The IRS is re-designing Form W-4, Employee’s Withholding Allowance Certificate. The changes to this form will affect nearly every employee and employer, potentially more than once a year. When a person starts a new job or his or her tax situation changes (e.g., due to a birth, a pay raise, a marriage, or a home purchase), he or she may be required by IRC § 3402(f)(2) to fill out a new Form W-4 and give it to his or her employer. The employer uses the number of “allowances” claimed on the Form W-4 to compute (based on IRS tables) how much of each paycheck to withhold and send to the IRS.
If employees claim too many allowances, they will have too little tax withheld (i.e., be under-withheld) and also violate IRC § 3402, whereas if they claim too few allowances, they will have too much tax withheld (i.e., be over-withheld). They can avoid an underpayment penalty under IRC § 6654 if either (1) they owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or (2) the amount withheld is at least 90 percent of their tax liability for the current year or 100 percent (or 110 percent for higher income taxpayers) of their tax liability shown on their tax return for the prior year, whichever is smaller.
Most employees are over-withheld. According to a report by the Government Accountability Office (GAO) (page 13), 76 percent were over-withheld for tax year (TY) 2017, but this figure is expected to decline to 73 percent for TY 2018, due in part to changes the IRS made to the withholding tables last spring.
Historically, the number of allowances was relatively easy to compute because it was tied to the number of personal exemptions a person could claim, plus any additional allowances needed to account for itemized deductions. Because Public Law 115-97, the Tax Cuts and Jobs Act (TCJA), set the personal exemption to zero for tax years beginning after December 31, 2017, and before January 1, 2026, there is no longer any nexus between exemptions and allowances. Moreover, Section 11041(f)(2) of the TCJA said the Treasury had to implement withholding-related changes by 2019. Thus, the form is due for an overhaul.
This spring, the IRS issued Notice 2018-14, which said that employers could continue to use the prior version of the Form W-4 for now, but that it would soon be revising the form and improving its online “withholding calculator.” In June, the IRS released a draft 2019 Form W-4 and instructions, and in July it asked for comments. It proposed to modify the Form W-4 “to remove the reliance on the personal exemption and discrete number of withholding allowances….” Instead of allowances, the draft Form W-4 would provide “more accurate withholding by addressing credits, other income, deductions and a graduated tax rate structure directly….” The IRS said this approach “reduces complexity for employees by allowing them to directly report tax credits and adjustments to income, rather than using worksheets to convert these items to withholding allowances.”
Commenters said the draft Form W-4 violated employee’s privacy by requiring too much information about their other income, placed too much responsibility on employers to figure out how much to withhold, and was too complicated and burdensome, even with the assistance of a withholding calculator, which also required too much information from employees and was too complicated. [Many of the comments on the draft 2019 Form W-4 are on regulations.gov (here), but others, such as comments from the American Institute of CPAs (AICPA) (here) and National Association of Enrolled Agents (NAEA) (here) are not. This link (here) includes excerpts of the comments.]
In response to these comments, on September 20, 2018, the IRS and Treasury pushed back the major redesign until 2020, and in October, they released a draft 2019 Form W-4 that is similar to the 2018 version. Subsequently, the IRS issued Notice 2018-92, which asks for comments on how the Treasury and the IRS should update the withholding regulations and clarifies that taxpayers may include an estimate of the 20 percent deduction allowed to sole proprietors and passthrough businesses under IRC § 199A in determining the additional withholding allowance. It also notes that taxpayers can use the withholding calculator or Publication 505, Tax Withholding and Estimated Tax, in lieu of the worksheets to Form W-4.
In mid-November, the IRS held a roundtable to hear directly from internal and external stakeholders about the draft 2020 Form W-4, which raises many of the same issues as the draft 2019 version. The rest of this blog identifies the major issues raised in these discussions.
COMMENTS ABOUT THE LEVEL OF DETAIL REQUIRED WHEN DETERMINING HOW MUCH TO WITHHOLD
A threshold issue is how much accuracy (and corresponding complexity) the Form W-4 should require. This question should not be confused with the question about what tools the IRS should provide to help employees achieve more accurate withholding than the minimum required, should they so desire. Providing tools can be helpful. Requiring everyone to understand and use complex tools is burdensome and unrealistic.
The draft 2019 Form W-4 seemed to require more accuracy than the 2018 version because it asked for more information. The additional questions made it more complicated and burdensome. Some commenters said employees would be confused and would not return the draft form because it asked for information they would not have on their first day of work.
While there may be some employees who do not mind doing more work to make their withholding more “accurate,” commenters said Form W-4 should shift those computations to an optional worksheet, rather than forcing everyone to disclose sensitive tax information to their employers. By signing a form that includes more details, employees would be affirming that more information it is accurate and complete under “penalties of perjury.” This may be unnecessary, because the sole purpose of the form is to ensure employees are not under-withheld. Some employees might also feel they have to update the Form W-4 more often if any of the detailed information on the form changes, even if they would not have had to change their withholding allowances based on the 2018 form.
