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.

Analysis of the Final Tax Reform Bill – Part III: New Source Rules and Tax Reporting and Withholding Requirements

On December 15, the House-Senate Conference Committee released the joint explanatory statement and final legislative text (the “Final Bill”) resolving differences between the House- and Senate-passed versions of the Tax Cuts and Jobs Act (the “House Bill” and “Senate Bill,” respectively).  The provisions of the Final Bill related to health reform, equity and executive compensation, deductions and exclusions for employee meals and other fringe benefits, private retirement plan benefit, paid leave, and various reporting, withholding, and income sourcing rules, largely track the bill passed by the Senate.  Many of the changes included in the House Bill but not the Senate Bill were dropped from the Final Bill. (Our earlier coverage of the House and Senate bills can be seen in a series of posts here.)

This post is the third in a series of three posts analyzing provisions of the Senate Bill. (Part I analyzes the elimination of the penalty for failing to maintain minimum essential coverage under the ACA and changes to equity and executive compensation.   Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.)

This post analyzes the new reporting and withholding requirements and source rules. Specifically, the Senate Bill will: change the methodology for determining the appropriate amount of federal income tax withholding on wages; require reporting for deductible amounts paid with respect to fines and penalties; require reporting for certain life insurance transactions; modify the reporting rules for Alaska Native Corporations; modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and impose withholding under section 1446 for sale of an interest in a U.S. partnership by a foreign person that is treated as effectively connected income under new Code section 864(c)(8).

These changes generally will be effective after 2017, except as otherwise noted below.

Wage Withholding. The Final Bill follows the Senate Bill and will raise the standard deduction and suspend personal exemptions, which currently allow individuals to reduce their taxable income.  However, the suspension of personal exemptions will no longer apply for tax years beginning after December 31, 2025.  In recognition of the suspension of personal exemptions, the Final Bill will also change the method of determining the proper amount of federal income tax withholding on an employee’s wages, a change not reflected in the House or Senate bills.  Under current law, the amount of wages taken into account for withholding purposes is the amount by which the wages exceed the number of withholding exemptions claimed, multiplied by the amount of one such exemption, the value of which equals one personal exemption under Code section 151(b).  The Final Bill will amend Code section 3402(a)(2) to require withholding on the amount by which wages exceed the employee’s withholding allowance prorated to the payroll period.  The Final Bill amends Section 3402(f) to instruct the Treasury to issue regulations specifying the methodology for determining an employee’s withholding allowance based on (A) whether the employee can be claimed as a dependent on another return; (B) whether the employee’s spouse is entitled to a withholding allowance (if the spouse does not have in effect a Form W-4 claiming the allowance); (C) the number of individuals for whom the employee may be entitled to a credit under Code section 24(a); (D) any other allowances that the employee elects to take into account (such as estimated itemized deductions, estimated tax credits, and additional deductions); (E) the standard deduction allowable to the employee (one-half the standard deduction in the case of married employee whose spouse is receiving wages); and whether the employee has a Form W-4 in effect for more than one employer.

These changes will likely require the IRS to develop a new Form W-4, and employers to collect new Forms W-4 from employees.  As highlighted in an earlier post, the IRS has indicated that it is delaying its annual update to guidance on employer withholding pending the passage of tax reform.   The IRS has indicated that transition relief will be provided.

Withholding on Periodic Payments from Retirement Plans.  In recognition of the elimination of personal exemptions, the Final Bill instructs the Treasury to promulgate regulations for determining the amount of federal income tax to withhold on periodic payments from a qualified retirement plan, IRA, or other account subject to withholding under section 3405(a) when no Form W-4P is in effect.  Under current law, such payments were subject to wage withholding as though the payee was a married individual with 3 withholding exemptions.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties.  As in the Senate Bill, the Final Bill will adopt a new Code section 6050X requiring government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into, where the aggregate amount required or directed to be paid or incurred exceeds a threshold ($600 in the statute, but subject to adjustment by Treasury).  The return must identify any amounts for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement. These changes will generally apply to amounts paid or incurred on or after the date of enactment, except that the changes will not apply to binding orders or agreements entered into or subject to court approval before that date.

