'Permanent' Regulation on Dropping Lock-in Letter

Thomson/RIA


Regs permanently drop prior requirement to send IRS questionable W-4s
T.D. 9337, 07/12/2007; Reg. 31.3402(f)(2)-1, Reg. 31.3402(f)(5)-1

IRS has finalized, with some modifications, temporary and proposed regs
issued in 2005 (see Federal Taxes Weekly Alert 4/21/2005) that streamlined
an employer's withholding-related paperwork by dropping the requirement to
send IRS copies of potentially questionable W-4 withholding forms. The final
regs also provide rules for income tax withholding when IRS notifies the
employer and employee of the maximum number of withholding exemptions
permitted.


-- Temporary regs. Under the temporary regs, which were effective on Apr.
14. 2005, employers were no longer routinely required to submit a copy of
any Form W-4 on which an employee claimed more than 10 withholding
exemptions. In addition, they were no longer routinely required to submit a
copy of any Form W-4 on which an employee claimed complete exemption from
withholding for the tax year if the employer reasonably expected, when the
Form W-4 was received, that the employee's wages from that employer would
usually be $200 or more per week. Rather, the temporary regs provided that
employers must submit copies of Forms W-4 only if instructed to do so in
published guidance or in a written notice to the employer from IRS. Thus
far, IRS has not issued any published guidance in this area.

The temporary regs authorized IRS to issue a notice to an employer
specifying the maximum withholding exemptions permitted to be claimed by the
employee without first obtaining a copy of the withholding exemption
certificate from the employer. Under the temporary regs, IRS issued this
notice to the employer with a copy for the employee. It also sent another
copy to the employee at his last known address. The temporary regs required
the employer to withhold in accordance with the notice as of the date
specified in it, which was required to be at least 45 calendar days after
the date of the notice.

The temporary regs permitted employers to give their employees a substitute
withholding exemption certificate, if the employers also gave them the
worksheets contained in the Form W-4 in effect at that time. They also
authorized employers to refuse to accept a substitute form developed by an
employee.

The proposed regs were identical to the temp regs. New process behind the
regs. IRS issued the temporary and proposed regs because it had developed a
process to use information already reported on Forms W-2 to more effectively
identify workers with withholding compliance problems. Changes in the final
regs include those triggered by IRS's implementation of the new process and
some made in response to comments received.

-- Final regs. Key aspects of the final regs and key changes reflected in
them include the following:

* The final regs don't require the routine submission of
Forms W-4, but permit IRS to require submission of Forms
W-4 under specific criteria either by written notice or by
future published guidance. (Reg. 31.3402(f)-2(g)(1))

* The final regs, like the temporary regs, authorize IRS
to issue a notice to an employer specifying the maximum
number of withholding exemptions permitted for a specific
employee. IRS may issue such a notice after it determines
an employee is not entitled to claim exemption from
withholding or more than a specified number of withholding
exemptions based on IRS records, without first obtaining
a copy of the withholding exemption certificate from the
employer. Alternatively, IRS may issue such a notice after
it reviews a particular withholding exemption certificate
and determines that it contains a materially incorrect
statement or determines, after a request to the employee
for verification of the statements on the certificate,
that IRS lacks sufficient information to determine if the
certificate is correct. (Reg. 31.3402(f)-2(g)(2))

* IRS will send the notice both to the employer (with a copy
for the employee) and to the employee directly. The final
regs provide a period during which the employee can address
the pending withholding adjustment by contacting IRS. The
earliest the notice may be effective is 45 calendar days
after the date of the notice, but the notice may specify
a later effective date. (Reg. 31.3402(f)-2(g)(2))

* The final regs also provide that if IRS is unable to
determine a last known address for the employee, it will
use other available information as appropriate to provide
the notice to the employee. (Reg. 31.3402(f)-2(g)(2)(ii))

* The final regs clarify that the notice to an employer
specifying the maximum withholding exemptions permitted for
a specific employee will also specify the marital status
for purposes of calculating the required withholding under
the notice. Accordingly, the employer must use the maximum
number of withholding exemptions permitted and marital
status specified in the notice for calculating income tax
withholding, unless a new withholding exemption certificate
is submitted by the employee that must be honored under
the final regs. (Reg. 31.3402(f)-2(g)(2)(ii))

* In the course of conducting the withholding compliance
program, IRS received questions from taxpayers asking
about the implications of receiving a notice specifying
the maximum number of withholding exemptions permitted and
marital status when possible exclusions from withholding
apply. IRS says that receipt of an IRS notice does not
impose a requirement to withhold income taxes where one
does not already exist. The final regs include an example
to illustrate this point. (Reg. 31.3402(f)-2(g)(4), Ex 6)

* If the employee is still employed by the employer,
the employer must furnish the notice of maximum number of
withholding exemptions permitted to him within 10 business
days of receipt. This may be done using any reasonable
business practice. (Reg. 31.3402(f)-2(g)(2)(iii))

* The temporary and proposed regs provided that the employer
is not required to furnish IRS notice to an employee who is
no longer employed by the employer. The final regs clarify
that the determination of whether the employee is employed is
made as of the date of the notice, and is based on all the
facts and circumstances, including whether the employer has
treated the employment relationship as terminated for other
purposes. They also specifically state that an employee who
is not currently performing services is nevertheless employed
for purposes of this rule if on the date of the notice (a)
the employer pays wages subject to income tax withholding
to the employee for prior employment on or after the date
specified in the notice, (b) the employer reasonably expects
the employee to resume the performance of services for the
employer within twelve months of the date of the notice,
or (c) the employee is on a bona fide leave of absence if
the period of such leave does not exceed twelve months or
if the individual retains a right to reemployment with the
employer by contract or under an applicable statute. (Reg. 
31.3402(f)-2(g)(2)(iii))

* If the employer must furnish the notice, it must
withhold based on the notice as of the date specified in
it unless (a) the employer receives a modification notice,
(b) the employee has provided or provides a new Form W-4
that results in more withholding than would result based
on the notice, (c) the employer must furnish the notice
only because it reasonably expects the employee to resume
the performance of services within twelve months of the
date of the notice but the employee does not resume the
performance of services until after such time, or (d)
the employment relationship is terminated for more than
twelve months. The regs have examples illustrating these
requirements. (Reg. 31.3402(f)-2(g)(2))

* The final regs provide that employers may not accept
a substitute form developed by an employee, and the
employee submitting such form will be treated as failing
to furnish a withholding exemption certificate. (Reg. 
31.3402(f)-5(a)(2))


Effective date. The final regs are generally effective on April 14, 2005.
However, the new provisions in them that (a) specify when an employee who is
not currently performing services is employed for purposes of the
requirements to furnish the employee notice and withhold based on the
notice, (b) require the employer to withhold based on the notice if a
terminated employment relationship is resumed within 12 months, and (c)
require employers to refuse to accept substitute withholding exemption
certificates developed by employees, apply on Oct. 11, 2007. But taxpayers
may rely on the new provisions for notices issued before that date. (Reg. 
31.3402(f)-2(g)(5))

RIA Research References: For withholding allowance certificates Form
W-4, see FTC 2d/FIN H-4516; United States Tax Reporter 34,024;
TaxDesk 538,031; TG 9232.

Source: Federal Taxes Weekly Alert (preview) 07/19/2007, Volume 53, No. 29