Backup Withholding Regime -- New Emphasis
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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