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. 

You Received An IRS CP2000 Notice

I read a considerable amount on a routine basis. It might be fairer to say that I skim, changing it to a read if I think that something might apply here at Galactic Command.

I came across something recently that made me scoff out loud.

Somebody somewhere was talking about never receiving an IRS CP2000 notice again.

Yeah, right.

What is a CP2000?

You know it as the computer match. The IRS cross-checks your numbers against their numbers. If there is a difference – and the difference is more than the cost of a stamp – their computers will generate a CP2000 notice.

How does the IRS get its numbers?

Easy. Think of all the tax reporting forms that you have received over the years, such as:

W-2 (your job)   

1099-INT (interest from a bank)

1099-DIV (dividends from a mutual fund)

1099-SA (distribution from an HSA)

1099-B (proceeds from selling stock)

It is near endless, and every year or so Congress and/or the IRS requires additional reporting on something. There is already a new one for 2022: the minimum threshold for payment card reporting has been reduced from $20,000 to $600. Think Venmo or Pay Pal and you are there.

If the IRS has information you didn’t report: bam! Receive a CP2000.

It happens all the time. You closed a bank account but forgot about the part of the year that it did exist.  You traded on Robinhood for a couple of weeks, lost money and tried to forget about it. You reimbursed yourself medical expenses from your HSA.   

The common denominator: you forgot to tell your tax preparer.

We get a ton of these.

Then your tax preparer might have caused it.

Maybe you did a 60-day roll on an IRA. Your preparer needs to code the distribution a certain way. Flub it and get a CP2000.

These you try to never repeat, as you are just making work for yourself.

Is this thing an audit?

Technically no, but you might still wind-up owing money.

The notice is proposing to make changes to your return. It is giving you a chance to respond. It is not a bill, at least not yet, but ignore the notice and it will become a bill.

The thing about these notices is that no one at the IRS reviews them before they go out. Yours are the first set of eyes to look upon them, and your preparer the second when you send the notice to him or her. You there have one of the biggest frustrations many practitioners have: the IRS sends these things out like candy; many are wrong and would be detected if the IRS even bothered. Attach an explanation to your return in the hope of cutting-off a notice? Puhleeze.

You really need to respond to a CP2000. I have lost track of how many clients over the years have blown these notices off, coming to see me years later because some mysterious tax debt has been siphoning their tax refunds. Combine this with the statute of limitations – remember, three years to file or amend – and you can be digging a hole for yourself.

If you agree with the notice, then responding is easy: check the box that says you agree. The IRS will happily send you a bill. Heck, don’t even bother to reply. They will send you the same bill.

If you disagree, then it can be more complicated.

If the matter is relatively easy – say an HSA distribution – I might attach the required tax form to my written response, explaining that the form was overlooked when filing.

If the matter is more complicated – say different types of mismatches – then I might change my answer. My experience – especially in recent years – is that the IRS is doing a substandard job with correspondence requiring one to think. They have repetitively forced me into Appeals and unnecessary procedural work.  My response to more complicated CP2000 notices? I am increasingly filing amended returns. Mind you, the IRS DOES NOT want me to do this. Neither do I, truthfully, but the IRS must first give me reason to trust its work. I am not there right now.

You can fax your response, fortunately.

You might try to call the IRS, but I suspect that will turn out poorly. Shame, as that would be the easiest way to request additional time to reply to the CP2000.

Whatever you do, you have 30 days. The days start counting beginning with the date of the letter, so mail delays can cost you.

Is the IRS gunning for you?

Remember: no one at the IRS has even looked at the notice you received.

 

Can You Tell When You Are Being Audited?

 I am looking at a Tax Court pro se decision.

Pro se means that the taxpayer represents himself or herself.

Technically, that is explanation insufficient. I, for example, could represent someone in Tax Court and it would still be considered to be pro se.

I tend to shudder at pro se cases, because too often it is a case of someone not knowing what they don’t know. And – once you are that far into the tax system – you had better be up-to-speed with tax law as well as tax procedure. Either can trip you up.

There is a cancer surgeon who inherited an IRA in 2013. He took distributions in both 2014 and 2015 – distributions totaling over $508 thousand - but he researched and came to the conclusion that the distributions were not income.

COMMENT:  How did he get there? The first thing that comes to mind is that these were Roth IRAs, but that was not the case. He argued instead that the IRAs included nondeductible contributions, and those nondeductible amounts were not taxable income coming out.

The reference here is to nondeductible IRAs, the cousin to Roth IRAs. These bad boys would be almost extinct except for their use in backdoor Roth conversions. Still, the doctor was wrong: it is EXTREMELY unlikely that a nondeductible IRA would be fully nontaxable. The reason is that only the contributions are nontaxable; any earnings on the contribution would be taxable. I suppose that one could have a completely nontaxable distribution, but that would mean the nondeductible IRA had no - none, nada, zippo - earnings over its existence. That would be among the worst investments ever.

The IRS computerized matching program kicked-in, as the IRA distributions would have triggered issuance of a 1099. The IRS caught 2014. The doctor disagreed he had income. The IRS machinery ground-on and resulted in the issuance of a 90-day letter (also known as a Statutory Notice of Deficiency) for 2014. The purpose of the SNOD is to reduce a proposed tax assessment to an actual assessment, and it is nothing to snicker about. The doctor had the option to appeal to the Tax Court, which he did.

