Two new requirements involving withholding on nonemployee compensation and rent payments will require operational changes for many organizations.
November 27, 2017
On October 30, 2017, Governor Wolf signed House Bill 542 (H.B. 542) into law. H.B. 542 makes a variety of changes to state tax law, but this E-Flash will focus on two:
- First, Pennsylvania businesses and non-profits will be required to withhold Personal Income Tax from nonemployee compensation paid to nonresident individuals and to single-member LLCs that have a nonresident owner.
- Second, withholding will be required on payments to nonresident landlords for commercial real estate located in Pennsylvania.
These new requirements are significant because they will require operational changes for many organizations and because they go into effect quite soon: By its terms, House Bill 542 provides for the withholding requirements to go into effect on December 29th. The Department of Revenue has issued informal guidance indicating that they expect withholding to go into effect on January 1, 2018, but that still does not provide much time to adapt to the new withholding regime.
Withholding on Nonemployee Compensation
The requirement that businesses and non-profits withhold tax from nonresident contractors and vendors appears to have the broader potential application and to carry the greater risk of non-compliance between the two new requirements.
Essentially, the existing withholding requirements that apply to employees will now be applied to a variety of nonresident contractors or vendors who receive $5000 or more in payments in a year.
What Is the Withholding Requirement?
Any “person” making “payments of income” from Pennsylvania “sources” that are either “compensation” or “net profits” to either a nonresident individual or “an entity that is disregarded under section 307.21 that has a nonresident member” will be required to withhold tax from the payments at the rate for the Pennsylvania’s Personal Income Tax if the payor is required to file a copy of a 1099-MISC with the Department of Revenue and the amount paid is $5000 or more in a year.
Before analyzing the impact of this requirement, the technical terms need to be unpacked:
- “Person” is a defined term under the Personal Income Tax, and the definition is quite broad, reaching individuals and entities of every description, as well as estates and trusts. 72 P.S. § 7301(o).
- “Compensation” is defined under the Personal Income Tax, and H.B. 542 cross-references that definition to define one category of payments that are potentially subject to withholding. The definition of “compensation” is very broad; it not only reaches “salaries, wages, commissions, bonuses and incentive payments,” but also covers “fees, tips and similar remuneration received for services rendered, whether directly or through an agent, and whether in cash or in property.” 72 P.S. § 7303(a)(1)(i).
- “Net profits” is also defined under the Personal Income Tax, and H.B. 542 cross-references that definition to define the second category of payments that are potentially subject to withholding. The statutory definition embraces “net income from the operation of a business, profession, or other activity, after provision for all costs and expenses incurred in the conduct thereof . . . .” 72 P.S. § 7303(a)(2).
- The term “sources” is a particularly complicated subject. In general, income is derived from a Pennsylvania source if it is the result of sales of goods in Pennsylvania or services rendered in Pennsylvania, but the standards for sourcing of services are in a state of flux, creating a degree of uncertainty.
- “An entity that is disregarded under section 307.21 that has a nonresident member” is a direct reference to a specific provision under the Personal Income Tax, 72 P.S. § 7307.21. That section provides that “an unincorporated entity that has a single owner shall be disregarded as an entity separate from its owner.”
With those technical terms out of the way, it is apparent that payments to contractors and vendors who are nonresident individuals will potentially be subject to withholding if the payments are from Pennsylvania sources. And while the language governing LLCs in H.B. 542 is cumbersome, the direct statutory reference to 72 P.S. § 7307.21 strongly suggests that only single-member LLCs will be subject to the potential withholding requirement.
The other condition for the withholding requirement is that the person making the payments is required to file a copy of Form 1099-MISC with the Department. H.B. 542 directly references 72 P.S. § 7335(f)(1), which requires a payor to file a copy of a Form 1099-MISC with the Department of Revenue if it is making “payments of income from sources within the Commonwealth.” 72 P.S. § 7335(f)(1)(i). The other situation when a payor is required to file a copy of a 1099-MISC with the Department is when it “makes payments of nonemployee compensation or payments under an oil and gas lease . . . to a resident or nonresident individual, an entity treated as a partnership for tax purposes or a single-member limited liability company.” 72 P.S. § 7335(f)(1)(ii).
Before concluding the discussion of the withholding requirement, a brief review of the requirements for filing Form 1099-MISC is appropriate. Under the Internal Revenue Code, anyone engaged in a trade or business must report to the IRS all payments made of $600 or more. I.R.C. § 6041(a). Under the Treasury Regulations, this requirement reaches virtually any type of income. Form 1099-MISC is the form that is used to report these payments.
What Are the Uncertainties Surrounding this Withholding Requirement?
