When the IRS reclassifies a self-employed worker as an employee, there usually are tax consequences—an increase in income taxes and a decrease in social security taxes. Income taxes are increased because self-employed taxpayers can claim a number of "above the line" deductions on their income tax return that are not available to employees. These include deductions for half of a taxpayer's self-employment tax, a portion of the taxpayer's health insurance premiums, and contribution to a "Keogh" retirement plan. Income taxes also will be increased if the taxpayer has business expenses that are either unreimbursed, or reimbursed under a "nonaccountable" arrangement. Such expenses are fully deductible by self-employed persons, but only partially (if at all) by employees. On the other hand, social security taxes are slashed when a self-employed worker is reclassified as an employee, since the social security and Medicare tax rate for employees is 7.65 percent compared to the "self-employment tax" rate of 15.3 percent.
When the IRS reclassifies a self-employed worker as an employee, can it "offset" a "refund" of excess social security taxes by the additional income tax liability? Or, must it refund the entire overpayment of social security taxes, and charge the taxpayer for the additional income tax liability? In a recently published internal memorandum, the IRS said that it will offset the refund by the additional income tax liability. FSA 1992-116.1.
Example. Assume that a church treats its full-time custodian as self-employed. It does not withhold taxes from his pay and issues him a 1099 form at the end of each year. The IRS reclassifies the custodian as an employee. The custodian will be entitled to a refund of the excess social security taxes he paid as a self-employed person, but the IRS can offset this refund by the amount of the custodian's additional income tax liability.