IRS Ruling Addresses Backup Withholding

Important guidance for church treasurers.

IRS Letter Ruling 19990603

Background. A used car dealer made payments in excess of $600 during the year to various independent contractors for personal services provided to his business. For example, the dealer paid auto repair shops, auto body shops, and auto detail services for work performed on his dealership’s cars. These independent contractors were paid by checks drawn on the dealer’s business account. At the time the dealer made payments to the independent contractors, no taxpayer identification numbers were obtained, and the dealer did not issue a Form 1099 to any of the contractors. The dealer asked the IRS if he was required to engage in “backup withholding” on payments he made to these contractors.

What the IRS said. The IRS ruled that the dealer was required to engage in backup withholding at the time it made payments to the contractors, since it failed to obtain their taxpayer identification numbers. Here are the points the IRS made:

(1) Form 1099 reporting requirement. Any employer engaged in a “trade or business” that makes payments of $600 or more in the course of that trade or business to an independent contractor, as compensation for services rendered, must issue the contractor a Form 1099 reporting the contractor’s name, address, taxpayer identification number, and amount of compensation.

(2) The $600 requirement. The Form 1099 reporting requirement is triggered “if the aggregate amount of the current payment and all previous payments to the payee during the calendar year equal $600 or more. The amount subject to withholding is the entire amount of the payment that causes the total amount paid to the payee to equal $600 or more and the amount of any subsequent payments made to the payee during the calendar year.”

(3) Backup withholding. An employer is required to withhold at a rate of 31 percent on any payment subject to the Form 1099 reporting requirement, at the time of the payment, if the employer has not received the contractor’s taxpayer identification number.

The IRS concluded that the dealer’s payments to the independent contractors were subject to the Form 1099 reporting requirement. And, since he failed to obtain the contractors’ taxpayer identification numbers, his “obligation to backup withhold commenced with the entire amount of the payment that caused the total amount paid to an independent contractors to equal $600 or more for the calendar year.”

Relevance to church treasurers. This ruling demonstrates that a church must issue a 1099 form to a person if the following five requirements are satisfied: (1) the church is “engaged in a trade or business”; (2) the church pays the person compensation of $600 or more during the calendar year; (3) the person is an independent contractor (not an employee of the church); (4) the payment is in the course of the church’s “trade or business”; and (5) no exception exists. The income tax regulations specify that the term “person engaged in a trade or business” includes not only “those so engaged for gain or profit, but also organizations the activities of which are not for the purpose of gain or profit” including organizations exempt from federal income tax under section 501(c)(3) of the Code. This includes churches and other religious organizations. There is no doubt that churches are required to issue 1099 forms if the other requirements are satisfied.

It is important for church treasurers to recognize that if an independent contractor performs services for the church (and earns at least $600 for the year), but fails to provide you with his or her taxpayer identification number, then the church is required by law to withhold 31 percent of the amount of compensation as “backup withholding.” And, this must be done at the time of payment. There is no way to do it retroactively, since the compensation has been paid.

Here are some tips for church treasurers to consider in complying with the backup withholding requirement:

Know when a Form 1099 is required. Be familiar with the requirements summarized above. In particular, note that the Form 1099 reporting requirement only applies to payments made to independent contractors. Be aware of common examples of independent contractors, including guest speakers, and contract laborers. Examples of contract laborers include custodians and computer consultants who are hired for a specified fee, do not work full-time, advertise their services to other employers in the community, provide their own equipment and supplies, and perform their services without any direction or control from the church.

No Form 1099 is required for some kinds of payments, including (1) payments to a corporation; (2) travel expense reimbursements paid under an “accountable” reimbursement arrangement; and (3) payments of bills for merchandise, telegrams, telephone, freight, storage, and similar charges.

Example. A church hires a local landscaping company to maintain the church grounds. There is no need for the church to issue a Form 1099 if the company is a corporation. Note, however, that this exception only applies to corporations—and not to partnerships.

Tip. An independent contractor informs you that he is incorporated, and so the church is not required to issue him a Form 1099. Do you take the person’s word for it, or are you required to do more? Here are two options: (1) Have the person complete and sign Form W-9, checking the “corporation” box and writing “exempt” in Part II. Note that a taxpayer identification number should be provided, even though the church will not be issuing a Form 1099. This will be the corporation’s “employer identification number.” (2) Ask the independent contractor for proof of incorporation before relying on this exemption. This could include a copy of the certificate of incorporation issued by the state. Or, call the office of secretary of state (in the state of incorporation) and confirm the existence of the corporation.

Obtaining taxpayer identification numbers. For many independent contractors, their taxpayer identification number will be their social security number. The income tax regulations state that you can obtain an independent contractor’s taxpayer identification number either orally or in writing.

Tip. Before making a payment to an independent contractor of $600 or more (or a lesser amount that increases annual compensation paid by the church to $600 or more), require the contractor to complete an IRS Form W-9. This form asks for the contractor’s taxpayer identification number. It is a good practice to have several of these forms on hand in the church office. Be sure you have the current version, since they are updated each year.

Key point. Churches can be penalized if the social security number they report on a Form 1099 is incorrect, unless they have exercised “due diligence.” A church will be deemed to have exercised due diligence if it has independent contractors provide their social security numbers using Form W-9.

The backup withholding requirements were designed to ensure that independent contractors fully report their income. Without backup reporting, such persons can often underreport their true income (without detection) by simply refusing to provide their social security numbers to employers. Of course, to avoid backup withholding, some independent contractors may consider providing you with a false social security number. The IRS will discover such a scheme when it receives the Form 1099 containing the false number. At such time, the IRS will notify the church to commence backup withholding on any future payments to the individual (until a correct social security number is provided).

Form 941. Don’t forget to report backup withholdings on your quarterly Form 941 (employer’s quarterly tax return).

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

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