The new withholding requirement for nonemployee compensation creates two types of uncertainties:
- There are practical uncertainties, as businesses will need to establish withholding procedures and determine which vendors and contractors are subject to withholding; and
- There are legal uncertainties because certain aspects of the new withholding requirement are not entirely clear.
An initial problem is that the accounts payable function in most organizations is not set up to withhold tax. It will take time to train staff to perform this function.
The more daunting problem is determining which contractors and vendors will be subject to withholding. For example, assume that an organization in Pennsylvania has a vendor known as ABC LLC with which it does a significant volume of business, and payments are mailed to an address in another state. Here are some potential scenarios:
- ABC LLC is not a single-member LLC, which means that withholding should not be required under the plain language of H.B. 542.
- ABC LLC is a single-member LLC that is based in another state (or simply has a lock-box arrangement with its bank, which is based in another state), but its owner is actually a Pennsylvania resident, so there is no withholding requirement.
- ABC LLC is a single-member LLC with a nonresident owner, and withholding is required.
The answer to some of these questions may be covered by contracts with the vendor or contractor, but those records may not be readily accessible, and the information that they contain may not be current, as in the following examples:
- The payor may assume that ABC LLC is taxed as a partnership because it was when the relationship was established, but now it is a single-member LLC that is potentially subject to withholding; or
- The payor may realize that ABC LLC is a single-member LLC but not realize that the owner moved from Pennsylvania to another state, triggering the withholding requirement.
And while it would be tempting to assume that you don’t have to withhold from an LLC that has a Pennsylvania address, the possibility exists that the owner of that entity is a nonresident.
If you multiply those scenarios by the number of vendors that a business has, it is apparent that a lot of work will be necessary to assure compliance.
There are a lot of legal uncertainties, starting with the effective date.
By its terms, H.B. 542 is effective sixty days after enactment, which means that the withholding requirements go into effect on December 29th. The Department of Revenue has issued a summary of the bill indicating that the withholding requirement applies as of January 1st. Technically, the statute controls, and informal guidance probably will not bind the Department of Revenue. Is the Department likely to change its position? Probably not, but if you want to be certain, pay your vendors before December 29th or wait until after January 1st.
Another uncertainty is how the mandatory withholding threshold works: H.B. 542 provides that withholding is optional for payees who receive less than $5000 per year. That may be a bit of a trap.
Assume that PA Inc., a Pennsylvania business, has a vendor, XYZ LLC, that is a single-member LLC with a nonresident owner, and PA Inc. does not withhold because prior history suggests that XYZ LLC will not receive more than $5000 in payments in 2018. As luck would have it, XYZ LLC does significantly more work in 2018, making a total of $12,000; here are the theoretical options:
- PA Inc. should withhold on the entire $12,000; or
- PA Inc. should withhold on only the amount over the $5000 threshold, which would be $7000 on these facts.
There is a certain logic to withholding the tax on $7000, but that is probably not the right answer. The withholding requirement directs that a payor “shall deduct and withhold from the payments an amount equal to the net amounts of the payments multiplied by the tax rate,” which is 3.07% under 72 P.S. § 7302(a). On the facts outlined above, the statutory language indicates that the entire $12,000 is subject to withholding.
As a practical matter, that means businesses will need to start to withhold below the $5000 threshold to assure that when a vendor reaches the threshold, the amount of the payment that brings the total to $5000 is large enough to cover the tax on $5000. For example, if a vendor with a total of $4900 in payments submits an invoice for $100, the amount due is less than the amount of tax due at the statutory rate of 3.07%.
The terminology concerning disregarded entities is awkward. The withholding requirement reaches nonresident individuals and entities that are disregarded under 72 P.S. § 7307.21. The phrase “disregarded entity” has an accepted meaning from federal regulations: An LLC “with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.” Treas. Reg. § 301.7701-3(a). That means the owner of an LLC has three options for federal tax purposes:
- The default, treatment as a disregarded entity;
- Electing to be taxed as a C corporation; or
- Electing to be taxed as an S corporation.
Meanwhile, the relevant Pennsylvania statute provides that unless it is subject to the Corporate Net Income Tax (which would only apply to entities electing C corporation treatment), “an unincorporated entity that has a single owner shall be disregarded as an entity separate from its owner.” 72 P.S. § 7307.21. While a vendor that has elected to have her single-member LLC treated as an S corporation may argue that withholding should not apply, the safer assumption is that withholding is required.
And then there is the issue of sourcing. The withholding requirement only applies to payment of income from sources within Pennsylvania. The determination of how income is “sourced” to a specific state can be tricky. Certain transactions are obvious: If a Philadelphia-based business hires a New Jersey-based painting contractor to perform work at its Philadelphia office, that is plainly income from a Pennsylvania source and is potentially subject to withholding if the other criteria are met.
