Backup Withholding On A Gig Worker

I am minding my own business when an IRS notice lands in my office. Here is a snip:

Question: is this bad?

Answer: it might be.

Let’s talk about it.

The IRS requires Form 1099-NEC be provided a nonemployee service provider paid over $600 over the course of a year. This is the tax form sent to self-employeds and gig workers.

The acronym “BWH” means backup withholding.

So, we are talking about withholding on nonemployees.

How can this be? Employee withholding is easy to understand: federal income tax, FICA, state income tax and whatnot. Anyone who is a W-2 has seen it – or is seeing it – every pay date. But there is no withholding on a nonemployee. A nonemployee is responsible for his/her own taxes. How do we even get here?

There are several ways. Let’s go through two.

Let’s say that I own a business called Galactic. Galactic hires someone to take care of our IT system. That someone is named Rick, and Rick does business as REM Consulting.

OK.

Rick does work. He sends an invoice for $750. Galactic pays him $750.

Here is our first way to backup withholding.

Rick immediately exceeded the $600 hurdle. He provided covered services, i.e., he is a gig worker. Galactic will send Rick a 1099-NEC at year-end. Presently, that 1099 is at $750. It will increase every time Rick does additional work.

Galactic needs some information from Rick to prepare that 1099: a name, an address, and a taxpayer identification number (TIN). I expect the name and address to be easy, as that would be on Rick’s business card or invoice. The TIN might not be so easy. A common TIN is a social security number. I guess Rick could provide Galactic his SSN, but then again, Rick might not be keen with passing-out his SSN all day every day.

Rick instead is thinking of making REM Consulting a single member LLC. Why? The default tax rule is to disregard a single member LLC as a separate entity. To the IRS, REM Consulting is just Rick (mind you, state rules may be different). Why bother, you wonder? Because REM Consulting can get its own employer identification number (EIN). If I were Rick, I would use that EIN instead of my SSN for all business purposes.

COMMENT: If you read the instructions, REM Consulting technically does not have to apply for an EIN until it has employees. That is true but beside the point. We automatically request an EIN for all new LLC’s – single member or not.

Back to the first way into backup withholding.

Galactic asks Rick for a TIN. Rick says “No.” Why? Because we need Rick to say “No” to continue our discussion.

Galactic is required to start backup withholding immediately, as Rick has already cleared the $600 floor. The withholding rate is 24%. Galactic will withhold $180 and send Rick a check for $570. Galactic will of course have to send that $180 to the IRS (it is withholding after all). Hopefully Rick relents and provides a TIN. If so, Galactic will include his TIN and withholding on the 1099-NEC, and Rick can get his withholding back when he files his personal return.

A second way is when the payor has the wrong TIN. Let’s say that Rick gave Galactic his EIN, but Galactic wrote it down incorrectly. Galactic and Rick are a year into their relationship, and everything is going well, except that Galactic receives a letter from the IRS saying that that Rick’s 1099-NEC is incorrect. The name and TIN do not match.

There is a short period of time allowed for Galactic to review its records and get with Rick if necessary. If the matter is resolved (someone wrote the TIN down incorrectly, for example), then Galactic corrects the matter going forward. That is that, and no backup withholding is required. Galactic does not even have to contact the IRS for permission.

However, say the matter is not resolved. Rick has no interest in helping. Galactic will have to start backup withholding on its next payment to Rick. Mind you, it can later stop withholding if Rick comes to his senses.

Withholding is a pain. There is additional accounting, then one must remit the money to the government and file additional tax returns. Every step has due dates and penalties for not meeting those dates.

Let’s say you receive that IRS notice and blow it off. After all, what is the worst the IRS can do, you ask.

Well, they can hold you responsible for the withholding.

But I didn’t withhold, you answer.

They don’t care. They want their money. You were supposed to withhold from Rick and remit. You chose not to withhold. You now have substitute liability and will have to reach into your own pocket and remit. Perhaps you can ask Rick for reimbursement, but you probably should not pack luggage for that trip.

A few more things about backup withholding:

• There is a form to provide your TIN (of course): Form W-9. It is extremely likely you filled one out when you started your job.
• You might be surprised how many different types of income are subject to backup: interest, dividends, rents and so on. It is not limited to gig income.
• A famous exception to backup is retirement income. Realistically, though, you won’t be able to even open an IRA account with the major players (Vanguard, Fidelity and so on) without providing a TIN upfront.
• It can apply to nonresident foreign nationals, although the withholding rate is different.
• The way to stop backup is to correct the situation that created it in the first place: that is, provide your TIN.

A difference between the two scenarios is when responsibility for withholding begins:

In scenario one, it begins with the first payment to Rick.

In scenario two, it begins more than a year later, upon receipt of a notice from the IRS.

Both scenarios can be bad, but scenario one especially so. At least scenario two is prospective (assuming you do not blow off the multiple notices the IRS will send).

Back to the start of this post. Which scenario do I have: scenario one or scenario two?

I do not know at this moment.

Let’s hope it is not bad.