Business groups in Los Angeles and throughout the state are opposing a Democratic leadership proposal that companies withhold 3 percent of their payments to independent contractors and turn that money over to the state.

The proposal, which could generate up to $2 billion in one-time revenues for the state, first surfaced last year, but was vetoed by Gov. Arnold Schwarzenegger during budget negotiations. Now, it has reappeared in the state Senate Democratic Caucus budget proposal, and business groups fear it could squeak through.

The state Franchise Tax Board estimates the withholding tax would raise between $1.5 billion and $2 billion during the first year for the state, but much less in subsequent years as refunds would be paid back to independent contractors.

But in that first year especially, the tax would represent a hit to the cash flow of independent contractors, especially those in low-margin industries.

Examples of independent contractors range from personal trainers to freelance special-effects artists. The withholding proposal would affect thousands of businesses and hundreds of thousands of workers.

Take Beneficial Exterminating Inc., a company in Hawthorne that provides tents and other accessories to the pest exterminating industry. Beneficial Exterminating is considered an independent contractor since it receives IRS 1099 forms each year from its major customers.

“For our industry, we work on such thin profit margins, withholding 3 percent will severely impact the ability to meet cash flow demands,” said Lee Whitmore, vice president of Beneficial Exterminating. “Those margins are already stressed because of the recession. Taking 3 percent off the top could push some companies over the edge – or could result in higher prices for the customers.”

Most independent contractors in California pay estimated income taxes each quarter, with 70 percent due by June. The proposed 3 percent withholding tax would come in addition to the quarterly estimated payments. If an independent contractor’s tax liability is equal to or less than the estimated tax payments, then the contractor gets the 3 percent withholding tax back in a refund. If not, the state keeps whatever is owed and the contractor pays any additional money due on filing.

A wide array of business interests – including the state and local chambers of commerce, trade groups and contracting associations – coalesced to convince Schwarzenegger to veto the withholding tax proposal last year. But now, they are concerned.

“Every year that we face these multibillion-dollar deficits, the options become fewer and fewer, and the odds increase that something like this will pass,” said Marc Burgat, vice president of government affairs for the California Chamber of Commerce.

Democratic leaders have been pushing hard for the withholding tax, saying it’s preferable to making deeper cuts in state programs.

Business groups counter that the withholding tax is really an interest-free loan from independent contractors to the state and that it won’t address California’s long-term budget deficit. They favor going after businesses that don’t pay their taxes.

“This is a state-mandated low-interest loan on the backs of this state’s small businesses,” Burgat said.