Compiled by Robert W. Ditmer,
CPP
What Income Is Subject to the Earned Income Tax?
When Act 511 was originally enacted in 1965, it contained a definition of earned income that was supposed to be used consistently by all municipalities and school districts that adopted the EIT. However, one of the problems facing tax administrators and employers alike was the fact that the definition of earned income was inconsistent with the definitions used by either the Pennsylvania Code for the personal state income tax or the definitions used by the Internal Revenue Code. So the Pennsylvania Le gislature amended Act 511 by passin g Act 166, effective February 7, 2003, in order make the definition of earned income for the EIT conform to the definition of earned income under the Pennsylvania Code.
Earned income is now defined as follows: “Compensation means remuneration received for services whether directly or through an agent and whether paid in cash or property. Compensation includes salaries, wages, tips, gratuities, commissions, bonuses, incentive payments, vacation or holiday pay, termination or severance pay, sick leave pay (unless excludable), reimbursements and allowances in excess of allowable business expenses, and payments realized in the form of property or a discharge of indebtedness, unless specifically excludable from income.” [General Information for Withholding Pennsylvania Personal Income Tax, Pennsylvania Department of Revenue, Publication REV-415 AS (06-03). Download here]
As of July 7, 2005, the Pennsylvania legislature amended its definition of compensation to include distributions under IRC 409A nonqualified deferred compensation plans. In addition, income earned by a health savings account (HSA) or any amount paid or distributed out of an HSA used exclusively to pay the qualified medical expenses of the account beneficiary or to reimburse an account beneficiary for qualified medical expenses is excluded from Pennsylvania personal income tax.
The following payments by employers or fringe benefits, which may be taxable under federal law, can be excluded from earned income in Pennsylvania:
- The value of group term life insurance policies. (There is no $50,000 threshold as there is for federal income tax purposes.)
- Prizes and awards.
- Scholarships.
- An employee’s personal use of employer-provided property or services, such as company-provided vehicles, parking facilities, eating facilities, office equipment, and day care facilities, as long as the employee does not contribute to the cost of the property or services, either directly or through a payroll deduction.
- Deductions for health insurance premiums or medical costs that are made under a federally approved Section 125 cafeteria plan.
- Wages or compensation paid by the United States for active service in the armed forces.
The following payments, which may be excluded from compensation under federal law, must be included in earned income in Pennsylvania:
- Payments made by employers for adoption expenses.
- Additional payments for medical or dental expenses that are not covered by medical insurance, unless allowable as an ordinary, reasonable, and necessary business expense.
- Life insurance payments made by the employer on employees’ dependents.
- Deductions from payroll for 401(k) plans or other retirement plans.
In summary, the following is a list of the major changes from the definitions under the original Act 511 and the definitions under Act 166:
- Section 125 deductions for medical insurance and flexible spending accounts could not be excluded under the old definitions.
- Under the old definitions taxable fringe benefits that could not be excluded under federal rules had to be included in earned income. This included such things prizes and awards, and the personal use of employer-provided vehicles. (Group term life insurance has always been excluded.)
- Adoption assistance benefits did not have to be included in compensation under the old definitions.
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