Background. A company hired a new employee (“Mike”). By mutual agreement, the company paid Mike a fixed monthly sum, and then reduced it by 25% in order to cover Mike’s social security taxes and income taxes. Mike generally worked 40 hours each week, and was provided an office, a telephone, and a computer by the company. His duties were directed and controlled by the company. Despite these facts, the company treated Mike as an independent contractor for federal tax reporting purposes, and did not use any of the withheld wages to pay taxes.
Mike informed the IRS that he had not received a Form W-2 at the end of his first year of employment. He requested assistance regarding how he should complete his tax return, and in particular, how he should report his wages and the tax that was withheld. The IRS instructed Mike to include a Form 4852 (substitute W-2) with his tax return. Mike did so. On the Form 4852 he calculated income tax withholding of $2,700 and FICA tax withholding of $1,200, for a total of $3,900. These amounts represented the 25% of wages that had been withheld. In completing his federal tax return (Form 1040), Mike claimed a credit of $3,900 for withheld taxes.
Because Mike had no written documentation to substantiate his withholding arrangement with his employer, the IRS declined to give him credit for withholding. Mike appealed to the Tax Court which ruled that the $3,900 withheld from his wages by his employer should have been allowed as a credit against taxes owed by the IRS.
The Court noted that section 31(a)(1) of the tax code specifies that “the amount withheld as tax … shall be allowed to the recipient of the income as a credit against the tax imposed.” The tax regulations explain this provision as follows,
The tax deducted and withheld at the source upon wages … is allowable as a credit against the tax imposed … upon receipt of the income. If the tax has actually been withheld at the source, credit or refund shall be made to the recipient of the income even though such tax has not been paid over to the government by the employer.
The Court observed,
When net wages are paid to the employee, the taxes that were, or should have been, withheld are credited to the employee even if they are never remitted to the government; so the IRS has recourse only against the employer for their payment. This construction does not prejudice the rights of the IRS in any way. In fact, the tax code itself places the burden of tax remittance on the withholding agent …. In light of the IRS’s ability to monitor and punish a withholding agent for its illegal retention of withholding payments, it is unnecessary and unjust to hold an innocent taxpayer responsible for such illegal acts by preventing the adjudication of a refund claim.
The Court concluded that Mike had established that his employer withheld 25% of his compensation to cover his income tax and social security withholding and that these amountswere never remitted as withholding to the IRS. As a result, Mike was entitled to a tax refund of the amounts actually withheld by his employer and for which the IRS denied a credit against taxes on Mike’s Form 1040.
Relevance to church treasurers. Churches that withhold an amount from a worker’s compensation to cover income taxes and social security taxes remain fully liable for the amount withheld. If for any reason the church fails to remit the withheld taxes to the IRS, it will remain fully liable for the amount withheld and cannot transfer this liability to the worker. In this case, the employer attempted to evade its legal obligation by retroactively classifying Mike as an independent contractor. Such efforts usually will not work, especially in cases such as this where the worker is clearly an employee. Winter v. United States, 2000-2 USTC ¶50,780 (S.D. Tex. 2000).
Key point. A related question is the liability of an employer and employee if the employer fails to withhold any federal taxes. That issue is addressed in the April 2001 issue of Church Treasurer Alert.
This content originally appeared in Church Treasurer Alert, July 2001.