Bill would take taxes out of contractors hands: measure is worth an estimated $320 million this year.

Bill would take taxes out of contractors hands

Measure is worth an estimated $320 million this year

Persons operating as independent contractors -- including lawyers, doctors, accountants, consultants, building contractors and subcontractors -- could be the latest group affected by attempts to resolve the state's budget crisis.

Under a plan endorsed by Gov. Pete Wilson and some of California's Democratic legislative leaders, the state would require that withholding taxes be set aside when a payment is made to an independent contractor. This is similar to the procedure employers now follow for payroll withholding taxes.

The proposed withholding rates would be 1.25 percent of gross receipts per billing, except for medical contractors, who would be subject to 2.5 percent withholding rates. Currently, most independent contractors must make their own quarterly tax payments based on estimated net income for the period.

The bill would cover payments by businesses -- not by individuals -- to independent contractors. However, medical payments by insurance companies on behalf of individuals would be covered by the bill.

The bill would raise an estimated $320 million this year. The state's budget gap is estimated at $14.6 billion and rising.

Supporters of the bill point to studies showing that employers are more likely to pay withholding taxes than annual or quarterly income taxes.

"The state can achieve the highest level of compliance through withholding taxes," said James Lee, Wilson's deputy press secretary. "We have tax withholding for almost everyone, except for independent contractors."

Opponents -- including contractor and consulting associations, the California Building Industry Association, the California Chamber of Commerce and the California Taxpayers' Association -- point to the extra burdens the withholding tax would place on independent contractors.

"This bill is a gimmick to advance tax collections by a fiscal year by putting an extra burden on contractors," said Dave Ackerman, a lobbyist for the Associated General Contractors of California. "It reaps a one-time benefit for the state, but forces contractors to put costly, permanent bookkeeping programs in place."

The bill was introduced by Sen. Wadie Deddeh (D-San Diego) after Wilson endorsed the concept of an independent contractors' withholding tax in his January budget plan. It cleared the Senate Appropriations Committee recently and is now on its way to the Senate floor.

If the measure passes, payments businesses make to independent contractors could be taxed. The withholding tax would apply to those situations in which federal Form 1099 is used for medical service providers and non-employee compensation.

According to estimates made by the Senate Revenue and Taxation Committee, the bill would bring in about $32 million to the state's coffers this fiscal year, primarily by speeding up tax payments that are now made quarterly or annually; it would generate about $120 million a year in revenue thereafter by increasing tax compliance.

"In an ordinary year, a bill like this would not stand a chance in hell of passing," said Martin Helmke, a Senate Revenue and Taxation Committee staffer. "But this year, with the $14 billion budget deficit, it stands a good chance of getting through because it is not a tax rate increase or a new sales tax."

The main costs to independent contractors would be lost interest earned on the amount now to be withheld, plus additional bookkeeping. Those new costs might be passed along.

Critics of the bill also point to the probability that the state would frequently withhold too much with its flat withholding rates, putting an unnecessary cash flow squeeze on small independent contractors.

Doctors who set up medical corporations that invest client's payments could be particularly hard hit by the bill.

"Profit margins are often so small with independent contractors that even a 1 percent withholding rate can lead to significant cash flow problems," Ackerman said.

In an attempt to head off this criticism, an amendment was made to the bill establishing a minimum rate of $25 or 0.1 percent of gross receipts, whichever is greater, for independent contractors who certify that they will not make a profit on a specific project or client.

Howard Fine is a reporter with the Orange County Business Journal