When the services are provided by a nonresident vendor for a project outside Pennsylvania, existing regulations indicate that “[c]ompensation for personal services rendered by a nonresident individual wholly without this Commonwealth is not taxable regardless of the fact that payment may be made from a point within this Commonwealth or that the employer is a resident individual, partnership or corporation.” 61 Pa. Code § 101.8(e). While that sounds conclusive, Pennsylvania has adopted market-based sourcing criteria for purposes of its Corporate Net Income Tax, and the Department of Revenue now sources services based on a variety of factors, such as the address where the order was placed. If the Department of Revenue elected to take a market-based approach for purposes of the new withholding requirements, services rendered in another state for the benefit of a Pennsylvania-based business might well be subject to withholding. While it is hard to predict how likely the Department is to apply market-based sourcing, the prospect that it will be applying different sourcing rules to different types of businesses is problematic.
And then there are situations in which the services are rendered both in Pennsylvania and elsewhere, which will require the business to make a judgment about what portion of the income comes from Pennsylvania sources.
What Could Go Wrong?
As should be apparent from the uncertainties listed above, there is quite a lot that could go wrong, which makes this a good time to note that these are trust fund taxes. A payor that fails to withhold can find itself responsible for any shortfall, an obligation that may also fall upon its senior management.
Payors will be required to file quarterly withholding returns in April, July, October, and January, and they will be subject to a penalty for late filing. They also will be required to issue withholding statements to payees by furnishing a copy of Form 1099-MISC.
The payment requirements will be the same as the Department currently uses for employee withholding:
- Quarterly, if the aggregate expected to be paid for the taxable year is under $1200;
- Monthly, if the aggregate expected to be paid for the taxable year is over $1200 but under $4000;
- Semi-monthly, if the if the aggregate expected to be paid for the taxable year is over $4000 but under $20,000;
- As paid, if the aggregate expected to be paid is over $20,000.
72 P.S. § 7319(a)(1)-(4). Underpayments and late payments will trigger penalties.
While the decision to tie the payment schedule to the existing standards for employee compensation has a certain logic, it also creates some problems, such as the following:
- In determining the payment schedule based on aggregate payments, are anticipated payments to employees and vendors combined, or should anticipated employee and nonemployee payments be calculated separately?
- Because the payment schedule for larger organizations is designed to handle payroll, which is typically on a fixed schedule, it requires tax payments to be made on a schedule tied to when paychecks are issued. It is not clear how the deposit requirements will be administered for entities that may make accounts payable disbursements several times in a week and don’t qualify for quarterly, monthly, or semi-monthly payments.
Withholding on Rent Payments
H.B. 542 also imposes a requirement that Pennsylvania Personal Income Tax is withheld from payments to a nonresident lessor in connection with leases of non-residential real estate located in the Commonwealth. As with non-employee compensation, withholding is permissive for amounts below $5000 and mandatory at or above that level. The types of payments subject to withholding are “rents, royalties, bonus payments, damage payments, delay rents and other payments made pursuant to a lease, other than compensation derived from intangible property having a taxable or business situs in this Commonwealth.”
While this provision is not as problematic as the withholding requirement for nonemployee compensation, it is not without complications. For example, payments that are made to an agent on behalf of a non-resident landlord are subject to withholding, which means that the fact that the rent payment is sent to a Pennsylvania address does not eliminate the prospect that withholding is required.
Another problem is posed by the way the H.B. 542 delineates whose income is subject to withholding: A lessor is defined to “include an individual, estate, or trust.” It is not entirely clear where that leaves corporations, partnerships, and LLCs:
- Presumably, a single-member LLC that is treated as a disregarded entity for tax purposes is intended to be covered, since individuals are covered explicitly.
- Presumably, a C corporation is not covered by the withholding requirements, since the withholding requirement is for Pennsylvania Personal Income Tax.
- As for pass-through entities, such as partnerships, S corporations, and LLCs that have elected pass-through treatment, there appears to be room for debate.
Hopefully, the Department of Revenue will clarify this situation.
Disclaimer: This E-Flash does not offer specific legal advice, nor does it create an attorney-client relationship. You should not reach any legal conclusions based on the information contained in this post without first seeking the advice of counsel.
About the Author:
James R. Malone, Jr. is a Principal in the Firm’s Tax Controversy Practice. He represents clients in disputes with federal, state, and local tax authorities. Mr. Malone represents clients – including businesses, individual taxpayers, accountants and tax preparers – in both administrative proceedings and in court. Learn More.