Originally published on Forbes.com.
This is the time of year, I always start worrying about 1099s. You might say that my worrying is premature, since they won’t be coming for a couple of months and the ones from the investment companies will be wrong and you will have to wait for them to be reissued. So start worrying about 1099s in March.
But I’m not worrying about getting them, I’m worrying about sending them out – or not. A recently released memo from the IRS Chief Counsel – CCA 201447025 – drives home for me the point that there is probably a lot of exposure out there from not filing 1099s. I got the sense that a step removed from the request there was a desperate taxpayer trying to cut the rent on a disastrous audit. For them this ruling was more bad news, for you it could be a wake-up call.
When The Agent From Hell Reads The Audit Manual
There are all sorts of 1099s, but we’re just going to focus on those that are sent to service providers. This is from an IRS audit manual.
Generally speaking, a taxpayer is required to file a Form 1099 to report annual payments exceeding $600 made to an individual payee in the course of the taxpayer’s trade or business (as discussed above). Such payments are referred to as “reportable payments.”
With this in mind, when the taxpayer fails to file required Forms 1099 for payments over $600, in the course of a trade or business (reportable payments), it must be assumed that the payee failed to furnish the tax identification number. Therefore, the payments were subject to back-up withholding. Since the payer then failed towithhold, the payer is now liable for the penalties (Treas. Reg. section 35a.9999-3).
Since back-up withholding was presumably required and was not withheld, the payer is now liable for the back-up withholding. The penalty is 31 percent (20 percent for payments made prior to Jan. 1, 1993) of the gross amount of applicable payments paid by the payer. (See Treas. Reg. section 35a.9999-2 Q-11 for specific computations of includible payments.)
As is this:
If payments to non-employees are accepted in audit, and there is no income tax issue, there could still be a backup withholding issue—for example, if the contractor should have backup funds withheld because the subcontractor or homeworker did not provide a taxpayer identification number to the contractor.
What the diligent IRS agent is being told is that maybe those payments you are being allowed to deduct might have backup withholding associated with them. The current rate is 28%, so the agent might get more from you from backup withholding than from disallowing the expense, Like in the Everglades where if the skeeters don’t get him then the gators will.
The Good Old Days
Now I’m going to tell you how the reasoning went about sending out 1099s in a lot of the small business community in my region back when I was closer to things like this. The only service providers who were sent 1099s were the ones that probably should have been treated as employees. Basically people who showed up at your place and did what they were told like the other employees, only you had convinced them to accept “independent contractor” status. What about your other vendors who had their own places and only came when you called them or you went to them? The ones who sent you invoices and statements and had their own letterhead? Who ever thought to send them 1099s?
Well as it turns out there is a big exception to the 1099 service provider requirement. Under the regulations you don’t have to send them to corporations. So all those vendors who had their own offices and employees and letterheads and all that, they must be corporations. You’re not going to send a 1099 to your CPA or Joe’s Plumbing, with its fleet of trucks are you? Mainly just because, but if you did some closer analysis you would realize it was because they were incorporated that you didn’t have to send them. And you know what? In the eighties, that was probably not such a bad bet. But nowadays, not so much. Since the check the box regulations went into effect, incorporation has become much less favored. Many of your vendors, that are possibly much more substantial than you, may not be corporations. The limited liability company is a common entity choice for many businesses.
LLC Is Only A Corporation Some Of The Time
That is what the CCA was about. Do you have to send 1099s to LLCs? Here is the answer:
Payments to LLCs are exempt from section 6041 reporting requirements only if the LLC has elected to be classified for federal tax purposes as a corporation by filing Form 8832. Based on the documentation your office provided, the LLC-payees made no such election. Therefore, these LLCs would be classified as either partnerships or disregarded entities, depending on how many members they have. As such, payments to these LLCs are not exempt from section 6041 reporting requirements.
How the question came to be asked requires a little bit of inference, but here is what it is based on.
The taxpayer is protesting certain adjustments proposed by the examining agent. Specifically, the taxpayer argues that the agent should not include payments to LLCs as reportable payments under section 6041 because the LLCs are exempt payees.
Therefore, the taxpayer claims that no backup withholding was required with respect to the LLC-payees under section 3406.
Our advice is based on your office’s information that the taxpayer has failed to produce any documentation that the LLCs have elected to be classified as corporations for federal tax purposes.
Could This Happen To You?
So it is coming out of an audit, where the examining agent took to heart the direction to go after backup withholding. Here we have to speculate a bit, but presumably the taxpayer is responding. “Hey. Joes Plumbing Inc. Joes Plumbing LLC. Six of one, half a dozen of the other. That’s not who you send 1099s to .” Sadly it turns out to be 0% of one and 28% of the other. Unless you can show that Joe decided to elect to treat his LLC as a corporation, which is not a high percentage bet.
The thing that I find interesting about this is that it does not seem to be happening as often as it could. If you are a tax preparer and not incorporated does it worry you that your clients are not sending you 1099s? Maybe it should. Or maybe you need to charge more. I mean the threshold is only $600.
As I noted, examiners don’t seem to raise this issue as often as they might. In case you are the one that caught the agent from hell, there is some possible relief. If you can get the payees to sign Form 4669 in which they acknowledge receipt and indicate the return that they reported the income on, you get out of the withholding, although not all the penalties. Good luck with that.
Rather than relying on your vendors future help, the better thing to do might be to review whether you are sending out all the 1099s you should. Now would be a good time.