IRS Rolls Out Guidance, Raising Questions on Withholding

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By Michael Baer and Kathy Larsen

It was a head-spinning start to 2018 for employers, payroll companies, and possibly confused workers.

The new tax law not only cut taxes and changed tax brackets, but also made such big changes to exemptions and deductions that fundamental pieces of the employment tax system are being overhauled bit by bit.

And the Trump administration’s drive to deliver the cuts immediately means the changes are not coming at the same time.

By 2019, major adjustments to the withholding process may be finished, and more accurate ways to withhold on employee pay may be in place. In the meantime, companies and workers are left to determine whether paycheck withholding is too much, too little, or just right.

This is not the first time late-year tax law changes set up complications for withholding, but the magnitude of the changes is notable.

Congress’ top tax-writing Democrats expressed alarm about the potential for people to have too little withheld this year, leaving them with unexpected tax bills next year. Peter Isberg, president of the National Payroll Reporting Consortium, agreed there is some potential for that.

Based on the percentage-method withholding tables released Jan. 11 by the Internal Revenue Service, some employees could be in danger of tax underwithholding if they claim a significant number of withholding allowances, said Michael O’Toole, senior director of publications, education, and government relations with the American Payroll Association.

Amid confusion about the moving parts, however, some people may not have to worry. “It may be that some can ignore the changes and it will all turn out OK,” Isberg said.

Phase-In

The impact of the tax-code overhaul, which was signed into law Dec. 22 (Pub. L. 115-97), is meant to show up in paychecks no later than Feb. 15, the IRS said Jan. 11 in its first piece of employer guidance ( Notice 1036) about new income withholding tables. The tables reflect the new law’s much higher standard deduction and adjusted tax rates, but they keep the personal-exemption-based withholding allowances set in 2017 for 2018, even though the law eliminated personal exemptions. However, there may be mismatches between the allowances employees registered for in 2018 and the withholding that would be suitable for them under the new system.

Isberg, who also is vice president for government relations for payroll services company ADP LLC, said Jan. 16 that he had not expected the IRS to allow employers to rely on existing Forms W-4, Employee’s Withholding Allowance Certificate, where employees list personal exemptions. The guidance was surprising, but at least it makes the initial process easier than requiring employees to file new W-4s, he said.

In the next phase of the rollout, Isberg expects the agency to update its online tax calculator and issue a revised W-4 but not require employees to file new forms. Instead, he expects the IRS to “strongly encourage employees to review their status.”

More than ever, employees have to examine their withholding to translate and match their expected tax liability in 2018, O’Toole said.

In Notice 1036, the IRS said that by the end of February it would have the agency’s online withholding calculator ready, along with information to help people determine whether to adjust withholding to account for repeal of the exemptions, the higher child tax credit, and more.

Correct Estimates

The existing W-4 is “so focused on personal exemptions” as a base for withholding allowances, Isberg said, that he wondered “how do we come up with an estimate” that’s close to correct? Using the withholding allowance amounts was not perfect, either, he said, but people knew how to make adjustments to avoid overwithholding or underwithholding.

The IRS has gone out of its way to avoid a W-4 refiling requirement this year, Isberg said. The American Payroll Association did not receive the one-year transition period it asked lawmakers for in December, but at least the “worst-case scenario of, early on, requiring everyone to file a new W-4” was averted, Isberg said.

As for later phases, Isberg said the service-provider industry has a long history of recommending that the IRS institute a six-month delay in implementing withholding processes that involve new database fields, reporting, or recordkeeping requirements.

The database fields are to change for Form W-4, at least by 2019, and a new system would emerge to determine how to establish withholding.

For 150 million to 160 million workers, refiling W-4s in a short time frame is no small matter, Isberg said. Although it is not “as big a deal as it would be in print” because of automated systems, he said a lot of preparation is needed.

Tax Law Benefit Changes

Another big change for payroll is the elimination of tax-free moving expenses under the tax code overhaul. Because employees may not deduct moving expenses from 2018 to 2025, employers must include as wages any related reimbursements or payments.

Starting Jan. 1, 2018, employees may not deduct moving expenses unless a move was completed and paid for before Dec. 31, 2017, Mary Hevener, a partner with Morgan, Lewis & Bockius LLP in Washington, said Dec. 20 during a Bloomberg Tax webinar. For example, a deduction would not be allowed for a move that was completed Dec. 17, 2017, but was paid for Jan. 20, 2018, she said.

Employers are to lose a tax deduction for subsidizing qualified transportation fringe benefits starting in 2018. Employees still are able to take advantage of the up to $260 a month tax-free qualified transportation fringe benefits, but any costs expended for providing such a program will not be tax-deductible to employers at the corporate level.

This change could result in some employers modifying their programs to provide workers with additional amounts to pay instead of a subsidy amount paid into the plan directly in the name of the employee.

In addition, the law eliminates the qualified bicycle transportation fringe benefit of $20 a month.

Employer deductions for employee-related entertainment, amusement, or recreation activities would be disallowed, but the law would allow deductions for 50 percent of food and beverage expenses associated with operating a trade or business.

Under the new law, backup withholding would be reduced to 24 percent from 28 percent. Backup withholding is used to assure that federal income tax is paid on earnings in cases when an independent contractor or recipients of other, nonwage payments lack taxpayer identification numbers. Generally, such nonwage earnings are reported by employers on Form 1099-MISC, Miscellaneous Income.

Data Security for Payroll

Payroll professionals can expect continued emphasis on data security and data privacy as these issues relate to payroll.

In addition to now including a verification code box on Form W-2, Wage and Tax Statement, to be used voluntarily by payroll service providers to help match real W-2s submissions with Form 1040 filers, the IRS continues to warn about the vulnerability of payroll data to email phishing schemes.

First reported in early 2016, fake emails to those that access payroll data inquiring from a purported high-level company official about the employer’s Forms W-2 continue to be a primary cause of data compromise.

Technical Changes

Although the federal income tax withholding rate on supplemental wages exceeding $1 million fell to 37 percent, or the highest individual tax rate, from 39.6 percent starting Jan. 1, 2018, the optional flat tax rate used to withhold on supplemental wages of up to $1 million technically was to increase, Hevener said.

The rate, set by IRS in Notice 1036, is 22 percent.

However, a likely oversight by Congress means the new rate really should be 28 percent, up from 25 percent, because the new tax law eliminated Internal Revenue Code Section 1(i)(2) that in 2017 was the third-lowest rate, 25 percent, Hevener said.

Treasury regulations refer to this section of the code to determine the optional rate. Language in Treasury Regulations Section 31.3402(g)-1(a)(7)(iii)(F) set that rate at 28 percent, or the third-lowest rate under code Section 1(i)(2). Because that part of the law no longer exists now that H.R. 1 was signed into law, the only rate that may be used is 28 percent, she said.

In 2018, Congress could pass a technical amendment or the Treasury Department could issue new rules establishing that 22 percent rate, Hevener said.

To contact the reporters on this story: Michael Baer in Washington at mbaer@bloombergtax.com; Kathy Larsen in Washington at klarsen@bloombergtax.com. To contact the editor responsible for this story: Meg Shreve at mshreve@bloombergtax.com.

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