Which Tax Year Should End of Year Employee Paychecks Be In?

Which Year's W-2 for Tax Purposes?

employee paychecks
Atanas Bezov/E+/Getty Images

A common question from employers relates to writing and distributing employee paychecks at the end of the year.  

Which Tax Year Should an Employee Paycheck Be In? 

The Question: Are end-of-year paychecks taxable in the year of the work or the year of the paycheck?

The rule is: The paycheck is considered as taxable income in the year the paycheck is ISSUED (dated), even if the work was done and the pay was earned in a different year (but read the exception below).

For example:

You pay employees on January 2, 2017, for work done in the last week of December 2016. The gross pay is taxable in 2017, not 2016. If you pay employees on the last day of December for this work, the paycheck date of December 31, 2016, would mean the pay is taxable income in 2016.

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. Last year, I received a payment in the mail at the end of December, but the check was dated January 1.

It was a post-dated check.

Yes, I could have tried to deposit the check, but the bank would probably not have taken it. Just because I had the check in my hand, because it was dated in the future, I did not have constructive receipt. In addition, the amount of the check was included with my taxes for last year. 

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 increase before it is paid gives the employee time to change the W-4 form to add more withholding to that paycheck. 

How Does This Rule Affect W-2 Forms for Employees?

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. This new earlier W-2 filing date begins in 2017, for 2016 taxes.) 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? 

I checked with Patriot Software and they said, "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? 

Two suggestions: 

1. Don't get ahead of yourself and don't try to over-think this.

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.  

2. 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. 

3. If you are confused, 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.

Read more about selecting a payroll service.