Employer Misclassification of Workers - John R. Dundon II, Enrolled Agent
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Employer Misclassification of Workers

Employer Misclassification of Workers

The IRS and Department of Labor have joined forces to reduce employer misclassification of workers. Last fall, the IRS began auditing 6,000 companies to determine if they have misclassified workers as independent contractors or properly classified the workers as employees and paid the required employment taxes.

If an individual who has been treated as an independent contractor for tax purposes is notified that his/her worker status is actually that of an employee, the IRS will often require corrections to that person’s prior returns. Such a determination impacts the reporting of income and deductions, which in turn affects earned income credit, AMT, and any deductions based on adjusted gross income (AGI).

Individual workers who were not treated as employees most likely filed as self-employed, reported income and deductions on Schedule C, Profit or Loss From Business, and paid self-employment (SE) tax on the net result. These individuals are now required to report the income and expenses as an employee, so many of the deductions that were taken as business expenses on Schedule C will be lost.

Because their expenses must now be reported as employee business expenses on Form 2106, Employee Business Expenses, and carried to Schedule A, Itemized Deductions, the deduction often vanishes when subjected to the 2-percent of AGI limitation.

Reclassification from a self-employed individual to an employee also affects adjustments to income on Form1040, U.S. Individual Income Tax Return. One such adjustment is the deduction on Form 1040, Line 27, for one-half of the self-employment (SE) tax paid. As an employee, that deduction is eliminated, as well as any other deduction originally allowed as a self-employed individual, such as a deduction for self employed health insurance (Line 29), or a self employed SEP, SIMPLE, or other qualified retirement plan contribution (Line 28).

Instead of paying self-employment tax, the employer and employee are each responsible for paying one-half of the total FICA and Medicare tax.

Usually, FICA and Medicare tax is taken out of each paycheck and calculated on the gross amount of wages, as reported on Form W-2 and on Line 7 of Form 1040. If the individual is still employed, he/she needs to pay any of the current year’s federal income tax withholding (FITW), based on the current year wages, before the end of the tax year. If the individual is no longer employed, the employer is ultimately responsible for payment of the FITW and needs to arrange for reimbursement, if any, from the reclassified employee. If the employer pays the FITW, the employee’s gross wages reported on Form W-2 need to include the amount of withholding paid by the employer.

Since this reclassification is generally determined after the individual has been paid for the services rendered, both the employer and the reclassified employee are responsible for paying a portion of any FICA and Medicare on the reclassified wages.

The employee portion of FICA and Medicare is reported on Form 8919, Uncollected Social Security and Medicare Tax on Wages, and attached to either an original or amended return.

For tax years prior to 2007, use Form 4137, Social Security and Medicare Tax on Unreported Tip Income. Cross out the word tip(s) and replace it with the word wage(s). This form is attached to Form 1040 or Form 1040X, as applicable.

If a refund is due the employee, the normal statute of limitations applies. Therefore, any original or amended return must be filed within three years of the due date of the original return or within two years after the date the tax is paid, whichever is later.

After Form 8919 (or Form 4137) is processed, this income will be reported to the Social Security Administration as wages earned.

Note: The employer portion of the employment taxes is reported on Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. For more information, see Pub. 4341, Information Guide for Employers Filing Form 941or Form 944, Frequently Asked Questions About the Reclassification of Workers as Employees.

A complete copy of Notice 989, Commonly Asked Questions When IRS Determines Your Work Status is Employee, is available at www.irs.gov/pub/irs-pdf/n989.pdf.