Due Diligence Firms Boom, But Questions About W-2s

Writing about tax issues for me is akin to getting root canal and discussing the microscopic details of employers filing W-2 forms for their mortgage workers doesn't sound all that exciting, but trouble could be brewing (once again) in the land of due diligence providers.

During the height of the subprime boom third-party due diligence firms like the Clayton Group, Bohan and Opus made a killing re-underwriting nonprime loan files for large Wall Street firms and correspondent lenders. Half those loans went bust and fingers were pointed at both the Street firms (Merrill, Bear, Lehman, etc.) and the contractors for doing shoddy work.

That's a column for another time, but suffice to say the due diligence firms charged their clients upwards of $150 an hour for their time and paid the actual grunt doing the underwriting work $40, leaving them a nifty little profit of $110. Roughly a decade ago, controversy centered around whether some of these firms paid their grunts via a W-2 form or declared them true independents (as in sole proprietors), forcing these workers to make their own tax payments to the government. In the wake of the subprime crash and clean up, due diligence firms are once again thriving because now they're working for investors, rescrubbing old loan files looking for underwriting flaws that would allow the investor to force a buyback on the originator. As you can tell by reading stories in this edition, the amount of money involved in buybacks is not insignificant, and like I said, business appears to be booming. (After the subprime crash due diligence firms saw their business tank only to revive recently.)

The larger due diligence firms - Clayton and Opus being at the top of heap - are paying their contractors via the W-2 but according to some grunts I talked to some of the smaller players are not. What's at stake is this: if an underwriter is paid via a W-2 the Social Security tax payment (12.4%) is split between the company and the worker. The same goes for the Medicare payment which comes to 2.9%.

But if a due diligence firm says that their underwriters (many of whom are freelancers but are regulars) are not really employees, that means they can file a 1099 Form and let the worker worry about the tax payments - the full 12.4%.

By doing this, the due diligence firm can save a ton of money upfront. And not only that, the due diligence firm can gain a potential advantage in bidding for contracts because they're putting less money out of pocket and can offer their services more cheaply.

Corissa Verbeski, a managing director for Opus in Lincolnshire, Ill., said her firm pays via a W-2 and she's none-too-happy that some of her competitors are not. "The use of 1099s over W-2s creates a competitive disadvantage for those firms paying via W-2," she said.

Ms. Verbeski said this pricing allows these companies to "offer lower pricing" to their Wall Street and bank customers.

Who are these non-W-2ers? Well, there's roughly seven of them that I know of. I contacted a few and got little in the way of replies.

One of the better-known firms on the list is Allonhill, based in the Denver area. One contractor who works for the company told me he is considered a 1099 worker and is none too happy about the situation. Not only does this contractor have to foot the tax bill because he's considered a sole proprietor, he must make his own payments for unemployment insurance and workers compensation - money a due diligence firm does not have to pay. It also means this contractor, if he loses his assignment, cannot easily collect unemployment.

Michael Foote, a veteran mortgage banker from California who doesn't like the situation one bit, told me it's all about due diligence firms avoiding payroll taxes. "It's just sad how much some firms get away with," he said. Mr. Foote believes all players in the mortgage market should W-2 their employees.

As for Allonhill, its CEO Sue Allon did not respond to telephone calls and e-mails. Eventually she issued a comment through a spokesman saying, "Allonhill conducts its business in compliance with applicable laws, including those governing employment. We do utilize independent contractors from time to time to perform services when it is appropriate to do so, and we pay independent contractors in accordance with pertinent legal requirements."

She added, "We predominantly employ full-time and temporary employees and adhere to the laws that govern these employee classes."

The whole W-2 controversy may not be a big deal in the scheme of things, but the due diligence industry is just getting on its feet again.

New York state attorney general Andrew Cuomo put them under a microscope for their role in the subprime mess, and another mark against this industry might send these firms reeling once again.