The Tax Consequences of Reclassifying an Employee as Self-Employed

A church’s liabilities.

Lucas v. Commissioner, T.C. Memo. 2000-14 (2000).

Background. The Tax Court addressed a question recently that will be of interest to church treasurers. A company treated one of its workers (“John”) as self-employed for 1995, and as a result did not withhold income taxes or FICA taxes from his wages. It assumed that John would pay his own income taxes and self-employment (social security) taxes using the quarterly estimated tax procedure. In fact, John did not pay the full amount of his income taxes.

The IRS later audited John, and determined that he was an employee and not self-employed in 1995. The question then was who was legally responsible for the underpayment of John’s income tax? John claimed that 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. He relied on IRS Publication 15 (“Circular E”), which states:

You [meaning the employer] will be liable for Social Security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a nonemployee.

The Tax Court’s ruling. The Court rejected John’s argument, noting that “IRS publications are not authoritative sources of federal tax law.” It noted that section 3509 of the tax code specifies that an employer who fails to withhold income tax from an employee’s wages (because it misclassified the employee as self-employed) is subject to a penalty equal to 1.5 percent of the employee’s wages (3 percent if no 1099 was issued). However, the Court also noted that section 3509 “specifically provides that the employee’s liability for income tax shall not be affected by the assessment or collection of any tax determined against the employer under section 3509. In other words, the employee 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 Court concluded:

It is unfortunate that [the company] did not ask [John] to complete a Form W-4 for the year in issue and did not withhold income tax from [his] wages. If it had done so, there might not have been any deficiency in income tax in respect of such wages. However, [it] never withheld, and [John] was paid his gross wages without any reduction for withheld income tax. As a consequence, there is a deficiency in income tax for which [John] is liable.

Application to church treasurers. It is often difficult for church treasurers to know if a worker is an employee or self-employed. This case illustrates the following possible consequences when a worker is improperly classified as self-employed:

1. The worker’s liability. If a church treats a worker as self-employed 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 fails to pay the correct amount of income taxes using the quarterly estimated tax procedure, he or she cannot hold the church liable for the unpaid taxes on account of the church’s misclassification and failure to withhold the correct amount of taxes.

Key point. It is common for self-employed workers to underpay their estimated taxes. One reason is that they have insufficient funds available to pay the full amount of their quarterly tax installments. Another reason is unfamiliarity with the estimated tax procedure. As a result, whenever a church misclassifies a worker as self-employed, there is a risk that the worker will underpay his or her taxes.

2. The church’s liability. The failure by an employer (including a church) to withhold payroll taxes from a self-employed worker who 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 the employee’s share of FICA taxes (40 percent if no 1099 was filed)
  • the employer is liable for the full employer’s share of FICA taxes
  • the employer is liable for the full amount of the employee’s taxes if it intentionally disregards the withholding rules

Example. Joan is a part-time secretary at her church, and works 20 hours per week at an annual salary of $10,000. The church treats Joan as self-employed, and she pays her income taxes and self-employment (social security) taxes by using the quarterly estimated tax procedure. The church issued Joan a 1099 form for compensation paid in 1999. 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: (1) She is responsible for the underpayment, and cannot transfer this liability to the church on the ground that it failed to properly classify her as an employee and withhold the correct amount of income taxes. (2) The church is liable for an “income tax” penalty of $150 (1.5 percent of Joan’s wages). (3) The church is liable for a “FICA” penalty of $153 (20 percent of Joan’s share of FICA taxes). (4) The church is liable for the full employer’s share of FICA taxes, or $765 ($10,000 times the employer’s FICA tax rate of 7.65 percent).

Example. Same facts as the previous example, except that Joan paid the correct amount of taxes using the estimated tax procedure. The church’s liabilities are the same as in the previous example.

Example. Same facts as the previous example, except that the church did not issue Joan a 1099 form for 1999. Because it failed to issue a 1099 form, the church’s “income tax” and “FICA” penalties are doubled to $300 and $306.

Example. A church treasurer decides to treat all lay employees as self-employed in order to avoid having to withhold taxes and comply with the payroll tax reporting requirements. Since this amounts to an intentional disregard of the withholding requirements, the church is potentially liable for all of its employees’ taxes.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

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