Newland's Business Notes

Back-up Withholding (Hernando’s Horrors)

Volume 12 Issue 4 -- July/August 2008

Hernando, owner of Hernando’s Hideaways (“HH”), a company that sells and installs hideaway beds, had a number of independent contractor installers. As it turned out, many of these installers to whom HH sent 1099’s had invalid Social Security Numbers (SSNs).

We have written before about the problems employers face when they receive “no match” letters from the Department of Homeland Security or the Social Security Administration, most recently in September/October 2007, but Hernando’s problems here were entirely tax related.

First, the Internal Revenue Service (“IRS”) rejected the 1099’s that HH sent to these installers and then imposed penalties on HH for filing incorrect 1099’s. Unfortunately for HH, that was only the beginning of its tax troubles.

On a subsequent tax audit, the IRS wanted to disallow a deduction of all of the compensation paid to these installers, which resulted in a proposed tax deficiency of close to $1 million. This would have resulted in what amounted to a tax on gross receipts.

After vigorous resistance by HH, the IRS eventually retreated from this position, but we have recently learned that in the Washington DC area, the IRS may still be taking this position in some other audits, even though it appears to be legally incorrect.

More recently, HH received a notice from the IRS telling HH that it is subject to an oddly named tax law provision called “backup withholding.” 

Backup withholding is essentially a set of rules requiring those who make certain types of payments (“payors”) to withhold and pay to the IRS 28% of the payment as a form of “backup” tax payment on behalf of the payee. One of the circumstances where backup withholding comes into play is where a payor makes non-employee compensation payments to a person with a missing or invalid SSN.

The way this regime works is that a payor, such as HH, will receive a notice CP-2100 from the IRS of a “Possible Payee Name/TIN Discrepancy.” This means that one or more payee/contractors who received payments and 1099s from HH had no SSN or an SSN that did not match the payee’s name in the IRS records. Employers with large numbers of incorrect 1099’s get electronic notices.

Unless the error was the result of a simple reporting or processing error, the payor, here HH, must within 15 days notify the payee of the problem and send out the first of potentially a series of notices. In cases of missing SSNs, the payor must send the payee a Form W-9 to obtain the SSN. In cases of incorrect SSNs, the payor must first send a so-called “B-Notice” that advises the payee that the payor will begin backup withholding.

Unless the payee/contractor can supply a correct SSN, the payor must begin withholding 28% of all payments made to the payee after 30 days from the original IRS notice. If the payor fails to send the required notices or fails to begin making the backup withholding payments to the IRS, penalties can be imposed on the payor.

In other words, after receiving the IRS notice, the person paying for the services of an independent contractor may be required to withhold 28% of all payments to independent contractors.  That person will get the credit for the amount withheld but in order to utilize the credits the person must file a tax return. 

While HH can protect itself from IRS imposed penalties by sending the required notices and, if it fails to receive a correct SSN, beginning backup withholding, the situation may not be quite so simple.

As a practical matter, some independent contractors will not tolerate backup withholding.  At least when business is readily available, some independent contractors will leave to work for another entity.  In other words, HH may find it difficult to comply with the backup withholding rules and keep its business fully staffed.

Backup withholding was first enacted in 1983, but the recent emphasis on enforcing the rules regarding incorrect SSNs, particularly for immigrant workers, has given backup withholding much greater prominence for companies that depend upon independent contractors.

If you have questions or have these issues, you can contact Newland & Associates for assistance.  

Copyright 2008

Published by the law firm of Newland & Associates, PLC
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Call us at (703) 330-0000 for a full range of business law and tax-related services.

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