Are you currently using the services of an independent contractor? Are you sure? Let’s look at some examples–and the applicable rules.

A company treated one of its workers, Pete, as an independent contractor for 1995 and did not withhold income taxes or FICA taxes from his wages. The company assumed that Pete would pay his own income taxes and self-employment (social security) tax.

In fact, Pete did not pay the full amount of his income taxes. The IRS later audited Pete and determined he was an employee and not an independent contractor self-employed in 1995. The question then: Who was legally responsible for the underpayment of Pete’s income tax? Pete claimed his employer was responsible for his income tax liability for 1995 because it failed to withhold these taxes from his wages when they were earned. Tax Court rejected Pete’s argument and agreed with the IRS. In other words, the worker remains fully liable for income tax arising from the receipt of gross wages.

Therefore, even though the company misclassified John as self-employed and failed to withhold income taxes, he remained liable for his own income taxes for the year. The employer was, however, fined penalties for failing to withhold taxes. Now let’s take a detailed look at both the worker’s and employer’s liabilities for improperly classifying an employee as an independent contractor:

The Worker’s Liability
If an employer treats a worker as selfemployed who is later reclassified as an employee by the IRS, the worker remains liable for paying his or her own income taxes. If the worker originally failed to pay the correct amount of income taxes, he or she cannot hold the employer liable for the unpaid taxes on account of the employer’s misclassification and failure to withhold the correct amount of taxes.

In fact, self-employed workers often underpay their taxes. One reason is that they spend the money and do not have it available to pay the tax. Another reason is unfamiliarity with how they should file and pay the tax. As a result, whenever an employer misclassifies a worker as self-employed, there is a risk that the worker will underpay his or her taxes.

The Employer’s Liability
The failure by an employer to withhold payroll taxes from a self-employed worker whom the IRS later reclassifies as an employee has the following consequences: The employer is liable for an “income tax” penalty of 1.5 percent of the employee’s wages (3 percent if no 1099 was filed), the employer is liable for a “FICA” penalty of 20 percent of theemployee’s share of FICA taxes (40 percent if no 1099 was filed), and the employer is liable for the full employer’s share of FICA taxes. In addition, the employer is liable for the full amount of the employee’s taxes if it intentionally disregards its withholding role.

More Examples Joan worked part-time and earned $10,000 for the year. Her employer treats Joan as self-employed, and she pays her income taxes and self-employment (social security). The employer issued Joan a 1099 form. Joan’s 1999 tax return is audited, and she is reclassified as an employee by the IRS. If Joan failed to pay the correct amount of income taxes for 1999, then she is responsible for the underpaid tax.

The employer incurs a penalty of $1068. The penalty is made up of (1) 1.5 percent of Joan’s wages (2) 20 percent of Joan’s share of FICA taxes (3) the full employer’s share of FICA taxes of 7.65 percent. Even if Joan had paid the correct amount of taxes, the employer’s penalty is the same. If the employer did not issue Joan a 1099 form, penalties are increased to $1674.

If an employer decides to treat all employees as self-employed to avoid withholding taxes, this is considered intentional disregard, and the employer is potentially liable for all of its employees’ taxes.

Unsure of your situation now? The members of SBRN’s Accounting Network are just a phone call away—and ready to work for you.

Mark Wilkinson was SBRN’s 1999
president and is a partner with
Hartman, Blitch & Gartside, CPAs. He
specializes in audits, tax planning and
profit analysis, and can be reached at
396-6675 or maw@hbgcpa.com.