IRS Finalizes Income Tax Withholding Regs; Provides Optional Computational Bridge Entries

(Parker Tax Publishing October 2020)

The IRS issued final income tax withholding regulations which provide guidance on changes made to the tax withholding rules by the Tax Cuts and Jobs Act of 2017. In the regulations, the IRS addressed practitioner concerns surrounding programming changes necessary to correctly determine tax withholdings under pre-2020 and post-2019 rules by introducing rules for optional computational "bridge" entries. T.D. 9924.

Background

Generally, under Code Sec. 3402, every employer that pays wages must deduct and withhold a tax determined in accordance with tax tables or computational procedures. While Code Sec. 3402 sets forth certain methods of withholding, it also gives the IRS broad authority in providing for tables or computational procedures for income tax withholding. Employers generally apply the withholding tables or computational procedures based on a Form W-4, Employee's Withholding Certificate, provided by an employee when the employee is hired. The employee may provide a revised Form W-4 when he or she experiences a change of status that reduces the withholding allowance to which the employee is entitled. The employer puts the Form W-4 into effect in accordance with the timing rules in Code Sec. 3402(f)(3). Once in effect, the employer generally applies the entries on an employee's Form W-4 (the withholding allowance) to compute the amount of income tax to withhold from the employee's regular wages under either the percentage method of withholding or the wage bracket method of withholding.

In certain cases, the IRS may issue an employer a lock-in letter that notifies the employer in writing that an employee is not entitled to claim exemption from withholding or is not entitled to the withholding allowance claimed on the employee's Form W-4 and prescribes the withholding allowance the employer must use to figure withholding. If the employer employs the employee at the time the employer receives the lock-in letter, the employer must furnish the employee notice of the lock-in letter within 10 days of receipt of the lock-in letter. In this case, the employer must withhold in accordance with the lock-in letter as of the date specified in the lock-in letter, which cannot be any earlier than 45 calendar days after the date of issuance of the lock-in letter.

After the lock-in letter becomes effective, the IRS may issue a subsequent notice (modification notice) modifying the lock-in letter. Generally, a modification notice is issued only after the employee contacts the IRS to request an adjustment to the withholding prescribed in the lock-in letter. In certain cases, if warranted, the IRS may issue a notice releasing the employee from the lock-in program. If the employee is subject to a lock-in letter or modification notice, the employer may put in effect a Form W-4 only if doing so results in more withholding than specified by the lock-in letter or modification notice. Finally, an employee who was subject to a lock-in letter or modification notice, who terminates employment and then resumes employment with the same employer within 12 months of termination, remains subject to the lock-in letter or the modification notice withholding instructions upon resuming the employment.

TCJA Changes

Before the Tax Cuts and Jobs Act of 2017 (TCJA), one withholding exemption was equal to the amount of one personal exemption under Code Sec. 151 prorated to the payroll period. TCJA enacted Code Sec. 151(d)(5), which reduced the personal exemption amount to zero for the years 2018-2025. TCJA permanently modified the wage withholding rules in Code Sec. 3402(a)(2) and, replaced "withholding exemptions" with a "withholding allowance, prorated to the payroll period." TCJA also repealed Code Sec. 3401(e), which, before TCJA, provided that the number of withholding exemptions claimed meant the number of withholding exemptions claimed in a withholding exemption certificate, except that if no such certificate was in effect, the number of withholding exemptions claimed was considered zero.

TCJA further changed the list of factors on which the withholding allowance is based. The change allows an employee to take into account the number of individuals for which the employee expects to take an income tax credit under Code Sec. 24 instead of the number of individuals with respect to whom the employee reasonably expects to claim a deduction under Code Sec. 151. Code Sec. 3402(f)(1)(D) also changed an employee's entitlement to take into account the standard deduction from an amount generally equal to one withholding exemption to the standard deduction allowable to such employee (one-half of the standard deduction in the case of an employee who is married and whose spouse is an employee receiving wages subject to withholding). Finally, TCJA added Code Sec. 3402(f)(1)(F), which provides that the employee's withholding allowance also takes into account whether the employee has withholding allowance certificates in effect with respect to more than one employer.

Redesigned Form W-4

The IRS issued a redesigned Form W-4 that does not use withholding allowances. An employee selects a filing status on the Form W-4, and this entry generally results in the basic standard deduction relating to the filing status being taken into account in determining the amount of tax withheld from the employee's pay. In addition, the redesigned Form W-4 streamlines the multiple jobs procedures and gives employees three options to account for a working spouse or multiple jobs held concurrently. Specifically, employees may (1) use the Tax Withholding Estimator to achieve accurate withholding; (2) complete the Multiple Jobs Worksheet and enter an additional amount to withhold from pay for each pay period; or (3) check the box in Step 2(c) on the redesigned Form W-4 to request withholding using higher withholding rate tables. For married taxpayers filing jointly with two jobs held concurrently, the effect of checking the box in Step 2(c) is similar to selecting "Married, but withhold at higher Single rate" on a 2019 or earlier Form W-4. The redesigned Form W-4 also allows an employee to enter dollar amounts for tax credits, other income, and deductions the employee expects to claim on his or her income tax return.

