Tax & Business Insights

Immigrant Workers and the IRS

Volume 20 Issue 6 --  November/December 2008

In the last issue ("Immigrant Workers: An Overview") we mentioned that both the Internal Revenue Service (IRS) and the Social Security Administration (SSA) may send out “no-match” letters and we briefly looked at the potential implications of the SSA no-match letters.  In this issue we will look at the IRS counterpart.

Most commonly, the IRS will send its “no-match” letter to a business with independent contractors (IKs) who have received payments reported on 1099s.

We have been using the term “payor” rather than “employer” because many of these workers are treated as independent contractors and receive 1099s rather than W-2s.  To illustrate the problems that a business can face, we have been referring to Kon Fused, or “Kon,” as the payor, and its worker and payee, “Jose.”

IRS no-match letters take the form of a CP2100 or CP2100A notice to a payor that a payment recipient, usually on a 1099, has an SSN or ITIN that does not match IRS records. The notice instructs the business to take certain required steps to verify the payee’s SSN or ITIN, or to begin collecting “backup withholding.”

For example, if Kon receives a CP2100 he is required to send out a notification to the listed recipients of the payments telling each recipient that unless a valid SSN or ITIN is provided to Kon within 30 days, mandatory backup withholding will begin.

If Kon Fused cannot obtain a valid SSN from Jose, then Kon must begin withholding 28% of all payments to Jose. The backup withholding must begin on all payments after 30 days from the receipt of the IRS form CP2100 letter for all those workers with questioned SSNs.

If Kon Fused is required to withhold 28% of the payments to Jose what will Jose do?  Jose will not receive the same gross amount for the same number of hours or work, but an amount which is reduced by 28%.

If Jose obtains a valid SSN or ITIN after Kon receives a CP2100 and notifies Kon of that number, then the payments to Jose are not subject to backup withholding.

This clarifies the situation of the status of Jose, but it does not prevent Jose from being reclassified as an employee by the IRS in a standard employment tax audit, should one occur.

Businesses sending out five or more 1099s to IKs in the amount of $20,000 or more each, where the recipients receive no other 1099s, may face an increased risk of an employment tax audit, where the IRS would seek to establish whether a business’s workers are properly classified as IKs or as employees.

Traditionally, the IRS addressed the status of a worker by doing an “employment tax audit” to review the status of all of the workers of Kon and make a determination as to whether Jose and other workers are employees or IKs. It appears in recent times, at least here in Northern Virginia , that few, if any, employment tax audits are taking place.

The effect of either backup withholding (28%) or an employment tax audit making Jose an employee is, for many purposes, the same. Jose will no longer receive a gross amount of compensation, but as an employee or as an IK, he will received payments reduced by either regular wage withholding or 28% backup withholding.

In either situation, Jose may leave. The problems many small employers, such as Kon, have will be amplified if other businesses in the area have chosen to ignore or do not comply with IRS rules. This does not mean that small employers should flaunt the law; nor is this newsletter encouraging them to do so. Even if there are only a few workers, there could be criminal prosecution against Kon Fused if he continues to use workers with invalid SSNs.

Another potential consequence of receiving a CP2100 type notice from the IRS is the potential for adverse income tax audits. In Northern Virginia , we have learned of a number of audits in which the IRS has, apparently, targeted Latino-owned businesses with immigrant workers, some of whom may not have valid SSNs. A related newsletter on that subject ("Is the IRS Targeting Latino Businesses?") is available.

In some of these audits, IRS agents and their supervisors have taken the position that no contract labor expenses can be deducted unless the worker has a valid SSN. Although the stated justifications have varied somewhat, the IRS auditors have sometimes cited a CP2100 notice as a basis for totally disallowing deductions for all worker-related expenses and payments.

In some of these audits the IRS has relented and acknowledged that worker payments are deductible even if Jose has an invalid SSN, but some of these cases are still pending.

If you or your clients have further questions about this subject, please call The Tax and Business Professionals.  Additional information about this topic is available elsewhere on this website.

Copyright 2008
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