With the speedy year-end passage of the “Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” otherwise known as the Tax Cuts and Jobs Act (the TCJA), employers are facing uncertainty about the withholding rates to be used in 2018 for supplemental wages such as equity compensation.
Although it is reasonably certain that the withholding rate for supplemental wages in excess of $1 million has gone down from 39.6% to 37%, the optional flat rate to be used for supplemental wages of $1 million or less is not clear. As explained below, until further guidance is issued by the IRS, it appears that employers may continue to withhold at the 2017 optional flat rate of 25% for supplemental wages of $1 million or less.
The uncertainty regarding withholding on supplemental wages of $1 million or less arises due to the TCJA’s elimination of provisions of existing law relating to the optional flat rate. Specifically, existing law provides that the optional flat rate “shall not be less than 28% or the corresponding rate in effect under Code Section 1(i)(2),” which has been 25% for the past several years. (See Section 904(a) of the American Jobs Creation Act of 2004, as well as the treasury regulations under Section 31.3402(g)-1(a)(7)(iii)(F).)
However, the TCJA eliminates Code Section 1(i)(2) for tax years beginning after December 31, 2017 and before January 1, 2026. As there is no longer any “corresponding rate in effect under Code Section 1(i)(2),” it would appear that the optional flat rate for supplemental wages is now 28%.
That said, an increase in the supplemental withholding rate from 25% to 28% presumably does not reflect the intent of Congress in passing tax reform. There is also some authority for not increasing the rate. The TCJA gives the Treasury Secretary discretion to administer wage withholding under the old rules during 2018 and the IRS announced “employers and payroll service providers should continue to use the existing 2017 withholding tables and systems” until it releases withholding guidance for 2018. This suggests that employers may continue to use 25% as the withholding rate for supplemental wages of $1 million or less, until further guidance is provided.
In contrast, until we get guidance from the IRS that interprets the apparent glitch in the TCJA, there is no authority for using 22% (i.e., the third lowest tax rate) as the withholding rate on supplemental wages of $1 million or less.
Separately, to avoid potentially adverse accounting consequences, employers withholding shares to cover taxes should ensure that their federal tax withholding rate does not exceed the new maximum statutory rate of 37%.
Employers should consult with their accountants and payroll providers to ensure that the appropriate withholding rates are being used to ensure that the financial accounting treatment of equity awards is not compromised by their application of the new withholding rates.