Practice can be described as doing what is not taught in school, so the story took an unusual twist. The doctor was contacted by a revenue agent for a real and actual audit of his 2014 tax return. The agent however was looking at issues other than the IRA, and the doctor did not mention that the IRS Automated Under Reporting unit was looking at 2014. The agent continued blithely on, not knowing about the AUR and eventually expanding his audit to 2015.

QUESTION: Why didn’t the doctor tell the agent about AUR? I would have tried to consolidate the exams myself.

The doctor was dealing with AUR over matching. They wanted money for 2014.

The doctor was also dealing with a living, breathing agent about 2014. The agent wanted money, but that money was from areas other than the IRA.

The doctor took both SNODs to Tax Court.

He argument was straightforward – he invoked the tax equivalent of double jeopardy: Section 7605(b):

         (b) Restrictions on examination of taxpayer

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

If there was double jeopardy, the doctor clearly wanted the revenue agent’s proposed assessment, as it did not include the IRA.

Did the doctor have an argument?

This Code section has an interesting history. It goes back to the 1920s, at a time when only the wealthy were subject to income tax and there were no computers, 1099s and what-not. Matching was not even a fevered dream. What did exist, however, was the potential for human abuse and repetitive examinations to beat someone into submission. The progenitor of our Section 7605(b) came into existence as an early version of taxpayer protection and rights.

What the Tax Court focused on was whether there were two “examination(s) or investigations.” If the answer was yes, the Court would have to continue to the next question: was the additional examination “unnecessary?”

The Court did not need to continue to the second question, as technically there were not two examinations. You see, the matching program is driven by 1099s and other reporting forms. The AUR unit is not “auditing” in the traditional sense; it is instead trying to reconcile what a taxpayer reported to what an independent party reported.  

Additionally, the only thing AUR is looking at is income.  AUR is not concerned with deductions. Its review does not rise to the level of an examination as AUR is intentionally ignoring all the deductions on one’s return.

But I get it: it does not feel that way to the person interacting with the AUR unit. And there definitely is no real-world difference when AUR wants additional money from you.

But there is a technical difference.  

The doctor saw two examinations. I suspect most people would agree. However, the doctor technically had one examination. He was not in double jeopardy. Section 7605(b) did not apply.

Our case this time was Richard Essner v Commissioner, TC Memo 2020-23.

The Abbott Laboratories 401(k)

Something caught my eye recently about student loans. A 401(k) is involved, so there is a tax angle.

Abbott Laboratories is using their “Freedom 2 Save” program to:

… enable full-time and part-time employees who qualify for the company's 401(k) – and who are also contributing 2 percent of their eligible pay toward student loans – to receive an amount equivalent to the company's traditional 5 percent "match" deposited into their 401(k) plans. Program recipients will receive the match without requiring any 401(k) contribution of their own.”

Abbott will put money into an employee’s 401(k), even if the employee is not himself/herself contributing.

As I understand it, the easiest way to substantiate that one’s student loan is 2% or more of one’s eligible pay is to allow Abbott to withhold and remit the monthly loan amount. For that modest disclosure of personal information, one receives a 5% employer “match” contribution.

I get it. It can be difficult to simultaneously service one’s student loan and save for retirement.

Let’s take this moment to discuss the three main ways to fund a 401(k) account.

(1)  What you contribute. Let’s say that you set aside 6% of your pay.

(2)  What your employer is committed to contributing. In this example, say that the company matches the first 4% and then ½ of the next 2%. This is called the “match,” and in this example it would be 5%.

(3)  A discretionary company contribution. Perhaps your employer had an excellent year and wants to throw a few extra dollars into the kitty. Do not be skeptical: I have seen it happen. Not with my own 401(k), mind you (I am a career CPA, and CPA firms are notorious), but by a client. 

Abbott is not the first, by the way. Prudential Retirement did something similar in 2016.

The reason we are talking about this is that the IRS recently blessed one of these plans in a Private Letter Ruling. A PLR is an IRS opinion requested by, and issued to, a specific taxpayer. One generally has to write a check (the amount varies depending upon the issue), but in return one receives some assurance from the IRS on how a transaction is going to work-out taxwise. Depending upon, a PLR is virtually required tax procedure. Consider certain corporate mergers or reorganizations. There may be billions of dollars and millions of shareholders involved. One gets a PLR – period – as the downside might be career-ending.

Tax and retirement pros were (and are) concerned how plans like Abbott’s will pass the “contingent benefits” prohibition. Under this rule, a company cannot make other employee benefits – say health insurance – contingent on an employee making elective deferrals into the company’s 401(k) plan.

The IRS decided that the prohibition did not apply as the employees were not contributing to the 401(k) plan. The employer was. The employees were just paying their student loans.

By the way, Abbott Laboratories has subsequently confirmed that it was they who requested and received the PLR.

Technically, a PLR is issued to a specific taxpayer and this one is good only for Abbott Laboratories. Not surprisingly there are already calls to codify this tax result. Once in the Code or Regulations, the result would be standardized and a conservative employer would not feel compelled to obtain its own PLR.

I doubt you and I will see this in our 401(k)s.  This strikes me as a “big company” thing, and a big company with a lot of younger employees to boot.

Great recruitment feature, though.