Reporting of Certain Life Insurance Transactions. As in the Senate Bill, the Final Bill will also adopt a new Code section 6050Y that will create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a “reportable policy sale”; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of “reportable death benefits.”  A “reportable policy sale” is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship to the insured.  A “reportable death benefit” is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements will apply for reportable death benefits paid and reportable policy sales after 2017.

Reporting Requirements of Alaska Native Corporations. Under current law, Alaska Native Corporations may deduct donations of cash or assets to “settlement trusts,” which are entities that manage Native lands.  Section 13821(c) of the Final Bill follows the Senate Bill and modifies the reporting requirements imposed on Native Corporations with respect to such deductions.  Specifically, Native Corporations that have made contributions to a settlement trust and elected to deduct those contributions will be required to provide the settlement trust a statement regarding the election not later than January 31 of the calendar year after the calendar year in which the contribution was made.  The statement will be required to include: (i) the amount of the contribution to which the election applies; (ii) whether the contribution was made in cash; (iii) for contributions of property other than cash, certain details about the property; (iv) the date of the contribution; and (v) any other information required by Treasury.

Sourcing Rule for Sale of Inventory Property. Under Code section 863(b), sales of inventory property produced in one jurisdiction and sold in another are currently sourced by allocating 50% of the sales income to one jurisdiction and 50% to the other.  Like the House and Senate Bills, Section 14304 of the Final Bill will change this sourcing rule so that the entire amount will be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. As in the Senate Bill, Section 14503 of the Final Bill will change two provisions affecting the sourcing rules related to U.S. possessions.  First, Code section 937(b), which controls whether income of U.S. citizens and residents is treated as possession source income, generally provides that income treated as U.S. source or effectively connected with a U.S. trade or business is not treated as income from sources within a possession or effectively connected with a trade or business in that possession.  The bill will amend Code section 937(b)(2) so that only U.S. source or effectively connected income attributable to a U.S. office or fixed place of business is excluded from possession source income.  Second, the bill will amend Code section 865, which sets forth the sourcing rules for personal property sales, so that capital gains earned by a U.S. Virgin Islands resident would always be U.S. Virgin Islands source income.

Withholding on Gain from the Sale by Foreign Persons of Interests in Certain Partnerships. Section 13501 of the Final Bill follows the Senate Bill and adds a new Code section 864(c)(8) that treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business. Under the provision, if a foreign corporation or nonresident alien individual owns, directly or indirectly, an interest in a partnership engaged in a U.S. trade or business, a portion of the gain or loss on the sale or exchange of such interest is treated as effectively connected with the conduct of a U.S. trade or business to the extent such gain or loss does not exceed: (1) in the case of a gain, the portion of the partner’s distributive share of the amount of gain which would have been treated as effectively connected if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange of the partnership interest (or zero, if no such deemed sale would have been effectively connected) or (2) in the case of a loss, the portion of the partner’s distributive share of the amount of loss on the deemed sale described in (1) which would have been effectively connected (or zero, if no such deemed sale would have been effectively connected).  The gain or loss treated as effectively connected under the provision is reduced by the amount so treated with respect to United States real property interests under section 897.

The Final Bill will also amend Code section 1446 to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under Code section 864(c)(8), similar to the existing rules under Code section 1445. Upon request by the transferor (generally, the seller) or the transferee (generally, the buyer), the Treasury may prescribe a reduce rate of withholding if the Secretary determines it is appropriate.  In addition, no withholding is required if a transferor furnish to the transferee an affidavit signed under penalty of perjury stating that the transferor is not a foreign person and providing the transferor’s U.S. TIN.  In the absence of such an affidavit (or if the transferee has actual knowledge that a provided affidavit is false or receives a notice from the transferor’s agent or transferee’s agent that such affidavit is false, similar to agent’s notice obligations under section 1445(d)), the transferee of the partnership interest is liable for satisfying the withholding obligation, but in the event that the transferee fails to withhold the required tax, the partnership must withhold an amount equal to the amount the transferee failed to withhold (plus interest) from distributions to the transferee.  The Final Bill clarifies the grant of authority to the Secretary of the Treasury, instructing the Secretary to issue regulations appropriate to implement the new section.  Specifically, the conferees intend that the Secretary may issue guidance permitting a broker, as agent of the transferee, to perform the 10 percent withholding with respect to a partnership interest.

