Significant Withholding Changes Ahead as Trump Signs Tax Bill

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By Keith Hill, Michael Trimarchi, and Michael Baer

Employers and their employees in 2018 are to see withholding methods change because of the elimination or suspension of many exclusions and deductions now that a tax bill overhauling the U.S. tax code for the first time in more than 30 years has become law.

The bill (H.R. 1), which was signed into law Dec. 22 by President Donald Trump, keeps the seven individual federal income tax brackets but lowers most of the rates, including the highest one. The rates of 10, 12, 22, 24, 32, 35, and 37 percent take effect Jan. 1, 2018, and expire Dec. 31, 2025. A transition period, set by the Treasury Department, allows the use of 2017 percentage income withholding methods into early 2018.

The Senate passed the Tax Cuts and Jobs Act on Dec. 20 by a vote of 51-48 after making some minor changes to bring it into compliance with Senate budget rules. The altered bill was sent back to the House, which had originally voted Dec. 19 on a previous version. The House passed the amended bill Dec. 20 by a vote of 224-201. A public law number soon is expected to be applied to the measure.

Revisions to Form W-4

Under the new tax law, personal exemptions were suspended from 2018 to 2025, a move that would require the Internal Revenue Service to update Form W-4, Employee’s Withholding Allowance Certificate. However, after the agency releases new income tax withholding guidance for the new law, 2017 Forms W-4 that employees already have filed would continue to be used by employers, the agency said Dec. 26.

“The IRS emphasizes this information will be designed to work with the existing Forms W-4 that employees have already filed, and no further action by taxpayers is needed at this time,” the agency said in an email.

Forms W-4 are completed by employees to inform employers of marital status and the number of withholding allowances to be claimed for federal income tax purposes. In 2017, a withholding allowance is the equivalent of the single personal exemption of $4,050.

Until the IRS releases initial guidance on 2018 percentage method income tax withholding brackets, expected by January, “employers and payroll service providers should continue to use the existing 2017 withholding tables and systems,” the agency said.

After new withholding guidance is released, possibly in mid-January, it may take two to six weeks for payroll departments to implement the changes that would appear on employee paychecks, the American Payroll Association’s Michael O’Toole, told Bloomberg Tax on Dec. 26. O’Toole is the senior director of publications, education, and government relations for the association.

Those implementing changes based on new guidance would be encouraged to do so by February, the IRS said.

The APA, in a Dec. 8 letter to Sen. Orrin Hatch (R-Utah), who is head of the Senate Finance Committee, also said that more time was needed for employers to adjust to the changes. The association recommended that “employers be allowed to continue to apply, throughout 2018, the 2017 versions of Forms W-4 (even though they reflect the use of ‘personal exemptions,’ which are no longer part of the law), because there is no time to design and implement a totally new Form W-4 system.”

By eliminating personal deductions, the new tax law “would make it nearly impossible for employees to complete their Forms W-4 so they could properly calculate their annual federal tax liabilities,” the APA said. The association also said that it was likely the IRS “would not allow employees across America simply to request income tax withholding at a rate to be selected by each individual employee; and even if such elections were allowed, such a system would be impossible to administer immediately.”

Additionally, the new law calls for a transition period established by the Treasury secretary that would give employers and payroll service providers time to adjust to the new requirements, Mary Hevener, a partner with Morgan, Lewis & Bockius LLP in Washington, said Dec. 20 during a Bloomberg Tax webinar. This period could last most of 2018, she said.

What Is an Allowance Amount?

The new tax law suspends personal exemptions until the end of 2025 and replaces them with an allowance amount for each employee, Hevener said. However, it does not explain what an allowance amount is, she said. The Internal Revenue Service would have to decide whether the allowance would be equivalent to personal exemptions and/or would be a specific amount, she said.

Although a withholding allowance amount could allow employees to consider other deductions as well, there was a concern that an employee could conceivably file to have a specific withholding amount, which would be difficult to implement and verify for accuracy, Hevener said. The IRS and employers would need to create payroll systems to account for the changes, she said.

The increased standard deduction under the law would not make up for the loss of personal exemptions in some cases, such as for employees with more than four exemptions, she said.

State Withholding

States with income tax withholding policies that use the federal personal exemption would be affected by the new law. Because of the elimination of personal exemptions, states that plan to follow the federal system in 2018 would have to change their withholding methods.

The 30 states that allow use of the federal Form W-4, Employee’s Withholding Allowance Certificate, may need to change their policies in 2018, Hevener said. The question then arises about when and how those states would modify withholding systems to accommodate the changes, she said.

Ten states require the use of federal Form W-4: Colorado, Idaho, Montana, Nebraska, New Mexico, North Dakota, Oklahoma, Oregon, South Carolina, and Utah. Changes to the W-4 would affect these states.

Many states use up to three additional elements of the federal tax code, including federal Form W-4, in the withholding process, according to a recent Bloomberg Tax analysis. Even if the state has its own W-4, sometimes the federal values for the personal exemptions and the standard deduction are related.

Supplemental Wages: New Flat Rate

Although the federal income tax withholding rate on supplemental wages exceeding $1 million would fall 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 is to increase, Hevener said.

The rate is set to increase to 28 percent from 25 percent because the tax law eliminates Internal Revenue Code Section 1(i)(2) that was the third-lowest tax rate, or 25 percent, in 2017, 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.

The optional rate could drop to 22 percent, or the third lowest rate, starting Jan. 1, if Congress passes a technical amendment or the Treasury Department issues new rules establishing that rate, Hevener said.

Payroll-Related Provisions

Another big change for payroll is the elimination of tax-free moving-expenses as of Jan. 1. Because employees will not be able to deduct moving expenses from 2018 to 2025, employers must include as wages any related reimbursements or payments. There has been concern about how this provision would affect the taxation of employee wages in 2018, Hevener said.

Employees would not be able to deduct moving expenses unless a move was completed and paid for before Dec. 31, 2017, Hevener said. 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.

Several exclusions that were to be eliminated in the original tax proposal from the House, such as tax-free employer-provided educational assistance, tax-free employer-provided adoption assistance, and employee achievement awards, were preserved in the new law. The tax law also retains the Work Opportunity Tax Credit.

The tax law would define tangible personal property as it relates to employee achievement awards to exclude cash, merchandise cards or coupons, meals, or similar items.

The law would eliminate the qualified bicycle transportation fringe benefit of $20 a month and the individual mandate tax under the Affordable Health Care Act.

Employer deductions for 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. Employers also are to lose the deduction for subsidizing qualified transportation fringe benefits starting in 2018.

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.

To contact the reporters on this story: Keith Hill in Washington at khill@bloombergtax.com, Michael Trimarchi in Washington at mtrimarchi@bloombergtax.com, and Michael Baer in Washington at mbaer@bloombergtax.com. To contact the editor on this story: Michael Baer at mbaer@bloombergtax.com.

For More Information

The payroll roadmap to provisions contained in H.R. 1 is found in the 2017 Bloomberg Tax Year-End Clearinghouse.

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