IRS Issues Guidance on Withholding Changes Made by Tax Reform

In the wake of changes made by the tax reform law (commonly referred to as the Tax Cuts and Jobs Act) to an employer’s withholding obligations, the IRS is working to update its forms and procedures to reflect those changes.  Yesterday, the IRS issued Notice 2018-14 to communicate its progress and provide transition relief in areas that it has not finished updating to reflect the changes in law, including Forms W-4 and application of the withholding rules personal exemptions.

Expiration of Exempt Forms W-4

Employees furnish Form W-4 to employers to claim withholding allowances, or to claim an exemption from income tax withholding.  Forms W-4 that claim an exemption from withholding expire the following year on February 15.  Accordingly, Forms W-4 furnished for 2017 claiming an exemption from withholding on Line 7 will generally expire on February 15, 2018.  In recognition of the fact that a 2018 Form W-4 will likely not be released prior to the expiration of those forms, Notice 2018-14 extends the validity period of 2017 Forms W-4 to February 28, 2018.  Accordingly, employers need not receive a new Form W-4 before February 15, 2017, for employees who have claimed an exemption from withholding nor must they begin withholding on those employees after that date.

Notice 2018-14 also provides specific instructions for how employees should claim an exemption in 2018 using the 2017 Form W-4 (such as striking through 2017 on Line 7 and entering 2018, entering “Exempt 2018” on Line 7, or a substantially similar method) until 30 days after the 2018 Form W-4 is released.  In all cases, the Form W-4 claiming an exemption from withholding must be signed in 2018 to be valid for 2018.  Employees who claim an exemption from withholding for 2018 on a Form 2017 Form W-4 are not required to submit a new Form W-4 for 2018 after the 2018 Form W-4 is released.

Changes in Withholding Allowances

Under the current law, employees must furnish a new Form W-4 to their employers within 10 days of a change in status that reduces the number of withholding allowances to which they are entitled (such as the loss of itemized deductions).  Notice 2018-14 provides that an employee is not required to furnish his or her employer a new Form W-4 reflecting the reduced number of allowances until 30 days after the 2018 Form W-4 is released.

Flat Rate Withholding

As reflected in the revised Notice 1036 (discussed here), employers are not required to implement the changes to the flat withholding rate available for supplemental wages until February 15, 2018, a delay from the otherwise-applicable January 1 effective date for the new rate.  Under the Act, the withholding rates were reduced from 25% and 39.6% to 22% and 37%, respectively.  If an employer withheld at a higher rate for optional flat-rate withholding (25%) on or after January 1, but before February 15, the employer may refund the excess withholding to the employee using the standard rules related to corrections of excess federal income tax withholding, but is not required to do so.  (Notice 2018-14 is silent on correction of overwithholding based on the higher rate for mandatory flat-rate withholding (39.6%), but presumably similar refunds could be made.)

The new 22% rate optional flat-rate withholding on supplemental wages of less than $1 million increases the likelihood that higher-income employees may be significantly underwithheld on bonus and other compensation.  IRS guidance prohibits employers from withholding at any other rate (higher or lower) than the specified rate if the flat-rate method is used.  As a practical matter, it is unclear what enforcement measures, if any, the IRS could take if an employer permitted employees to elect a rate in excess of 22% to avoid underwithholding and the need for estimated tax payments.  In years past, IRS personnel have informally expressed concern that some individuals may attempt to “game the system” by requesting increased rates of flat rate withholding, but this concern seems more hollow when the rate of optional flat withholding – particularly for higher income workers – seems to fall well below applicable income tax rates.

Withholding on Periodic Payments in the Absence of Form W-4P

Prior to amendment by the Act, withholding at the rate applicable to a married individual claiming three withholding allowances was required with respect to periodic payments made under an annuity, IRA, or qualified plan subject to withholding under Code section 3405 if the payee did not provide a Form W-4P.  The Act amended that provision to require withholding at a rate to be determined by the Secretary of the Treasury.  Due to the implementation timeline for changes under the Act, Notice 2018-14 instructs employers to impose withholding in 2018 on such payments at the same rate previously applicable (married individual claiming three withholding allowances).

For additional guidance on these requirements, employers should consult the 2018 IRS Publication 15, which was also released yesterday and is consistent with the relief provided in Notice 2018-14.

New Form 1042 Instructions Shift Reporting Obligations for QDDs

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January 18, 2018

The IRS recently released new Form 1042 instructions (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons), including changes to reporting for a withholding agent that is a qualified intermediary (QI) acting as a qualified derivative dealer (QDD).  As discussed in an earlier blog post, the QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on dividend equivalents, pursuant to Code section 871(m).

The Form 1042 instructions appear to respond to comments received after draft 2017 Form 1120-F instructions were released last October that required the reporting of QDD liabilities on the Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) and an accompanying schedule.  The updated instructions require the same information regarding QDD tax liability that the draft instructions required to be reported on Form 1120-F, which most QIs were not required to file absent the new QDD tax liability.  Accordingly, it is expected that QDDs will report their QDD tax liability on the Form 1042 (and Form 1042‑S) rather than the Form 1120‑F.

The 2017 Form 1042 includes a new Section 4, which a QI that is a QDD (or has a branch that is a QDD) must complete if it made any payments reportable on the Form 1042 in its QDD capacity.  The updated instructions provide guidance to QDDs regarding the proper withholding agent status code to use when filing Form 1042 and Form 1042‑S.  A QI that is a QDD should use the chapter 3 status code for a QI (code 12) on Form 1042, regardless of the types of payments it made for the calendar year.  But a QI that is a QDD is required to use the withholding agent chapter 3 status code for a QDD (code 35) on Form 1042-S for a payment that it made in its capacity as a QDD.  A filer must enter both a chapter 3 and a chapter 4 withholding agent status code on the form regardless of the type of payment being made.

The updated instructions also provide guidance to QDDs applying the transitional guidance in Notice 2016-76 for 2017 (see prior coverage).  This notice allows a QDD to deposit amounts withheld for dividend equivalents on a quarterly basis, and allows a QDD applicant awaiting a QI‑EIN to wait until it receives its QI‑EIN to deposit amounts withheld on dividend equivalents.  The withholding agent should write “Notice 2016‑76” on the center, top portion of the 2017 Form 1042.  For 2017 and 2018, the columns for total section 871(m) amount and total QDD tax liability pursuant to Section 3.09(A) of the Qualified Intermediary Agreement should state “not applicable.”

IRS Releases Withholding Guidance

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January 11, 2018

Earlier today, the IRS released new percentage method withholding tables for 2018 implementing the changes to major withholding provisions following the enactment of tax reform legislation.  In the revised Notice 1036, the IRS provided new withholding tables utilizing the value of personal exemptions that would have existed in the absence of tax reform and the existing withholding allowances claimed on employer’s Forms W-4.  The guidance also adjusts the amounts that must be added to a nonresident aliens’ wages to determine the proper amount of withholding.

In addition, the guidance sets the rates for optional flat-rate withholding on supplemental wages below $1,000,000 at 22%, mandatory flat-rate withholding on supplemental wages on $1,000,000 and above at 37%, and backup withholding at 24%.  The notice requires that the new withholding tables be implemented as soon as possible, but not later than February 15, 2018.