The changes will generally be effective for sales and exchanges on or after November 27, 2017, though the Final Bill provides that the withholding provisions are effective for sales or exchanges after December 31, 2017.

Employer Withholding Guidance Delayed Pending Tax Reform

The increasingly likely prospect of a tax reform bill being enacted by the end of the year has prompted the IRS to delay annual withholding guidance, according to Scott Mezistrano of the IRS Wage and Investment Division’s Industry Stakeholder Engagement and Strategy Office.  It is expected that any tax reform bill would change tax rates, increase the standard deduction, and eliminate personal exemptions.  These changes will necessitate changes in withholding rates and withholding tables to ensure that employers withhold the appropriate amount of tax from employees’ wages.  Speaking on an IRS payroll industry monthly conference call on December 7, Mezistrano said that the guidance that will be delayed includes Form W‑4 (Employee’s Withholding Allowance Certificate), the withholding tables, Publication 15‑A (Employer’s Supplemental Tax Guide), and Publication 15‑B (Employer’s Tax Guide to Fringe Benefits).  Employers will likely be required to continue using the 2017 withholding tables and guidance into 2018, even if the tax reform legislation were to be signed into law before year end and the new tax rates were to take effect on January 1, 2018.  Employers would also be provided a transition period to implement the new IRS withholding guidance, according to Mezistrano.

Currently, a conference committee with selected lawmakers from both chambers is negotiating a final bill to reconcile the two versions of the GOP tax reform bill passed in the Senate (discussed here, here, and here) and in the House (discussed in an earlier series of posts).  A final negotiated bill would need to pass both chambers before the President can sign it into law.  We will continue to monitor tax reform legislation and related IRS guidance for further developments.

Analysis of the Senate Tax Reform Bill – Part III: New Source Rules and Tax Reporting and Withholding Requirements

Early Saturday morning, the Senate voted 51-49 to approve a modified version of the Tax Cuts and Jobs Act (the “Senate Bill”). The Senate Bill differs from the House bill (discussed in an earlier series of posts here) passed last month in several respects, and a final negotiated bill will need to pass both chambers before the President can sign it into law. Given the difficulty of moving legislation through the Senate, it seems likely that any enacted legislation would likely be similar to the version passed by the Senate.

This post is the third in a series of three posts analyzing provisions of the Senate Bill. (Part I analyzes the elimination of the penalty for failing to maintain minimum essential coverage under the ACA and changes to equity and executive compensation.   Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.)

This post analyzes the new reporting and withholding requirements and source rules. Specifically, the Senate Bill would: (a) eliminate personal exemptions for income tax purposes but retain them for income tax withholding purposes; (b) require reporting for deductible amounts paid with respect to fines and penalties; (c) require reporting for certain life insurance transactions; (d) modify the reporting rules for Alaska Native Corporations; (e) modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and (g) impose withholding under section 1446 for sale of an interest in a U.S. partnership by a foreign person that is treated as effectively connected income under new Code section 864(c)(8).

These changes generally would be effective after 2017, except as otherwise noted below.

Withholding Exemptions. The Senate Bill would raise the standard deduction and eliminate personal exemptions, which currently allow individuals to reduce their taxable income.  However, section 11041(c) of the Senate Bill would keep the value of the personal allowance in place for purposes of determining the correct amount of federal income tax withholding.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties. As we previously covered, section 13306(b) of the Senate Bill would adopt a new Code section 6050X requiring government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into, where the aggregate amount required or directed to be paid or incurred exceeds a threshold ($600 in the statute, but subject to adjustment by Treasury).  The return must identify any amounts for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement. These changes would generally apply to amounts paid or incurred on or after the date of enactment, except that the changes would not apply to binding orders or agreements entered into or subject to court approval before that date. The House bill did not include any similar provision.

