The evolution of the California information reporting regime present challenges to the community in several areas, two of which we are going to comment on here. Firstly there is the ongoing work to transition transmittals to an XML filing system. If you have not received a letter from the state of CA asking you to move filings to this system you do not yet need to do anything, but you should be aware that the changes are coming and will eventually be mandatory for everyone (download the implementation guide here). This is a complex set of requirements that will be phased in over time, so it is important that you or your information reporting provider keep on top of this implementation so you can stay in compliance.  NOTE: Convey’s Taxport Service will be accomodating XML transmittals for California.

Secondly, California has a whole set of unique withholding requirements that bear discussion.  And starting in January of Tax Year 2010, California also instituted additional back-up withholding requirements.  If you were not aware and/or are not executing back-up withholding on California recipients AND California sourced income for non-residents, you should make sure to read on.

In this remainder of this post, the following topics will be briefly discussed to inform readers of California withholding rules, recent additions to these rules and how these rules may impact you.

• Nonresident independent contractor withholding
• Three phases of nonresident withholding
  • Before making a payment to a nonresident
  • At the time of making a payment to a nonresident
  • After making a payment to a nonresident
• New backup withholding legislation
• New processing requirements

Nonresident withholding is a prepayment of tax on California source income paid to a nonresident (of California) or to nonresident independent contractors (NICRs).  Withholding agents (defined in paragraph below) are required to withhold 7% on all payments greater than $1,500 in a calendar year. Withholding is optional on the first $1500 in a calendar year.  A withholding agent can begin withholding immediately or after the $1,500 threshold has been met. If the latter option is chosen, then a withholding of 7% is done on every dollar exceeding $1,500. No backup withholding is done to include the withholding on the first $1,500.

The withholding on NICRs exists because the California tax system is a “pay as you go” system thereby preventing a large tax payment at the end of the year for the taxpayer. The money is withheld by a “withholding agent” who is usually the person/organization that pays the NICR for work performed in California. A withholding agent at the time of payment will either withhold 7% on all payments made or, withhold according to instructions provided in a letter by the California Franchise Tax Board (FTB). The instructions may contain a waiver from withholding if requested as well as an expiration date for that waiver, or it may contain an approval to reduce withholding and by how much if requested.

Withheld amounts are remitted to the FTB using Forms 592 (Resident and Nonresident Withholding Statement) and 592-V (Payment Voucher for Resident and Nonresident Withholding) on certain due dates during the year. Form 592-B is provided to the payee at the end of the year to be attached with his/her California tax return showing withholding credit.

There are three phases of withholding each driving different form requirements.   The applicable form that can be used before making payments to NRICs to request a waiver, reduce or eliminate withholding are:

-          Form 590 – Withholding Exemption Certificate

-          Form 588 – Nonresident Withholding Waiver Request

-          Form 587 – Nonresident Withholding Allocation Worksheet

-          Form 589 – Nonresident Reduced Withholding Request

At the time a payment is made to an NICR there are no forms to use and the withholding agent simply withholds the 7% of all payments greater than $1,500 in a calendar year, unless the ICR qualifies for a reduced or waived withholding.

Effective January 1, 2010, new legislation requires backup withholding on California sourced payments to residents and nonresidents (to California). According to the new legislation, if a withholding agent must backup withhold and remit to the IRS on a recipient, then they must now also withhold and remit to the California FTB.   Backup withholding generally applies when a payee fails to provide or refuses to provide a correct tax identification number (TIN).  The backup withholding rate is 7% and federal minimum income levels apply. However, there are a couple of exceptions to California backup withholding. Backup withholding is not applicable to:

-          Payments and Dividends (Forms 1099-INT, 1099-DIV, 1099-OID and 1099-PATR)

-          Any release of loan funds made by a financial institution in the normal course of business

Several process changes have been introduced to manage these new withholding requirements. One of the major changes is that Form 590-V (this voucher is most important as it ensures accurate and  timely posting of the withholding amounts) is now required with any resident or nonresident withholding payments to the FTB, regardless of how the reporting of withholding is made, i.e. on paper or electronically. Other changes include:

-          New guidelines for faxed withholding forms (some forms may no longer be accepted).

-          In general faxed withholding forms (e.g. Forms 592, 592-A, 592-F and 592-V) used for reporting, paying or for informational purposes, are no longer processed.

-          Form 588 used for requesting a waiver is still acceptable via fax.

-          Form 589 used to request reduced withholding is acceptable via fax through December 2010.

-          Form 592-B is no longer a carbon format and therefore payers must provide a photocopy to payees.

-          The Substitute Forms Program must be contacted for new rules on types of substitute forms acceptable.

-          Excel sheets are no longer acceptable with lists of payees. For NCIRs this includes payees listed on Forms 588 and 592.

If you have recipients in the state of California and/or you generate California sourced income for residents of any state, you need to accommodate these rules.  You also need to make sure you have systems and processes in place to withhold/remit appropriately and to create and submit the appropriate 592 forms.  NOTE: If you are using Convey software, you have the ability to create and submit the 592 and 592-B.  Convey also has solution that can help you simplify and manage the detail withholding, remitting and reconciliation activities.