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Payroll Departments Could Be Caught Flatfooted

December 17, 2010

Congress’s passage this week of an extension of the current income tax rates could be a blessing for many payroll departments, outside payroll processors, and accountants, but the new payroll tax cut is bound to cause a period of readjustment.

The 2 percentage point reduction next year in the Social Security payroll tax rate, from 6.2 percent to 4.2 percent, is a brand-new wrinkle in the payroll world. For two years, payroll departments and accountants have needed to contend with the Making Work Pay Credit that originated with the Recovery Act in the early days of the Obama administration. That tax credit, while it put a few extra dollars in the paychecks of the majority of working taxpayers, also had its share of drawbacks.

A new report from the Treasury Inspector General for Tax Administration estimates that 13.4 million people ended up owing more in taxes because of the complexities of administering the Making Work Pay Credit for taxpayers such as single people who work more than one job and joint filers where both spouses work (see 13.4M People May Owe More Taxes Because of Making Working Pay Credit).

In part because of those complexities, but mainly because so few taxpayers even realized the Making Work Pay Credit was saving them money on their taxes because the difference on their paychecks was so paltry, the Obama administration opted this time for a one-year payroll tax cut instead. The difference in tax withholdings should be a lot more noticeable for many taxpayers next year. However, because the payroll tax cut was only just proposed a few weeks ago, it will likely take several weeks for payroll bureaus to implement it, according to The Wall Street Journal.

The White House struck the deal on extending the Bush-era tax rates with Republican congressional leaders soon after a separate six-man working group had been formed to come up with what was supposed to be the compromise. Instead the working group barely got working before the deal was announced.

The Internal Revenue Service was also caught by surprise, which is usually not a good thing to do. IRS Commissioner Doug Shulman had only recently informed congressional leaders that the IRS would be making the assumption that Congress would get around once again to patching the alternative minimum tax, but he also warned of service disruptions if they didn’t resolve the many lingering tax questions by the end of the year. The IRS had trouble adjusting during the 2007 and 2008 filing seasons because of changes in tax laws near the end of the previous year, and that may happen again as it adjusts to changes in the payroll withholding and estate taxes.

While it’s heartening that Congress has finally resolved some of the many questions surrounding the fate of the Bush tax cuts and the estate tax, the payroll tax is likely to add another level of uncertainty. That uncertainty will extend to not only workers’ paycheck withholdings, but also the solvency of the Social Security trust fund and the impact on the long-term budget deficit.

There are also a few other complexities. Workers who do not pay into the Social Security trust fund, such as some types of public sector employees, won't qualify for the payroll tax cut, even though they did get a tax cut with the Making Work Pay Credit, as CCH noted in a recent tax briefing on the legislation.

The one-year “payroll tax holiday” will expire at the end of next year, but will Congress have the courage to let it actually expire and allow workers to see their take-home pay reduced in 2012? Since 2012 is an election year, the answer to that question is probably going to be no.

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