posted 10-07-2010 09:03 AM                  

By LAURA SAUNDERS
Lack of congressional action on 2011 income taxes may force the Treasury Department to make unprecedented moves to prevent U.S. workers from seeing large tax increases in their January paychecks.

The issue: 2011 tax-withholding tables. Treasury officials usually release the tables, which determine the take-home pay of millions of wage-earners, by mid-November because it takes payroll processors weeks to adjust their systems before Jan. 1.

But congressional leaders recently postponed voting on taxes until after the election and lawmakers don't reconvene until Nov. 15. The Senate is scheduled to take up several nontax issues when it returns and is expected to leave for Thanksgiving soon after, possibly pushing a vote on taxes into December.

"Things get very dicey after the first of December" because of employers' need to know the 2011 rates, said Michael Graetz of Columbia University Law School, a former Treasury official.

Lawmakers' recent track record on dealing with tax matters doesn't inspire confidence that they will act with dispatch. Congress has yet to resolve the estate tax, which expired at the end of last year and is set to snap back to high rates come January. Nor has it tackled the alternative minimum tax for 2010, a levy that is set to hit 32 million taxpayers this year, compared with five million last year.

Some Capitol Hill tax staffers have suggested that the Treasury could set 2011 withholding at current levels for joint filers earning less than $250,000 ($200,000 for single filers), on the assumption that Congress seems likely to enact this change. Others have suggested that if Congress doesn't act in time, Treasury officials might consider a one- or two-month grace period in which it maintains current tables until Congress passes tax legislation.

Treasury officials declined to discuss what they will do if lawmakers don't come to a quick decision.

"The president and Secretary [Timothy] Geithner are confident Congress will vote to pass middle-class tax relief before the end of the year," but Treasury "will maintain flexibility on the release of the withholding tables for 2011," said a spokeswoman.

Any Treasury move to extend the status quo involves risks: If lawmakers don't follow through, taxpayers could wind up owing big tax bills at the end of the year.

And such moves would be a radical departure from past practices, said Dennis Danilewicz, a recent president of the American Payroll Association who has done payroll work for three decades.

"I have never seen withholding tables based on assumptions about the law," he said.

.Treasury officials' most obvious option is the least attractive. If they publish tables based on expiration of the Bush tax cuts, which occurs Jan. 1, millions of low- and middle-income taxpayers who have paid little or no income taxes for a decade would likely see increases in January. Prof. Graetz estimates that higher withholding could take up to $10 billion a month out workers' pockets due to higher tax rates alone. Other benefits also are expiring.

A childless couple earning $40,000, for example, could see their monthly take home pay shrink by about $100, according to the nonpartisan Tax Policy Center. If they had three children, they might face a further cut of $125 a month, said Scott Mezistrano, an official with the American Payroll Association. (See table.)

If paychecks get smaller, even temporarily, taxpayer reaction is likely to be intense.

"The amount withheld from employee paychecks is one of the most politically sensitive issues faced by Treasury, Congress and the Internal Revenue Service," said former IRS Commissioner Lawrence Gibbs, now an attorney with Miller & Chevalier in Washington. He led the agency during an earlier withholding fracas, when taxpayers received smaller-than-expected refunds after the 1986 tax reform.

More recently, in 2009, confusion over withholding for the Making Work Pay tax credit angered taxpayers because many wound up underwithheld.

Payroll officials are "very concerned" about next year's withholding, said Mr. Danilewicz, head of payroll at New York University's Langone Medical Center, which has 15,000 employees. "It takes large employers three to four weeks to process and test these changes, and the government needs time before that to determine and publish them."

He adds that large firms often run payrolls a week or two ahead of time, further pressuring the process.

A spokeswoman for Paychex Inc., which handles payroll for about 8 million employees of more than 500,000 small and midsize firms, said it takes two weeks to update systems properly.

A spokeswoman for Intuit Inc., which provides payroll programs to smaller firms, says it takes "fewer than 30 days" to incorporate withholding changes.

Payroll processor Automatic Data Processing Inc. declined to comment on the issue.

Even if Congress plans to extend current tax rates, it needs to do so quickly to avoid disruptions. There are enough differences between 2010 and 2011 numbers, such as inflation adjustments, that payroll executives still need weeks to update and test their systems.

"We need to get it right," Mr. Danilewicz said. "Withholding is a sensitive subject, especially in a down economy when people live paycheck to paycheck."

.Write to Laura Saunders at laura.saunders@wsj.com