There are jobs that are difficult to find employees to perform. This is particularly true for lower-paid jobs that require physical labor. This includes construction and maintenance jobs, such as painters, law care jobs, etc. It also includes some entry-level jobs in restaurants.
Businesses in these industries often have to supplement their workforce with illegal immigrants or others. This raises several tax issues. One issue relates to backup withholding (another issue relates to employee-vs.-contractor determinations). These workers usually cannot provide a valid taxpayer identification number. The rules say that the business is to withhold tax on payments to these workers. If the business makes the withholding, there is no doubt that the worker will simply not perform more work. Word would get out about the withholding with other workers and prospective workers, and the business would no longer be able to have the staff to allow it to continue to operate.
If the IRS catches on to this, the tax consequence is often insurmountable for the business. The resulting tax liability results in the business going under and, in many cases, the tax liability follows the business owner. The business owner then has to live with the outstanding taxes. If they close the business and get a job, their new employer will likely get a lock-in letter for their wages. If they are not doing well financially, they can also work out a settlement with the IRS to settle the taxes for less.
This brings us to the Quezada v. IRS, 982 F.3d 931 (5th Cir. 2020) case. The IRS recently issued AOD 2022-01 to say that it does not agree with the court’s holding in the case, but will follow it for taxpayers in the Fifth Circuit. The case addresses whether the IRS has an unlimited period for assessing withholding tax on businesses like those described above. The appeals court said that the IRS does not.
Facts & Procedural History
The taxpayer is a stone mason. He signs up jobs and uses subcontract labor to complete the jobs.
The taxpayer reported the payments to the IRS on Forms 1099. Many of the forms did not include taxpayer identification numbers as the payees did not provide the numbers to the taxpayer.
The IRS responded to these Forms 1099 with its standard letter saying that he was required to make backup withholding on the payments given the forms were incomplete. It also instructed the taxpayer to file a Form 945 to report the backup withholding. The taxpayer did not make the backup withholding or file the Forms 945 as instructed.
The IRS conducted an audit and assessed $1.2 million of withholding tax for the taxpayer. The IRS did not make this assessment until more than three years after the taxpayer filed his Form 1040 income tax return and the Forms 1099.
The taxpayer filed bankruptcy and asserted that the withholding tax was not timely assessed. The bankruptcy court and district court did not agree with the taxpayer. They both held that the assessment statute did not run because the Forms 945 were not filed. The Fifth Circuit Court of Appeals was tasked with reviewing the holdings in these prior court decisions.
About IRS Backup Withholding
Taxpayers are generally required to file Forms 1099 for payments in excess of $600 a year. These forms have to include taxpayer identification numbers.
Treas. Reg. § 301.6109-1(a)(1)(i) says that “taxpayer identification numbers” include “social security numbers, Internal Revenue Service (IRS) individual taxpayer identification numbers, IRS adoption taxpayer identification numbers, and employer identification numbers.”
Taxpayers who are not able to get this information may have to make backup withholding on the payments.
Section 3406(a) provides for backup withholding. It says that the party making a payment in excess of $600 is to withhold tax if, among other reasons, the taxpayer fails to provide a taxpayer identification number. The withholding tax is to be remitted to the IRS. As noted above, this is done by filing the Form 945.
The recipient usually does not lose the amount withheld. If they have a valid taxpayer identification number, they can then recoup the withholding tax by filing a tax return and applying the payment as a credit or, if the tax is not due, filing a return to request a refund of the withholding tax.
Time Limit to Assess Withholding Tax
The IRS generally has three years from the date the tax return was filed. If no tax return is filed, the IRS’s limitation period does not start to run.
The question for the appellate court was which tax return starts the assessment period for withholding tax. The IRS and the lower courts argued that the Form 945 was the applicable tax return. They reasoned that this form was not filed and, therefore, the IRS statute of limitations never started running.
The taxpayer argued that the filing of his Forms 1040 and Forms 1099 were the tax returns for purposes of withholding taxes. He reasoned that these forms provided the information the IRS needed to compute his withholding tax. Thus, these forms are the tax return for purposes of his withholding taxes.
The appeals court considered whether the Form 945 was the tax return and held that it was not. It held that the return does not have to include the form designated by the IRS, but rather, any tax form that puts the IRS on notice of the tax liability and allows the IRS to compute the liability. Since the Forms 1040 and Forms 1099 did this, the appellate court concluded that the Form 945 was not the tax return that started the statute of limitations for withholding tax.
The IRS issued its Action on Decision to note that it does not agree with the appellate court’s holding. The IRS believes that the Forms 1040 and Forms 1099 do not allow the IRS to determine whether withholding tax is due. The IRS argues that the liability for withholding tax is due to a failure to obtain the taxpayer identification numbers. According to the IRS’s arguments, the taxpayer may have the taxpayer identification numbers and omitted them on the Forms 1099 in error.
Those who pay contractors or subcontractors are often not able to file Forms 1099 as they cannot get taxpayer identification numbers. This is a very common problem. The taxpayer who receives an IRS letter or assessment for backup withholding should take note of this case.
The IRS announced in its AOD that it would follow the court’s holding for taxpayers in the Fifth Circuit, including taxpayers in Texas. This provides a hard deadline for the IRS to assess withholding tax for these taxpayers. Taxpayers located outside of the Fifth Circuit should expect the IRS to continue to challenge this issue.
Regardless of circuit, taxpayers may consider taking precautions to prepare for this situation. This may include providing additional information with the Forms 1040 (or other income tax return) and/or Forms 1099. This information may include a statement that the taxpayer was not able to obtain the taxpayer identification numbers and did not include them as they did not have them. This is one of several considerations that should go into tax planning for businesses that employ contractors and subcontractors.