1099 Risk Blog

Budget Crisis of the Undead

Our zombie news item for today is the grotesque revival of a proposed California budget fix that includes a 3% tax withholding for independent contractors. For those of you who don’t know what I am talking about, read on: this might be fun; I’m going to make yet another bold prognostication (see my last one on E-Verify).

Withholding taxes on independent contractors? If you are feeling some déjà vu, it’s not just you. This zombie of a proposal has been raised and killed so many times, Hollywood should be making movies about it. We just went through this in December-January, at the height of the California budget crisis media frenzy. Then, I opted not to blog the situation because I knew the measure would not see the light of day. This time around, I can’t not write about it. If it’s good enough for the New York Times, it is good enough for our 1099 Risk Blog.

The first we heard about this proposal in California was back in 1991 when then-Governor Pete Wilson introduced independent contractor withholding in his budget. The business community raised such opposition, due to the incredible costs of implementing it and the less than compelling net benefit, the proposal was dropped. Since, it has raised its ugly head enough times that we should recognize it readily for what it is: a dead policy walking.

(Here’s a sample 2004 news item if you’re looking for some history.)

So what’s the problem? Gross receipts are an extraordinarily bad predictor of taxable income, as small businesses and independent contractors have losses as well as expenses such as marketing costs, inventory, and overhead. That 2004 effort spawned a request for an actual policy analysis to be conducted. In their finely written January 2005 paper, Independent Contractor Withholding, the California Franchise Tax Board (FTB) concluded:

“Withholding on [independent contractor] payments . . . is estimated to generate a first-year revenue gain of approximately $1.3 billion (at 2 percent with no waiver process). However, only 6 percent of the first-year gain represents increased compliance. The balance is acceleration – either payments received earlier than they otherwise would have been or excess payments that would be refunded. By the third year, due to a reversal of acceleration, the combined revenue effect is estimated to be a loss of $200 million. By the fifth year, the combined revenue effect is estimated to be a gain of $400 million. Withholding on payments to independent contractors would require the state to implement complex and costly systems. One-time and annual operating costs are estimated to be about $21 million and $22 million, respectively. Businesses would also bear substantial costs. Such costs are difficult to quantify, but could be in the order of hundreds of millions of dollars. Additional costs would arise if the program were perceived as detrimental to California’s business climate. An undesirable feature of a withholding system is the potential for unwanted overwithholding. . .

"At a rate of 2 percent, almost 70 percent of independent contractors will be overwithheld and more than 40 percent of amounts withheld will be in excess of tax owed.”

How about that “reverse acceleration,” eh? To make it all worse, the new proposal up for vote right now asks for not just 2%, but 3%, magnifying the policy consequences due to an even greater rate of over-withholding. Talk about horror flicks.

This just might be the messiest possible way for California to get a cash advance.

So who’s in favor of it? The California Tax Reform Association, for one. You can read their argument for the measure at that link, although I'm not sure they make one.

We can hope Sacramento finds a way, and that the state doesn’t crumble into insolvency on July 24th when the money runs out, as the Governor just predicted might happen. But a legislature that can pass this particular measure, in the face of an unambiguous policy analysis like the one FTB produced, would be unbelievable even for California.

I just don’t think it’s going to happen.

What if I am wrong and independent contractor withholding of 3% becomes law in California? First, the private sector would be faced with figuring out processes for withholding taxes on 1099s. The state would be ensnared in costly lawsuits. Independent contractors would be incented to immediately recalculate quarterly estimated taxes, reducing anticipated acceleration, and their cash flows would be constricted. Businesses would be negatively inclined to operate in California, and workforce restructuring might deepen as cost cutting makes another pass. Industries heavily reliant on independent contractors would be stressed, and with this I’m thinking agriculture, healthcare, and high tech (isn’t that all of California?). There might be sudden demand for more independent contractors to be payrolled as W-2 employees by third party intermediaries. This would perhaps be a stimulant to the staffing industry, the hardest hit industry in this recession. En masse, it would make for sudden market labor price distortions, dramatic healthcare switcheroos, and other unforeseen ripple effects. Business not able to offload contractors would be looking to pass the cost of implementation on to someone else, probably consumers. And our telephones at MBO Partners would be ringing all the more, as we are undisputed in our expertise for engaging difficult-to-payroll independent contractors, in the IT sector especially.  

I am comfortable knowing that if I am wrong and by some outrageous leap the measure passes by both the legislature and the Governor, it may not be good for California, but it’s perhaps great for our unique business niche. We'd see a tidal wave influx of independent consultants and contractors being driven to MBO Partners either by the clients who want to avoid the tax withholding liability of their 1099s, and/or by the independent contractors themselves looking for a way to escape unreasonable overwithholding of state income taxes. 

Either way, at least you’ve been warned of this specter, and you know now that despite the media flurry, it is nothing new. I hope you all sleep well tonight – but don’t let the zombies bite. 

Liz Greene is not an attorney, and this blog post represents her sole opinion, and not the opinions of MBO Partners, Inc.

Please tell us your thoughts on the impacts of a proposed independent contractor tax withholding measure to your organization by leaving a comment below.

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