I just recently started working at a new company as the HR Manager and it has been a headache cleaning up the messes left by the woman who held this position prior to me. I'm preparing W-2s and noticed that 5 of the employees' box 16 did not match box 1. I did a little digging and determined that they were incorrectly set up in the system so for several paychecks were not having state income tax withheld. She must have corrected her mistake at some point within the year because when I started they all were having it deducted correctly. So my question is do I leave box 16 as the amount of wages they actually paid taxes on or do I change it to match box 1 to show what they should have paid tax on?

The amount of state wages reported in Box 16 should be their actual state wages they were paid for the year, and the amount of tax withheld in Box 17 is the amount actually withheld and paid to the state. You should let the employees know that state tax was under-withheld from their paychecks and this may have an impact on the amount they owe when they file their taxes. I also suggest you contact the state department of revenue to find out if they have any special procedures for making up under-withholding, and if there are implications in other areas such as unemployment insurance that may not have been properly paid as well. Finally, let your boss know that the state is likely to fine the company for its failure to properly withhold state taxes in a timely manner.

The state wage box should reflect what they actually EARNED while working in the state, NOT what the state tax was withheld on.

Report the state wages as a mirror of the federal wage (Box #1) UNLESS you live in a state that disallows certain pre-tax payments like FSA reductions or 403b withholdings.

Ebaines points are also valid and should be heeded!