Some commenters suggested most employees would rather have simplicity than perfect accuracy. They want refunds, rather than withholding that matches their tax liability. If they do not get refunds, they assume their preparers have done something wrong. Many employees who only need to file returns to get refunds (e.g., because they are eligible for the Earned Income Tax Credit—a refundable credit for the working poor) still file Forms W-4 to request withholding that is not required and merely increases their year-end refunds. Although some employees might be deliberately using the tax system to save, others might not understand the concept of withholding “allowances”—a technical term that may be difficult for laymen to grasp.
HOW TO COMMUNICATE HOW MUCH TO WITHHOLD: “ALLOWANCES” VS. TAX INFORMATION VS. SPECIFIC DOLLAR AMOUNTS OR PERCENTAGES
Allowances are obsolete, lack transparency, and can be confusing and burdensome.
Another key issue is whether an employee should continue to tell employers how much to withhold by computing withholding allowances. Perhaps allowances simplified withholding when they were tied to something concrete, such as the number of dependents (i.e., people). Because dependency exemptions have been suspended, however, allowances are now more abstract and obsolete. As abstract concepts, they may also be confusing. For example, a “zero” withholding allowance may sound like less withholding than “four,” but it is actually more.
Allowances also lack transparency. Even if employees figure out that more allowances mean less tax is withheld, they will generally not know how much withholding results from any particular number of allowances until they see their paychecks.
This lack of transparency can create unnecessary burden. Due to the availability of tax software, tax preparers, and similar resources to help taxpayers compute their tax liabilities, it can be easier for some employees to estimate how much they will owe in taxes for the upcoming year than to figure out exactly how many allowances to claim.
For example, it took me three calculations over three pay periods to figure out how many allowances to claim. Similarly, a member of my staff feels uncomfortable using the W-4s produced by his tax software because it suggests that he claim allowances that would make him under-withheld and that is wife claim allowances that would make her over-withheld.
Requiring people to compute allowances instead of a reasonably accurate amount of withholding makes some feel like they must use the Form W-4 and its worksheets (or Publication 505 or the withholding calculator)—a process that can feel like doing their taxes twice. As the Form W-4 and the underlying worksheets become more complicated, it becomes more burdensome to require people to use them instead of the resources they use to file returns.
On the other hand, the use of allowances has the limited benefit of masking exactly how much withholding an employee has requested. This may preserve the employee’s privacy to some extent. To know the exact amount, a third party would also need to know the employee’s salary and review the IRS’s withholding tables.
However, a third party does not need to know a person’s salary to know that more allowances result in less withholding. Moreover, this kind of masking could be achieved in other ways. For example, if the Form W-4 asked employers to withhold a percentage of each payment, the exact amount would be similarly masked unless the third party also knew how much the employee was paid.
DISCLOSURE OF TAX INFORMATION TO EMPLOYERS WOULD BE INVASIVE AND BURDENSOME FOR EMPLOYERS AND EMPLOYEES
An alternative to allowances that was adopted by the draft 2019 W-4 is for employees to disclose other income, credits, and deductions on the W-4 and for the employer then to figure out how much to withhold. Commenters said this raised concerns about privacy, disclosure, complexity and burden for both employees and employers.
Commenters said employees do not know what income, deductions and credits they will have, do not really understand these terms, and do not want the responsibility of having to estimate them before the end of the year. More importantly, they do not want employers to know how much their spouses make or that they have second jobs that suggest a lack of commitment to the employer and might even be against company policy.
Similarly, employers do not want the responsibility of having to figure out how much to withhold based on the employee’s income, deductions, and credits. They do not want to have to question the employee’s figures. Nor do they want to become the target of identity thieves—or even subpoenas to assist the employee’s creditors—by holding more personal financial information about their employees.
To minimize the information given to employers, the IRS could enable the withholding calculator to print a Form W-4 that is pre-populated with just the results. If the IRS needs more information to substantiate the results, the calculator could print a code on the Form W-4 that the IRS could tie back to the information entered into the calculator by the employee. However, not everyone will want to use the calculator and not everyone will have access to it when they need to submit a Form W-4.
DISCLOSURE OF HOW MUCH TO WITHHOLD WOULD BE SIMPLER AND EASIER TO UNDERSTAND
Perhaps the simplest way for an employee to tell the employer how much to withhold is to give the employer a specific number or the percentage to withhold from each paycheck. Employees would not have to figure out how many allowances to claim or hope that the allowances produce enough withholding to avoid an under-withholding penalty. For example, the employee could simply request withholding that is at least 100 percent of his or her tax liability for the prior year (or 110 percent for those with high incomes), which would avoid the penalty even if estimates of his or her current-year tax liability proved wrong.
An employee could rely on a tax preparer, tax software, the existing tax forms, worksheets, or withholding calculator to project a more exact figure that could easily be transferred to the Form W-4, either as a raw number or a percentage of each paycheck. As noted above, this is what some employees already do, but the current lack of transparency about how much withholding will result from each allowance hamstrings their efforts. Moreover, some employees may feel like they are doing something wrong by signing under penalties of perjury that the number of allowances they are claiming is correct based on W-4 instructions that they have not read and worksheets that they have not filled out. Thus, substituting a simple certification that merely affirms they are asking for enough withholding (rather than allowances) could allay any such concerns.
It is still too early to know how the IRS will address these comments. However, it is aiming to test and release another draft Form W-4 by early next year, so stay tuned for updates. This is certainly a challenging issue and, as we noted, one that affects the vast majority of individual taxpayers.
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