Recently, Illinois announced a large increase in both personal and corporate income tax rates as part of passing their first budget in two years. This will take effect immediately and affect all Illinois employers. To address the most pressing topics we have heard from clients and employees so far:
• Illinois has not given guidance on how the retroactive change will affect employers. However, given the nature of withholding for income taxes and the lack of guidance to the contrary, we do not anticipate that employers will need to make retroactive adjustments to payroll. Rates will adjust going forward and this will likely solve the issue from a payroll perspective.
• Illinois residents can avoid having penalties for paying too little in taxes during the year (both withheld from their paychecks and through estimated payments) by paying 100% of what they owed last year for Illinois income taxes or 90% of what they will owe this year if that amount is lower.
• Specific types of employees and business owners have a higher risk of penalties for underpayment when filing individual tax returns due to this change. However, most employees will not need to take any action to change tax withholding on their paychecks.
• Illinois residents will generally have increased withholding from their paychecks to cover the new tax rate and smaller take home pay. It is possible to quickly estimate this amount by increasing the amount of Illinois income tax withheld from the last paycheck by 32% and reducing your net pay as a result.
The impact of the new budget compromise is an increase in the individual income tax rate from 3.75% to 4.95%. In addition, the corporate tax rate will increase from 5.25% to 7%. This rate hike takes effect retroactively effective on July 1st for individual and corporate taxpayers when they file taxes for 2017. However, the retroactive element does not concern payroll providers and HR departments because income tax liabilities are calculated (generally but with some exceptions for businesses) after the end of the year. Payroll withholdings are simply trying to estimate this amount and take enough out of paychecks to avoid underpayment penalties or the inconvenience of paying a large lump sum when filing. The amount withheld stems from what the employee has put on their W-4 and the rules created by the relevant tax authority.
Illinois offers “safe-harbor” rules regarding withholding and payments made for taxes during the year. As the Illinois Department of Revenue writes, “We will waive the late-payment penalty for underpayment of estimated tax [this includes payroll withholding] if you timely paid the lesser of 100 percent of the prior year’s tax liability or 90 percent of the current year’s tax liability” (Form IL-2210). This clause means that Illinois taxpayers can avoid penalties for underpayment during the current year by paying the entire amount of their tax liability from the prior year.
Because the language associated with taxes is often challenging, here is an example with exaggerated numbers to illustrate the safe-harbor rule. Suppose an employee owed a total of $1,500 for Illinois income taxes when filing for 2016 and estimates (with perfect foresight for the sake of this example) that she will owe $15,000 for 2017 because of a big raise this year and the increased tax rate. How much will she have to have taken out of her paycheck this year to avoid underpayment penalties? The answer is $1,500 or 100% of last year’s tax. The problem she would have in this scenario, which is not related to payroll, is that she will have to pay the full balance due of $13,500 on her own by April 15th regardless of whether she filed an extension.
What would happen if the amounts owed each year reversed, i.e. the employee knew she would owe $1,500 this year and owed $15,000 last year? In that case, there is the option of using 90% of the current year as an estimate. Because we have specified perfect foresight, the safe harbor is now $1,350. Since perfect foresight is uncommon, it is generally better to use 100% of last year’s tax as a guide if planning to adjust a W-4 or make estimated payments; assuming income for 2017 has not substantially decreased.
I want to close by emphasizing that most people do not have to worry about these calculations as long they filled out their W-4s accurately. There are exceptions which I plan to discuss separately but these apply to far fewer people than the general rule. Also, our client’s HR departments will not have to worry about redoing payrolls or not withholding enough for their employees because it is ultimately the employee’s responsibility to pay throughout the year for income taxes at the federal, state, and local levels. Also, our software will reflect the new rate which means that enough should be withheld assuming this was the case before the rate change. It is never particularly exciting news to hear that your paycheck just became smaller but there are no especially unusual issues created for payroll and HR departments. At StratEx, we’re happy to answer any questions you may have about this issue as it relates to payroll and HR.