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.