Newland's Business Notes

Backup Withholding Regime -- New Emphasis  

Volume 13 Issue 2 -- March/April 2009

Backup withholding has been more or less in its present form since 1983. While in the past, backup withholding found more application in situations involving the payment of interest or dividends, today the backup withholding rules have been given an expansive application to a situation that Congress probably did not contemplate in 1983 — payments to immigrant workers without valid social security numbers (SSNs) or individual taxpayer identification numbers (ITINs).

Several prior newsletters have discussed some aspects of this problem (see, e.g., Tax & Business Insights, January/February 2008).

Let’s consider Dudo Pago, who immigrated into the U.S. and has a small contracting company that provides masonry services. In the heady economic days from approximately 2003 to 2007, Dudo brought in many immigrant workers and provided masonry services for large jobs. Dudo, like others in his business, treated the workers as independent contractors and issued 1099s to such workers annually.

While the IRS might have questioned, in an employment tax audit, whether these workers were really “employees,” recently IRS offices in Virginia have taken a different approach, first, by disallowing all labor costs for workers who had no or invalid SSNs or ITINs, and, second, holding Dudo liable for paying backup withholding.

The first part of this IRS strategy is arguably wrong — labor costs paid to a worker with an invalid or no SSN or ITIN are still valid business expenses. Faced with this challenge, the IRS in some cases will allow the labor costs and move to the backup plan — backup withholding.  Anyone who pays an independent contractor, and issues a Form 1099, is subject to backup withholding if the recipient does not have a valid SSN or ITIN.

To the dismay of some, it is possible for a person who may be in the country illegally to obtain a ITIN under which taxable income can be reported. Having an ITIN does not prevent the Department of Justice from proceeding against a worker for being in the country illegally, nor does it prevent the payor from being subject to criminal sanctions for hiring such individuals.

Based on the admissions of several IRS Revenue Agents, it is apparent that the IRS at least in this area has taken to using backup withholding as an expedient alternative to conducting employment tax audits.

If the IRS suspects (or knows) that Dudo is hiring workers without SSNs or ITINs, it will notify Dudo to begin backup withholding. In order to comply with that notice, Dudo must begin backup withholding. It is then necessary for Dudo to keep records of which workers have valid SSNs or ITINs and which do not, because only payments to workers without a valid ITIN or SSN are subject to backup withholding at the rate of 28% of the gross amount of the payments. For example, if Dudo pays a worker $1,000, he must withhold and pay to the IRS $280.

Dudo must pay and deposit those amounts in a special bank account much as if it were regular employee withholding. The timing of the payment of backup withholding is subject to the same schedule as regular employee (Form 941) withholding, which is based on the size of Dudo’s payroll. At the end of the year, Dudo is required to file an annual Form 945, entitled “Annual Return of Withheld Federal Income Tax.”

The 1099s which Dudo issues to the workers would also reflect the amount withheld on behalf of the workers. In any event, the only way they can receive a refund is to file a tax return. In other words, their choice is file a return and possibly get a refund or forgo the 28% and let Uncle Sam have it, even though it is possible that the 28% might exceed the tax liability of the worker (especially if there is a spouse and children). Some ITIN holders also want to file Forms 1040 for immigration purposes.

There are many practical considerations to bear in mind. It is possible that Dudo’s collecting backup withholding may cause some workers to quit. For those who remain, they will receive 72% of their pay, with the remaining 28% going into the backup withholding system. If the workers choose not to file, then they will also lose their eligibility for Social Security credits. 

Newland & Associates, PLC, has a sample spreadsheet for computing the backup withholding. If you would like a copy, please give us a call.

Copyright 2009

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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