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.

IRS Releases Four FATCA-Related Regulation Packages

Late Friday, December 30, 2016, the IRS and Treasury Department released four regulation packages related to its implementation of the Foreign Account Tax Compliance Act (FATCA).  Two of the packages include final and temporary regulations and two contain proposed regulations.  The packages are:

  • Final and Temporary Regulations under Chapter 4 that largely finalize the temporary regulations issued in 2014 and update those temporary regulations to reflect the guidance provided in Notices 2014-33, 2015-66, and 2016-08 and in response to comments received by the IRS.
  • Final and Temporary FATCA Coordinating Regulations under Chapter 3 and Chapter 61 that largely finalize the temporary coordination regulations issued under Chapter 3 and Chapter 61 in 2014 and update those temporary regulations to reflect the guidance provided in Notices 2014-33, 2014-59, and 2016-42 and in response to comments received by the IRS.
  • Proposed Regulations under Chapter 4 that describe the verification and certification requirements applicable to sponsoring entities; the certification requirements and IRS review procedures applicable to trustee-documented trusts; the IRS review procedures applicable to periodic certifications of compliance by registered deemed-compliant FFIs; and the certification of compliance requirements applicable to participating FFIs in consolidated compliance groups. The proposed regulations also reflect the language of the temporary Chapter 4 regulations described above.
  • Proposed Coordinating Regulations under Chapter 3 and Chapter 61 that reflect the language of the temporary coordination regulations described above.

We are reviewing the regulations and preparing a series of articles discussing various provisions in the regulations.  We will post the articles over the next several days.

IRS Guides for the Field Summarize U.S. Withholding Agent Responsibilities and Confuse Issue Related to U.S. Source Gross Transportation Income

[UPDATE: LB&I revised the practice unit “FDAP Payments – Source of Income” on July 15.  The link below now accesses the updated version, which removes the statement regarding transportation income described in this article.  For our discussion of the change and images of the original and updated language, see this article.]

The Large Business and International division of the IRS released two new practice units (slide presentations) that can serve as a guide to U.S. withholding agents with respect to several key compliance issues.  The first practice unit, “FDAP Withholding Under Chapter 3,” serves as a quick summary of U.S. withholding agents’ obligations under Chapter 3 and the risks of noncompliance (i.e., penalties), while the second practice unit, “FDAP Payments – Source of Income,” can help U.S. withholding agents determine the source of income for purposes of deciding whether Chapter 3 applies.

One issue that U.S. withholding agents have struggled with relates to whether withholding is required  for payments of U.S. source transportation income to foreign persons.  Generally, Sections 1441 and 1442 require withholding agents to withhold 30% on payments subject to the 30% gross tax under Sections 871 and 881 (i.e., FDAP income).  However, payments of gross transportation income that is U.S. source because the transportation begin or ends (not both) in the United States are subject to a 4% excise tax under Section 887 that is self-imposed by the payee, unless an exception applies.  Section 887(c) provides that the 30% gross tax applicable to most U.S. source income of foreign persons (other than income effectively connected with a U.S. trade or business) does not apply to transportation income.

The issue that has arisen is that neither Section 1441 or 1442 explicitly reference Sections 871 and 881 as a basis for the withholding.  However, it seems illogical to require 30% withholding on U.S. source gross transportation income given that such income is only subject to the 4% excise tax.  To this end, IRS Publication 515 provides that such amounts are not subject to Chapter 3 withholding under Section 1441 or 1442.  Nonetheless, various large taxpayers have had examiners raise the issue on audit asserting that such amounts are subject to Chapter 3 withholding notwithstanding the inapplicability of the underlying tax that Chapter 3 is intended to collect although the examiners have ultimately retreated with respect to the issue.  As a result, U.S. withholding agents have struggled to determine their withholding obligations with respect to such payments, and the IRS has ignored repeated requests from the IRS Information Reporting Program Advisory Committee (IRPAC) (for example, see the 2013 IRPAC report) and others to provide formal guidance in this area.

The “FDAP Payments – Source of Income” practice unit confuses the issue further by definitively stating that transportation income is not FDAP income.  Because Chapter 3 applies only to payments of FDAP income, the 30% withholding for payments subject to Chapter 3 would not apply to payments of transportation income.  Although this might seem like welcome news, the conclusion is puzzling given that FDAP income is generally defined very broadly to include all income, except gains derived from the sale of real or personal property and items of income excluded from gross income.  This broad definition would seemingly include U.S. source gross transportation income, which is a payment for a service paid in an amount known ahead of time or calculable.  Moreover, this is not the basis given in Publication 515 for excluding such amounts from withholding.  Thus the conclusion in the practice unit would seem incorrect and suggests that the document was not reviewed for accuracy by the Chief Counsel attorneys in Branch 8, the international withholding branch.

The pronouncement of law contained in the practice unit continues a worrying trend toward informal guidance in frequently asked questions, publications, comments at conferences, and on the IRS website.  Taxpayers are not permitted to rely on informal guidance, but have often been left without any formal guidance upon which to rely.  Until the IRS issues formal guidance, taxpayers are left to navigate an issue that could arise on audit but truly should not be an issue in most cases.  It would be preferable if the IRS issued a notice announcing the IRS and Treasury intend to amend the Section 1441 regulations to preclude withholding on U.S. source gross transportation income that is subject to the 4% excise tax under Section 887.