A six-month grace period during which Pennsylvania’s Department of Revenue (the “Department”) indicated it would not assess taxpayers for failing to comply with a new tax-withholding and reporting requirement that became effective January 1, 2018, will soon end (i.e., on the last day of June 2018).
1. New Tax Withholding Duty
A new Pennsylvania law requiring a business to withhold state income taxes from payments to nonresident independent contractors, contained in newly enacted 72 P.S. § 7316.2, became effective January 1, 2018. The Department indicated that taxpayers would not be subject to an assessment for failing to withhold taxes in accordance with the new law for a period ending prior to July 1, 2018.
Guidance the Department issued explaining the new law indicates that the new tax-withholding duty is imposed on a payor of Pennsylvania-source non-employee compensation or business income[1] if the following three conditions are satisfied:
- the payments are made to (i) a nonresident individual, or (ii) a disregarded entity that has a non-resident member,
- the payments are reportable on a Form 1099-MISC, and
- the Form 1099-MISC is required to be filed with the Department.
The tax-withholding rate is 3.07%. A payor is required to register with the Department and remit the withheld amounts in accordance detailed rules. The new law exempts federal and Pennsylvania government payors.
“Business income” is defined in 72 P.S. § 7401(2)(a)(1)(A) to mean “income arising from transactions and activity in the regular course of the taxpayer’s trade or business ….”
Pennsylvania-source income for a nonresident is defined, in relevant part, in 72 P.S. § 74301(k)(2) to mean “compensation, net profits, gains … to the extent that it is earned, received or acquired from sources within this Commonwealth in connection with a trade, profession, occupation carried on in this Commonwealth or for the rendition of personal services performed in this Commonwealth.”
The foregoing suggests that the tax-withholding requirement would apply with respect to a nonresident independent contractor who (i) provides services within the Commonwealth of Pennsylvania, or (ii) provides services out-of-state that are in connection with the payor’s business. The Department’s guidance appears to reaffirm this interpretation, explaining that a payment typically is considered “nonemployee compensation” if it is made (i) to a nonemployee of the payor, and (ii) for services in the course of the payor’s trade or business. The guidance states that the tax-withholding duty would apply, for example, to payments by a Pennsylvania company to its nonresident directors.
The new tax-withholding law contains a de minimis exception, under which tax withholding is optional with respect to payments from a payor to a payee of less than $5,000 annually.
Nonresident independent contractors will need to file a Pennsylvania income tax return each year to recover overwithheld amounts.
2. New Tax Reporting Duty
New tax-reporting duties also were enacted. The Department explains that commencing in tax year 2018, a payor that pays Pennsylvania-source income – of any kind – to a resident or nonresident individual, partnership or single member LLC that is reportable on a Form 1099-MISC is required to file a copy of the Form 1099-MISC with the Department and provide a copy to the payee. Thus, the duty to file copies of Forms 1099-MISC with the Department applies with respect to payments made to all independent contractors, regardless of whether a contractor is a resident or a nonresident.
3. Commentary
- Imposing this new tax-withholding duty only with respect to independent contractors (and disregarded entities) – but not other forms of businesses – discourages Pennsylvania-based companies from doing business with nonresident independent contractors.
- The new law creates a trap for the unwary company that contracts with a nonresident independent contractor and a nonresident corporation to perform different parts of a project, without suspecting that the fees it pays to the independent contractor could be subject to tax withholding.
- The new law creates new uncertainties for companies that seek to comply.
- For example, new 72 P.S. § 7316.2(a)(2) provides that the tax withholding is to be in “an amount equal to the net amount of the payments multiplied by the [specified] tax rate.” It is unclear what the term “net amount” means, or how it is to be calculated. Pennsylvania’s Taxation and Fiscal Affairs statute does not define the term. If “net amount” means the net amount subject to Pennsylvania income tax, a client will seldom know what portion of a gross payment to an independent contractor this amount represents. For that matter, the independent contractor will seldom know, either. The Department’s guidance glosses over this term and suggests that tax withholding is required with respect to the gross payment amount.
- While the Department’s guidance defines non-employee compensation as “services in the course of [the payor’s] trade or business,” it is often unclear whether a specific type of services will meet this test, as a company and taxing authorities often disagree on what constitutes “the course of the company’s trade or business.” An overly cautious Pennsylvania company might tend to withhold taxes, when in doubt. It is not clear what recourse a nonresident independent contractor might have when a client improperly withholds a portion of the fees the contractor earned, especially when the contractor is counting on those fees to fund his or her business operations.
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The foregoing is intended solely as general information and may not be considered tax or legal advice; nor can it be used or relied upon for the purpose of (i) avoiding penalties under any taxing statute or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should not take any action based upon any information contained herein without first consulting legal counsel familiar with your particular circumstances.
[1] New tax reporting and withholding duties also apply with respect to certain lease payments.
