The tax bill formerly known as the Tax Cuts and Jobs Act (the Act) reduces tax rates for individuals, lowering the top marginal tax rate from 39.6% to 37%, effective January 1, 2018. Employers should make sure that the tax rates used for federal tax withholding on equity awards are reduced to correspond to the lower rates under the Act, in order to avoid adverse financial accounting consequences. This change may require an adjustment to payroll systems.
Under existing Treasury regulations, employers whose supplemental wage payments to an employee exceed $1 million during a calendar year must withhold on the excess above $1 million (or may withhold on the entire payment) at a rate equal to the highest individual income tax bracket in effect for the calendar year. This flat rate has been 39.6%.
For other employees, under existing Treasury regulations, the flat tax rate for withholding on supplemental wage payments has been 25%. As a result of conflicting language between existing Treasury regulations and the revised rates in the Act, it is not clear whether the new withholding rate for wages under $1 million will be 22% or 28%. We expect the IRS will clarify which rate applies.
The conference agreement to the Act provides that the existing tax withholding rules under section 3402 of the Internal Revenue Code may continue to be used for taxable years beginning before January 1, 2019, without regard to the amendments made by the Act. Thus, at the Treasury secretary’s discretion, wage withholding rules may remain the same as under present law for 2018.
However, the Financial Accounting Standards Board rules only allow tax withholding on equity awards up to the maximum statutory rate in the applicable jurisdiction, in order to maintain favorable equity classification treatment for share-based awards. See our prior ML Benebits blogposts for more detail: New FASB Rules on Equity Compensation Withholding: Summary and Issues. Under the financial accounting rules, if shares are withheld in an amount in excess of the maximum statutory rate in the applicable jurisdiction, the award must be classified and accounted for as a liability, resulting in mark-to-market accounting.
In addition, equity plans may limit share withholding to the maximum statutory rate.
We recommend that employers make sure that their payroll providers will properly implement these changes before the next equity award distribution date, to ensure that favorable financial accounting treatment of share-based awards is not compromised.