Analysis: IRS holds key to preventing tax hikes on Jan 1

NEW YORK/WASHINGTON Tue Nov 23, 2010 4:20pm EST

A car passes a sign advertising tax return services in Falls Church, Virginia April 8, 2010. REUTERS/Kevin Lamarque

A car passes a sign advertising tax return services in Falls Church, Virginia April 8, 2010.

Credit: Reuters/Kevin Lamarque

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NEW YORK/WASHINGTON (Reuters) - If lawmakers fail to renew Bush-era tax cuts before the end of the year, the Internal Revenue Service could offer millions of Americans an immediate respite from higher taxes.

That could mean a time-out for anxious investors worried that nearly every taxpayer will take a financial hit amid the tepid economic recovery, and give breathing room to millions of employers waiting for clarity.

Without congressional action, tax cuts enacted a decade ago will expire on the last day of 2010, and higher rates will legally go into effect. In practice though, many observers expect the IRS to hold off in issuing new withholding tables, which are used to determine the amounts taken out of paychecks for taxes.

"I could see the IRS saying, 'in this sort of situation, it's probably in everybody's best interest to just wait,' " said Scott Mezistrano, senior manager of government relations for the American Payroll Association.

Companies need time to change tax withholding rates in their payroll systems. Unless lawmakers act soon, some payroll managers could have trouble putting any changes into effect for the first checks of 2011.

"Delay is causing great problems," said Joann Weiner, a professor at George Washington University and a former tax economist at the Treasury Department, which oversees the IRS.

"There is some talk about action not happening until after the new year, in which case things would be in an even bigger mess, since something would have to be done retroactively," she said.

TIME CRUNCH FEARED

The IRS usually publishes new tax-withholding tables in mid-November, but this year the agency has neither said what it plans to do nor when it plans to do it.

"We understand that businesses and payroll processors need at least a few weeks to implement new withholding tables and we are hopeful that Democrats and Republicans in Congress will work together to extend tax cuts," said Treasury Department spokeswoman Sandra Salstrom.

Lawmakers return from Thanksgiving break next Monday, when they are expected to first take up a food safety bill and then a bill to keep the government running.

Both parties say the tax cuts are priority, but it is unclear they can reach a deal before January.

President Barack Obama and most fellow Democrats want to renew the Bush-era tax cuts for only the first $200,000 of an individual's income. They would let the Bush tax cuts for income above that amount expire.

Republicans, invigorated by their big wins in the congressional elections, says they will only support lower rates for all incomes, including those greater than $200,000.

Payroll managers said they are already getting concerned about a timing crunch.

"Payroll is not something that can really just move on a dime," said Alicia Williams, payroll manager for engine maker Cummins Inc. "It affects a lot of systems, so waiting on this action by Congress puts us in a tough situation."

While Cummins uses an outside vendor to prepare its payroll software each year, the software has to be checked and tested before paychecks go out to its 16,000 U.S. employees, she said.

MAJOR WRINKLE

The IRS has some discretion to adjust withholding tables because they are projections of tax liabilities, not final payments, said John Harrington, a former Treasury official now in private practice advising employers.

Still, he said, it is always safer for the IRS to stick with the law.

"If they do anything that departs from current law, there is a risk you'll be pulled in front of some congressional committee," he said.

While the IRS has some discretion on withholding tables, it is unlikely to leave them on a long-term hold without a joint agreement by the White House and congressional tax-writing committees, said Anne Mathias, director of research at MF Global.

With so much uncertainty, the IRS is likely preparing several sets of tables to be ready in different scenarios, many observers said.

The worst case for employers and workers would be new tables that revert to pre-Bush rates. Not only would employees face higher taxes, but payroll managers would have to re-set their systems, then do it all over again after Congress acts.

And that would happen at the busiest time for payroll managers, when they are setting up systems for the new year and preparing workers' W-2 tax forms.

"There's just a lot that goes on in closing one year correctly and starting the new year off correctly," said the APA's Mezistrano. "This just throws a wrinkle in all of it."

(Editing by Steve Orlofsky)

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