The Treasury and IRS have published final regulations governing federal income tax withholding from periodic payments of deferred income made after December 31, 2020. The new regulations follow changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) to the default withholding rate rules. Payors and plan administrators who hoped that the IRS would set out predictable and uniform standards will be disappointed: while the regulations remove the pre-TCJA default withholding rate, they do not replace it with a new default rate. Instead, the Commissioner of the IRS will be responsible for providing sub-regulatory guidance to determine the default rate. At least for calendar year 2021 distributions, however, there appears to be no need for payors and plan administrators to worry about the transition to a new default-rate-determination method.

As we have previously discussed, periodic payments of deferred income are generally taxed, for federal income tax purposes, in a manner similar to wages: deferred income recipients make a withholding election and the payor withholds the amount (if any) indicated in the election. Code Section 3405(a) sets out the rules that apply to these withholding elections, and Section 3405(a)(4) provides that a default withholding rate is used in the absence of an election. Until 2018, when the TCJA went into effect, the default rate was the rate applicable to a married person claiming three withholding allowances. The TCJA, however, eliminated personal exemptions upon which withholding allowances were based, and amended Section 3405(a)(4) to provide that the default rate will be determined under rules prescribed by the Secretary of the Treasury.

The IRS has continued to use the pre-TCJA default withholding rate since 2018, relying on annual interim guidance. The IRS indicated in Notice 2020-3 that the Treasury and IRS were considering eliminating the use of the pre-TCJA default rate. In May, the agencies released proposed changes to the applicable regulations to carry out the elimination of the pre-TCJA default rate. The final regulations are identical to the proposed regulations.

The regulations remove portions of the applicable regulations that required the use of the pre-TCJA default rate. Unfortunately, the regulations do not fill the gap left by this removal. Instead, the regulations provide that, for distributions made after December 31, 2020, the default withholding rate “must be determined in the manner described in the applicable forms, instructions, publications, and other guidance prescribed by the Commissioner.” Any such guidance would also describe the date on which the new method for determining the default rate would take effect.

Commenters had encouraged the IRS to instead adopt a flat 10-percent default withholding rate, rather than delegating responsibility to the Commissioner to determine the method by which the default rate will be determined. The IRS rejected the flat-rate structure, explaining that its chosen approach “enables the Treasury Department and the IRS to make updates more quickly, including to address legislative changes, [and] to provide payors and plan administrators processing payments adequate time to program their systems to withhold the proper amount of income tax.”

Although the Commissioner has not yet issued any guidance on how the default withholding rate should be calculated for distributions made after December 31, 2020, the IRS press release accompanying the final regulations notes that the IRS intends to continue using the pre-TCJA default rate for 2021.  It remains to be seen whether Congress pursues any further amendments to Code Section 3405(a). Ultimately, that may depend on the outcome of the November elections and whether a new Congress takes steps to undo the changes made to the Code by TCJA.

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Photo of Sarah Friedman Sarah Friedman

Sarah Friedman works with private, public, and non-profit clients of all sizes to design and maintain their employee benefits and executive compensation programs. She also advises executives on compensation arrangements in connection with employment, separation, and change-in-control agreements.

In particular, Sarah counsels clients…

Sarah Friedman works with private, public, and non-profit clients of all sizes to design and maintain their employee benefits and executive compensation programs. She also advises executives on compensation arrangements in connection with employment, separation, and change-in-control agreements.

In particular, Sarah counsels clients on compliance with ERISA, the Internal Revenue Code, and agency regulations. She has experience drafting and advising on tax-qualified retirement plans, health and welfare plans, and cash and equity incentive compensation plans. Sarah also advises on ERISA litigation, including on claims related to investment fees and breaches of fiduciary duty.

Sarah maintains an active pro bono practice, both as part of her employee benefits practice as well as outside of it. She has a particular interest in helping clients with life planning documents.

Photo of S. Michael Chittenden S. Michael Chittenden

Michael Chittenden practices in the areas of tax and employee benefits with a focus on the Foreign Account Tax Compliance Act (FATCA), information reporting (e.g., Forms 1095, 1096, 1098, 1099, W-2, 1042, and 1042-S) and withholding, payroll taxes, and fringe benefits. Michael advises…

Michael Chittenden practices in the areas of tax and employee benefits with a focus on the Foreign Account Tax Compliance Act (FATCA), information reporting (e.g., Forms 1095, 1096, 1098, 1099, W-2, 1042, and 1042-S) and withholding, payroll taxes, and fringe benefits. Michael advises companies on their obligations under FATCA and assists in the development of comprehensive FATCA and Chapter 3 (nonresident alien reporting and withholding) compliance programs.

Michael advises large employers on their employment tax obligations, including the special FICA and FUTA rules for nonqualified deferred compensation, the successor employer rules, the voluntary correction of employment tax mistakes, and the abatement of late deposit and information reporting penalties. In addition, he has also advised large insurance companies and employers on the Affordable Care Act reporting requirements in Sections 6055 and 6056, and advised clients on the application of section 6050W (Form 1099-K reporting), including its application to third-party payment networks.

Michael counsels clients on mobile workforce issues including state income tax withholding for mobile employees and expatriate and inpatriate taxation and reporting.

Michael is a frequent commentator on information withholding, payroll taxes, and fringe benefits and regularly gives presentations on the compliance burdens for companies.