 23 percent paid nothing.
Some employers make military differential payments for a limited time, such as one year, while others pay for the full period of deployment.
Generally, private-sector employers pay the difference between civilian and military salaries, while public-sector employers pay the difference between the civilian salary and total military income, which includes pay and allowances for housing, food, clothing, family separation and hazardous duty—reducing the size of the differential, Palmer says.
State laws also play a role. In Arizona, for example, public-sector employers are required to pay called-up service members the difference, if any, between their civilian pay just prior to leave and their military pay and allowances for the duration of deployment. Massachusetts requires publicsector employers to give 17 days of paid military leave for service in the Reserves and 34 days for service in the Massachusetts National Guard. Other states, including Pennsylvania, pay a bonus to returning Reserve and Guard members.
Under USERRA, employees can use accrued vacation and personal time to continue receiving pay during military leave, although employers can’t require them to do so. Employees cannot use sick leave, however, unless the employer allows all employees to use sick leave for other types of absences.
Not for Everyone
Since differential pay kicks in only when a civilian salary is higher than a military salary, middle-income professional and technical jobs are most affected, according to the Mercer survey. Two categories of employees are largely outside the scope of differential pay: Executives are rarely members of the Reserves or the Guard, and lower-paid employees typically make more in the military than in civilian life.
The military basic-pay grades most likely to trigger military differential pay, according to Soss, are E1 (entry-level Army private, for example) through E4 (Army specialist or corporal), which pay $15,612 to $24,744 annually, and O1 (entry-level officer) and O2 (Army first lieutenant, for example), which pay $29,628 to $47,566 annually.
Those figures do not include military allowances, which, if figured into the formula for military differential pay, can substantially reduce or eliminate the spread between civilian and military income.
Also part of the calculation is a 2006 federal law that gives Guard and Reserve members various new benefits, including a government-funded pay differential of up to $3,000 per month upon completion of a certain period of involuntary active duty.
The Tax Considerations
Employers’ generosity to called-up employees does come with a catch, however. Military differential pay, like military pay (though not allowances or combat pay), is taxable. But the Internal Revenue Service (IRS) has long held that called-up employees are “terminated,” so any payments they get from the employer are not wages—and thus are not subject to withholding for federal income, Social Security and unemployment taxes.
With no taxes taken out of military differential pay, an employee who is called to active duty—depending on the amount of differential pay received and his or her tax bracket—could face an unexpectedly large tax bill come April 15.
Although deployed employees could save part of their differential pay as it is received, “the last thing on their mind is putting away some of their money for income taxes,” Soss says.
HR professionals can help called-up employees deal with this tax anomaly by spelling out their options before they leave for military duty. “The most important thing is to explain that this money is taxable,” says Tom Reeder, benefits tax counsel at the U.S. Treasury Department. HR can also help employees estimate the amount of tax that will be due.
The simplest option is to pay the tax in a lump sum when filing annual income tax returns. Soss says he put aside money in a separate account to pay for taxes and emergencies before he left. But not everyone can afford that option.
It’s also fairly easy to adjust the withholding on one’s military pay to take out the estimated tax due on differential pay. Withholding can also be adjusted on a spouse’s pay or the service member’s civilian pay upon his or her return. Again, an employer can help an employee consider the options and do the calculations.
Another option is to make estimated federal (and state, if applicable) tax payments four times a year, as many selfemployed people do. Many tax experts dismiss this option as impractical, however, especially for Reservists and Guard members stationed overseas.
Slightly easier is to arrange, prior to deployment, automatic electronic payments from a bank account to the IRS. Employees must estimate how much each payment should be and make a final adjustment when filing annual income taxes.
A Chancier Tactic
More controversial than making estimated tax payments are so-called voluntary withholding agreements, in which an employer and an employee agree to have taxes withheld as normal during military leave. Some tax experts say it’s legal; others aren’t so sure.
“It might be OK, but I’d skirt away from it,” says Jason Kovac, compensation practice leader at WorldatWork, a compensation trade association based in Scottsdale, Ariz. Reeder of the Treasury Department adds, “It’s not technically allowable with the civilian employer.”
Nonetheless, some employers treat employees on military leave as active employees and continue to withhold taxes on their extra pay. “This ensures that when they return they are not faced with a large tax burden, as they might be if employees are terminated or their wages had been paid on [Form] 1099s and not taxed during their activation,” says Verizon spokesman Alberto Canal.
Some tax experts say the IRS is unlikely to challenge the practice because it’s receiving tax money. Tax attorney Gary Glenn of the Detroit based law firm Miller, Canfield, Paddock and Stone PLC says, “I don’t see a reason for anyone to get upset as long as both the employer and employee have consented to it.”
Off the Job—But How Far Off?
The IRS’s ban on withholding taxes from military differential pay stems from a 1969 ruling that considers employees called to active duty as terminated. Any employer payments to these employees are technically not wages and thus not subject to withholding.
This interpretation is at odds with USERRA, which says that such employees are on a leave of absence but defers to the IRS on tax issues. Making matters more complicated, the IRS treats military differential pay as wages for pension purposes.
“There’s an inherent problem with the IRS theory of this,” says James B. Thelen, in the Lansing, Mich., office of Miller Canfield. However, the IRS is unlikely to change its ruling because it’s not a high priority, attorneys say.
“I think any kind of change would have to be legislative,” says Treasury’s Reeder. Pending in Congress is the Active Duty Military Tax Relief Act (S. 455), which would treat differential payments as wages for workers on active duty for more than 30 days. A similar bill died in the last session of Congress.
The lack of withholding isn’t necessarily a bad thing, says Patricia McDermott, a tax expert and partner in the Washington, D.C., office of Venable LLP, because “more money ends up in the pocket of the employee” during deployment. “Changing the revenue ruling—many would view that] as a tax increase. … The IRS wants to be sensitive to not raising taxes on people who are fighting a war.”
Carolyn Hirschman is a business writer in Rockville, Md., who specializes in HR and benefits issues.
SHRM article: Workplace Rights for Service Members: The USERRA Regulations Deconstructed (Legal Report)
Web site: The National Committee for Employer Support of the Guard and Reserve (ESGR)
FAQs: Military Differential Pay (Internal Revenue Service)
‘In Line with Our Values’
Since 2001, Wachovia Corp., the financial-services giant based in Charlotte, N.C., has paid full salary to employees called to active duty. Last November, the company removed its one-year time limit and made the pay of unlimited duration.
“It’s in line with our culture and our values,” says Sharon Matthews, senior vice president and director of workforce policy at Wachovia. The extra pay helps employees and their families financially and encourages service members to return to the company after their deployment ends, she adds. From tellers to managers, about 500 of Wachovia’s 108,000 employees belong to the Reserves or the National Guard.