Final Regulations

In February of 2020, the IRS issued proposed regulations under Code Sec. 3402 which addressed the changes under TCJA. The IRS finalized those regulations in T.D. 9924 on October 6. The final regulations address concerns that the proposed regulations and the related forms, instructions, publications, and other guidance require maintenance of two different systems for computing income tax withholding from wages: one system for 2019 or earlier Forms W-4, and another system for redesigned Forms W-4. Practitioners noted that these two systems complicate computer programming and exacerbate inaccuracy of employees' withholding determined using 2019 or earlier Forms W-4. The IRS acknowledged those concerns and addressed them in two ways: (1) through instructions to the redesigned Form W-4 for employees with multiple jobs, and (2) through optional computational "bridge" entries permitted under these regulations and described in Publication 15-T, Federal Income Tax Withholding Methods.

First, in redesigning the Form W-4, the IRS said it was aware of the challenges facing employees who have multiple employers paying wages subject to withholding and who have 2019 or earlier Form(s) W-4 in effect in completing the redesigned Form W-4. The redesigned 2020 Form W-4 includes instructions advising employees that, "[t]o be accurate, submit a 2020 Form W-4 for all other jobs." The IRS stated that it intends to continue providing an updated version of this instruction on Forms W-4 for future years.

Second, to address concerns relating to employers maintaining separate withholding systems, the regulations adopt optional computational bridge entries that will allow employers to continue in effect 2019 or earlier Forms W-4 as if the employees had furnished redesigned Forms W-4. According to the IRS, this will allow employers to use one process for both 2019 and earlier Forms W-4 and 2020 and later Forms W-4 and free employers from the need to use the number of allowances data field from 2019 and earlier Forms W-4 once the employers apply the appropriate computational bridge entries for their employees. The IRS said that, starting for calendar year 2021, the IRS intends to include instructions in Publication 15-T for these optional computational bridge entries. The computational bridge entries will allow employers to use the computational procedures and data fields for the redesigned Form W-4 to arrive at the equivalent withholding for an employee that would have applied using the computational procedures and data fields related to a 2019 or earlier Form W-4 furnished by the employee.

Specifically, Publication 15-T will provide for the following four adjustments to accurately implement these computational bridge entries.

First, Publication 15-T will provide for treating an employee as having made an entry on line 1(c) (filing status) of the redesigned Form W-4 that most accurately reflects the employee's entry on line 3 (marital status) of a 2019 or earlier Form W-4. In this regard, an employee will be treated as having selected "single or married filing separately" on the redesigned form if the employee selected either "single" or "married, but withhold at higher single rate" on a 2019 or prior Form W-4. An employee will be treated as having selected "married filing jointly" on the redesigned form if the employee selected "married" on a 2019 or prior Form W-4.

Second, Publication 15-T will provide for treating an employee as also having made an entry in step 4(a) (other income (not from jobs)) on the redesigned Form W-4 based on the marital status on line 3 of a 2019 or earlier Form W-4 to help offset the full basic standard deduction that has otherwise been incorporated in tables related to the various filing statuses in step 1(c) of the redesigned Form W-4. In particular, the employer would treat the employee as having entered the value of two allowances corresponding to a single employee's filing status and the value of three allowances corresponding to a married employee's filing status in step 4(a) of the redesigned Form W-4.

Third, Publication 15-T will provide for treating an employee as having made an entry in step 4(b) (deductions) of the redesigned Form W-4 to replicate the effect of allowances claimed on line 5 (number of allowances) of a 2019 or earlier Form W-4. In particular, the employer would multiply the number of allowances claimed on line 5 of a 2019 or earlier Form W-4 by $4,300 and treat the employee as having entered the product in step 4(b) of the redesigned Form W-4.

Finally, fourth, Publication 15-T will provide for treating an employee as having made an entry in step 4(c) (extra withholding) of the redesigned Form W-4 to replicate the effect of any additional amount that the employee requested to have withheld using line 6 (additional amount withheld from each paycheck) on a 2019 or earlier Form W-4. In particular, the employer would treat the employee as having entered any additional amount the employee requested to have withheld from each paycheck on line 6 of a 2019 or earlier Form W-4 in step 4(c) of the redesigned Form W-4.

To facilitate the use of the computational bridge entries, starting in 2021, the IRS will no longer index the withholding allowance to reflect cost-of-living adjustments to what would have been the value of a personal or dependency exemption in pre-TCJA Code Sec. 151(b). The withholding allowance will be fixed at $4,300 in 2021. Thus, employers that choose to implement the computational bridge entries starting in 2021 will not have to make any adjustments to employees' withholding entries that the employee is treated as having made on the redesigned Form W-4 within their system unless the employee furnishes a new, redesigned Form W-4.

Use of the computational bridge entries will be optional. The IRS intends to continue publishing withholding tables and procedures for employers that choose to continue computing withholding using the computational procedures related to 2019 or earlier Forms W-4 furnished by employees.

As with the proposed regulations, the final regulations do not require the IRS to reissue lock-in letters or modification notices solely because of the redesign of the Form W-4. Employers may not assume that a lock-in letter or modification notice ceases to be effective because of changes resulting from the redesigned Form W-4 and related withholding procedures. Unless the employee furnishes the employer a Form W-4 that results in more withholding than under the lock-in letter or modification notice, the employer must continue following any lock-in letter or modification notice until the IRS releases the employee from the program.

However, the final regulations provide that, for ease of administering the withholding instructions in lock-in letters or modification notices that were based on 2019 or earlier Forms W-4, employers may use the optional computational bridge entries discussed above to comply with the requirement to withhold based on the maximum withholding allowance and filing status permitted in a lock-in letter or modification notice and to adapt to the redesigned Form W-4 and computational procedures.

For a discussion of the rules on withholding allowances, see Parker Tax ¶212,115. For a discussion of Form W-4, see Parker Tax ¶212,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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