Reporting of Certain Life Insurance Transactions. As we previously covered, section 13520 of the Senate Bill would also adopt a new Code section 6050Y that would create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a “reportable policy sale”; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of “reportable death benefits.”  A “reportable policy sale” is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship to the insured.  A “reportable death benefit” is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements would apply for reportable death benefits paid and reportable policy sales after 2017. The House bill did not include any similar proposal.

Reporting Requirements of Alaska Native Corporations. Under current law, Alaska Native Corporations may deduct donations of cash or assets to “settlement trusts,” which are entities that manage Native lands. Section 13821(c) of the Senate Bill would modify the reporting requirements imposed on Native Corporations with respect to such deductions. Specifically, Native Corporations that have made contributions to a settlement trust and elected to deduct those contributions would be required to provide the settlement trust a statement regarding the election not later than January 31 of the calendar year after the calendar year in which the contribution was made. The statement would be required to include: (i) the amount of the contribution to which the election applies; (ii) whether the contribution was made in cash; (iii) for contributions of property other than cash, certain details about the property; (iv) the date of the contribution; and (v) any other information required by Treasury.

Sourcing Rule for Sale of Inventory Property. Under Code section 863(b), sales of inventory property produced in one jurisdiction and sold in another are currently sourced by allocating 50% of the sales income to one jurisdiction and 50% to the other.  Section 14304 of the Senate Bill would change this sourcing rule so that the entire amount would be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. Section 14503 of the Senate Bill would change two provisions affecting the sourcing rules related to U.S. possessions.  First, Code section 937(b), which controls whether income of U.S. citizens and residents is treated as possession source income, generally provides that income treated as U.S. source or effectively connected with a U.S. trade or business is not treated as income from sources within a possession or effectively connected with a trade or business in that possession.  The Senate Bill would amend Code section 937(b)(2) so that only U.S. source or effectively connected income attributable to a U.S. office or fixed place of business is excluded from possession source income.  Second, the Senate Bill would amend Code section 865, which sets forth the sourcing rules for personal property sales, so that capital gains earned by a U.S. Virgin Islands resident would always be U.S. Virgin Islands source income.

Withholding on Gain from the Sale by Foreign Persons of Interests in Certain Partnerships. Section 13501 of the Senate bill would add a new Code section 864(c)(8) that treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business. Under the provision, if a foreign corporation or nonresident alien individual owns, directly or indirectly, an interest in a partnership engaged in a U.S. trade or business, a portion of the gain or loss on the sale or exchange of such interest is treated as effectively connected with the conduct of a U.S. trade or business to the extent such gain or loss does not exceed: (1) in the case of a gain, the portion of the partner’s distributive share of the amount of gain which would have been treated as effectively connected if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange of the partnership interest (or zero, if no such deemed sale would have been effectively connected) or (2) in the case of a loss, the portion of the partner’s distributive share of the amount of loss on the deemed sale described in (1) which would have been effectively connected (or zero, if no such deemed sale would have been effectively connected).  The gain or loss treated as effectively connected under the provision is reduced by the amount so treated with respect to United States real property interests under section 897.

The Senate Bill would also amend Code section 1446 to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under Code section 864(c)(8), similar to the existing rules under section 1445. Upon request by the transferor (generally, the seller) or the transferee (generally, the buyer), the Treasury may prescribe a reduce rate of withholding if the Secretary determines it is appropriate.  In addition, no withholding is required if a transferor furnish to the transferee an affidavit signed under penalty of perjury stating that the transferor is not a foreign person and providing the transferor’s U.S. TIN.  In the absence of such an affidavit (or if the transferee has actual knowledge that a provided affidavit is false or receives a notice from the transferor’s agent or transferee’s agent that such affidavit is false, similar to agent’s notice obligations under section 1445(d)), the transferee of the partnership interest is liable for satisfying the withholding obligation, but in the event that the transferee fails to withhold the required tax, the partnership must withhold an amount equal to the amount the transferee failed to withhold (plus interest) from distributions to the transferee.

The changes would generally be effective for sales and exchanges on or after November 27, 2017.