Employee or Contractor? There Is a New IRS Program

One of my individual tax clients came in around ten days ago. He brought his 2010 tax information, including a cleaning business reported as a proprietorship (technically it is a single-member LLC). I noticed that his payroll stopped somewhere during quarter 4, 2010. This of course prompted the question: why?

I suppose I did not need to ask. I have heard it before: the payroll taxes, including workers compensation, were becoming expensive. He consequently moved everyone over to a “Form 1099,” figuring that would solve his problem.

Let’s go through the steps: (1) If you can control and direct them, they are not contractors – they are employees; [2] removing them from payroll does not make them contractors; [3] issuing a 1099 at the end of the year (which he did not do, by the way, because I would have done it) does not make them contractors; and [4] a very important person – the IRS – may disagree with your opinion that they are contractors. If they disagree, the IRS may want the payroll taxes from you anyway. You would have gained nothing except an IRS audit and my professional fee for representing you.

Yep, I got stern with my client. I do not like dumb, and what he did was dumb. Payroll tax problems can get very messy – and absurdly expensive - very fast. I told him to restart the payroll.

The reason for this story is that the IRS came out this month with a “Voluntary Classification Settlement Program.” The program allows employers a chance to reclassify independent contractors and limit their resulting federal payroll taxes. To participate one must have consistently treated the individuals as contractors (that would eliminate my client) and have filed all Forms 1099 (again eliminating my client). One cannot currently be under audit, as there is a separate program for those under audit. One also has to agree to extend the statute of limitations assessment period for each of the three years going forward.

In return, one gains a substantial tax break. Before explaining, I would like to review Section 3509 of the Internal Revenue Code:

3509(a)In General.— If any employer fails to deduct and withhold any tax  … with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for—

3509(a)(1)Withholding taxes.— Tax … for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages…paid to such employee.

3509(a)(2)Employee social security tax.— Taxes … with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph.

Let’s go over the math:

                                Employer share of FICA                             7.65%

                                Employee share of FICA                            1.53%  (i.e., 7.65% times 20%)

                                Employee federal income tax                  1.50%

                                                                                                      10.68%

So that reclassification is going to cost you an immediate 10.68%, plus penalties and interest.

The new program will allow one to

·   pay 10% of the tax otherwise due, which is 1.07% (10.68% times 10%)

·   limited to one year

·   no interest or penalties, and

·   the IRS will not conduct an employment tax audit with respect to one’s worker classification for prior years.

This is a pretty good deal.

Remember that the IRS’ new position (although they deny it) is that virtually anyone who does anything for anybody is an employee. Please remember to fork-over that social security tax, thank you. If you are “walking the line” on worker classification, please consider this program.