The employment tax provisions of the Internal Revenue Code impose a number of obligations on employers with employees. Generally, an employer must withhold social security, Medicare and income taxes on wages paid to employees. In addition, an employer must pay its share of FICA taxes and pay federal unemployment tax (FUTA) based on wages paid to employees.
* An employee misclassified as an independent contractor raises several issues for an employer including:
* the employers liability for payroll taxes that should have been collected and/or paid;
* the availability of Act Sec. 530 relief;
* the employer's right to have the IRS's classification of an employee by the Tax Court;
* the employer's ability to participate in the IRS's Classification Settlement Program.
Effect of Worker Reclassification
Reclassification of a worker's status affects both the worker and the employer. A worker classified as an independent contractor is self-employed and, therefore, pays self-employment tax instead of FICA. An employer whose workers are reclassified as employees may owe both its share and its employees' share of FICA. Such a reclassification can create a large tax liability.
Worker Reclassification - Effect on Worker
When a worker who has been treated as self-employed is reclassified as an employee, he no longer pays self-employment tax. Instead, he pays social security and Medicare (FICA) taxes.
Employees who have been misclassified as independent contractors use Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report the employee's share of uncollected social security and Medicare taxes due on their compensation. Using Form 8919 allows the employee's social security and Medicare taxes to be credited to the employee's social security record. See Example Form 8919 below.
A worker who files Form 8919 loses the ability to deduct business expenses on Schedule C, since employee expenses are deductible only on Schedule A and are subject to the 2-percent floor for miscellaneous itemized deductions.
Worker Reclassification - Effect on Employer
It is important for an employer to properly classify a worker as an employee or an independent contractor. If an employer erroneously classifies an employee as an independent contractor, and has no reasonable basis for doing so, the employer is liable for employment taxes.
The individuals responsible for withholding and paying the taxes can be held personally liable for a penalty equal to the tax. This is called the trust fund recovery penalty. The determination may also affect any retirement or benefits plans maintained by the employer.
Because of the serious tax deficiencies that can arise when workers are misclassified, Code Sec. 3509 fixes an employer's liability for employment taxes at a fraction of the amount that should have been withheld. Thus, Code Sec. 3509 provides relief to employers who would otherwise be liable for the full amount of such taxes.
Employer Liability for Reclassified Workers' Taxes
If, during any calendar year, an employer fails to deduct and withhold income or FICA tax from an employee's wages by reason of treating the employee as a non-employee, the employer's liability for those taxes is generally calculated as follows:
* The employer's liability for an employee's income tax withholding is 1.5 percent of the wages paid to the employee for the year.
* The employer's liability for the employee's share of FICA taxes is 20 percent of the actual amount imposed under those provisions for the year (Code Sec. 3509(a)).
Under these rules, an employer has failed to deduct and withhold tax when it fails to pay the total tax required to be withheld during the calendar year by the due date of the employment tax return for the final quarter of that calendar year (Reg. Â§31.3509-1(b)(1)).
Exceptions to the Employer Liability Rules
An employer who fails to timely file any return or statement, such as a Form 1099-MISC, required for consistent treatment of the worker as a nonemployee must pay an increased amount, The employer's liability doubles to 3 percent for income tax withholding and 40 percent for FICA tax withholding (Code Sec. 3509(b)).
Further, no rate relief under Code Sec. 3509 applies at all when:
* the employer withheld income tax but not FICA tax, or
* the employer intentionally disregarded its obligation to deduct and withhold the tax.
An employer has intentionally disregarded the requirement to deduct and withhold a tax if it intentionally fails to deduct and withhold the full amount of the tax from an employee's wages paid after the employer ascertained the worker's status as an employee (Prop. Reg. Â§31.3509-1(d)(4)).
These employer liability rules do not apply to FICA tax for statutory employees. This exception applies even if the statutory employee is also an employee by reason of his status as a corporate officer or a common law employee (Code Sec, 3509(d)(3)).
Satisfying Employer Misclassification Liability
An employer's worker misclassification liability may not be collected from an employee and the employer may not offset the liability against any tax the employee has paid.
On the other hand, an employer's misclassification liability is satisfied to the extent that the employer actually withheld tax from the employee's wages and paid it to the IRS. However, if the amount withheld, deducted, and paid exceeds the employer's Code Sec. 3509 liability, the employer may not claim a refund or credit for the excess amount.
Code Sec. 3509 applies only to the employee's share of FICA. The employer remains liable for its share of FICA. Similarly, an employee's FICA and income tax liability is not affected by assessment or collection of any tax under Code Sec. 3509. In addition, any amount assessed or collected under Code Sec. 3509 is not credited against the employee's tax liability (Code Sec. 3509(d)(1); Prop. Reg. Â§31.3509-1(d)(1)).
Employers may use Code Section 3509 to calculate their liability when a worker reclassification results from an IRS enforcement action in an examination, or when the employer receives a determination letter from the IRS reclassifying a worker as an employee.
Act Sec. 530 Safe Harbor Relief from Liability
An employer may be relieved of misclassification liability if the employer had a reasonable basis for treating the worker as an independent contractor. Act Sec. 530 of the Revenue Act of 1978, as amended, is a safe harbor for employers that misclassify workers. For purposes of the employment tax provisions when:
* a taxpayer did not treat an individual as an employee for any period, and
* the taxpayer filed all required federal tax returns (including information returns) as if the individual were an independent contractor (Rev. Proc. 85-18), then the individual is treated as not being an employee for that period.
This exception does not apply if the employer had no reasonable basis for treating the individual as an independent contractor. In addition, the employer may continue to treat the individual as an independent contractor.
The IRS must provide the employer with written notice of Act Sec. 530 at the beginning of any worker classification audit.
The notice requirement is fulfilled by IRS Pub. 1976, Independent Contractor or Employee, if delivered to the employer by the agent when commencing the payroll audit.
Act Sec. 530 relief is available even if the worker is a common-law employee.
Act Sec. 530 relief does not apply to a three-party transaction in which the taxpayer arranges with a second party for a third party to provide the services as a technical service specialist.
A technical service specialist is an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work (Notice 87-19). The worker status of a technical service specialist in such three-party arrangements is determined under common law principles. However, Act Sec. 530 relief applies when a taxpayer directly contracts with a worker to provide services for the taxpayer.
Reasonable Basis for Classifying Worker
To obtain Act Sec. 530 safe harbor relief, the business's basis for treating the worker as an independent contractor must be reasonable.
The IRS has identified three safe harbors that provide a reasonable basis under Act Sec. 530 for treating a worker as an independent contractor:
* judicial precedents or rulings,
* prior audit, and
* long standing recognized practice.
If an employer relies on any of these safe harbors, it meets its burden of proof by simply establishing a prima facie case. The IRS bears the burden of proving the employer wrong as long as the employer cooperates with the IRS's investigation.
The IRS's position is that Act Sec. 530 relief is not available if the employer has not timely filed Forms 1099 for the workers involved (Internal Revenue Manual (IRM) 184.108.40.206.2.1(2)(A)).
In contrast, the Tax Court has held that Act Sec. 530 does not require timely filing; therefore, late filing of Forms 1099 would not preclude a taxpayer from qualifying for Act Sec. 530 relief (Medical Emergency Care Associates, S.C., Dec. 55,154, 120 TC 436).